Department of Labor's Fiduciary Rule Will Have Substantial Effect
Morningstar analyst Michael Wong examines the impact on the financial sector.
The U.S. Department of Labor has released its finalized conflict of interest rule for financial advisors. We believe this fiduciary standard will disrupt many business models in the industry. We've already seen the exit of several foreign banks ( Barclays (BCS), Credit Suisse (CS), Deutsche Bank (DB)) from U.S. wealth management, sale of life insurance retail advisory businesses ( American International Group (AIG), MetLife (MET)), and restructuring of wealth management platforms (LPL Financial, RCS Capital, Waddell & Reed Financial (WDR)) in anticipation of the rule. The finalized fiduciary standard is in many ways more lenient than the initial proposal, especially in terms of the operational feasibility of the best-interest contract exemption. That said, a couple of areas of the rule were made even more restrictive, and the rule still has teeth through the best-interest contract as a litigation-based enforcement mechanism. We believe compliance with some of the rule's provisions may cause changes not only in how financial advisors service retirement accounts, but also in how they serve taxable accounts.
Through the fiduciary rule's ability to influence the policies and procedures of wealth management firms and the behavior of financial advisors to many tax-qualified accountholders, the entire value chain from financial product manufacturers to financial product distributors and investors has to be reconceived.
Our primary estimate of the assets that will be subject to a new fiduciary duty is $3 trillion of advised, commission-based brokerage IRA assets. In addition, we estimate that advice services are being offered to approximately $4 trillion of private, defined-contribution plan participant assets, and that there's upward of $800 billion of plan assets that are using advice and could be subject to the rule. Advice providers to private defined-contribution plan participants need to double-check that how they formerly advised or managed assets on behalf of retirement plan participants remains in line with the Department of Labor's updated rule.
The finalized rule classifies advice on rollovers from an employer-sponsored plan to an IRA as fiduciary advice. Besides broker/dealer advisors that have to comply with the full best-interest contract, even level-fee registered investment advisors have to comply with the streamlined best-interest contract that requires acknowledging fiduciary status and documenting why the rollover is in the best interest of the client. The documentation must take into account the difference in fees and services between the employer-sponsored plan and the IRA. Because of the increased compliance procedures and potential difficulty in justifying a rollover, it's reasonable to believe that more assets will stay in employer-sponsored plans like 401(k)s.
Assets staying in 401(k) plans will benefit retirement plan platform providers while reducing net inflows to wealth management firms. According to the Investment Company Institute, 63% of households with traditional IRAs used a professional financial advisor as a source of information when making their rollover decision. Translating this into dollar terms, we estimate that over $200 billion of annual rollover assets will be covered by the fiduciary rule. Looking at rollovers from the perspective of financial advisors that may decline to advise small-balance clients, we estimate that nearly $50 billion of IRA rollovers are for amounts less than $100,000 and about $10 billion of IRA rollovers annually are from households that don't possess $100,000 of total investable assets.
Based on the Department of Labor's cost estimates, the aggregate value of the affected firms would decrease by approximately $15 billion if the costs aren't mitigated or offset by additional revenue opportunities. The value impact on the sector can also be much greater or smaller than $15 billion based on an increase or decrease of the affected revenue, which we estimate at around $19 billion, or costs that haven't been quantified, such as penalties related to lost litigation. The $15 billion loss for the sector from explicit implementation expenses also understates the gross transfers of value that will occur from firms challenged by the rule, such as alternative asset managers and life insurance companies, to those advantaged by the rule, such as discount brokerages, financial technology companies, and passive investment management firms.
Finalized Rule Ensures Acceleration of Three Key Financial Sector Trends
We believe the fiduciary rule will accelerate three key financial sector trends: the movement to fee-based from commission-based full-service wealth management accounts; adoption of robo-advisors and digital advice solutions; and a shift to relatively lower-cost passive investment products from actively managed.
Through 2015, the movement to fee-based accounts from commission-based continued. Morgan Stanley's (MS) proportion of fee-based assets increased 1.3 percentage points, while Raymond James' (RJF) increased 2.4 percentage points. Stifel Financial's (SF) proportion actually decreased 0.7 percentage point, but this was probably due to the account mix of the firm's 2015 Sterne Agee and Barclays U.S. wealth management acquisitions.
From 2014 to 2015, the client assets at several of the leading robo-advisors increased over 150%. We continue to believe that the stand-alone robo-advisors, like Wealthfront, are a logical landing place for clients with low account balances that may be unprofitable for full-service wealth management firms. Capturing just a fraction of the $250 billion-$600 billion of low-account-balance assets will accelerate these robo-advisors' growth by several years and bring them closer to our estimated $16 billion-$40 billion client asset break-even point.
While the fiduciary rule will be a boost to the robo-advisors that serve investors directly, it will be an even greater accelerant to robo-advisors or digital advice technology used by the established full-service wealth management firms. Digital advice companies that support wealth management firms should experience a more explosive growth rate than that experienced by the robo-advisors serving investors directly, as they can quickly leverage the advisor networks they tap. BlackRock's (BLK) FutureAdvisor unit has already signed agreements with LPL Financial and Royal Bank of Canada (RY) since the beginning of 2016. The wirehouse wealth management firms are exploring digital advice solutions as well. For firms without core competencies in design, technology, and investing, partnering with an established robo-advisor makes economic sense.
We put the potential shift to passive investment products after the rule at over $1 trillion from the amount of mutual fund assets held in affected IRAs and robo-advisor opportunity. We believe passive investment share will accelerate from the reduction in potential conflicts of interest stemming from third-party payments, increased adoption of robo-advisors, and total cost balancing. We also think firms with previously more-closed architecture may add products like index-based target-date funds to supplement their limited product menu. Index-based target-date funds should also benefit from more assets staying in defined-contribution plans from enhanced fiduciary rollover substantiation requirements.
Digging down into just the shift of assets into exchange-traded funds, not including passive index funds, we estimate a reasonable opportunity upward of $140 billion based on the ETF product allocation difference between RIAs that are currently under a fiduciary standard and broker/dealer advisors under a suitability standard.
Fiduciary Rule Brings Challenges and Opportunities
We believe the fiduciary rule will disrupt the financial services sector, with both positive and negative effects on financial industries and firms. We expect the beneficiaries will be discount brokerages, financial technology companies including robo-advisors, and providers of passively managed products (primarily index funds and exchange-traded products like ETFs). There will be a mixed effect on active asset managers and full-service wealth management firms, while certain alternative asset managers and life insurance companies will be challenged.
Rule Has Positive and Negative Repercussions Throughout Financial Sector
We see the financial technology and information companies as playing a key role in efficiently addressing some of the requirements of the rule and as a preventive measure for reducing legal liability risks. Given the increased compliance costs of the rule, wealth management firms will have an even greater incentive to streamline their workflows to offset these costs. Financial software providers that can help increase the productivity of financial advisors will become more ingrained and valued partners of wealth management firms.
The best-interest contract requires financial advisors to act prudently and receive only reasonable compensation. We believe advisors and financial institutions will have to use more data and analytics to substantiate their best-interest obligations. Examples of best practices include benchmarking of financial product expenses to support reasonable compensation, benchmarking of plan expenses for rollovers, outside research to justify recommendations, and account aggregation capabilities to ensure that advisors using a limited menu of products don't imprudently overallocate, such as to proprietary alternative asset products. Savings in time and legal costs should more than make up for these additional measures.
Scalable advice and investment management enabled by technology will be in higher demand. Firms and advisors may find it especially effective to use a digital advice or investment management service to handle low-balance retirement accounts. This will allow advisors to focus more of their time on higher-balance taxable accounts and potentially move some fiduciary responsibilities and compliance burdens to outside parties. Multiple full-service wealth management firms are also developing their own in-house digital advice solutions. Because the economics of robo-advisors can be challenging, it might make more sense for many firms to partner with an existing one rather than develop their own.
We believe discount brokerages like Charles Schwab (SCHW) and TD Ameritrade (AMTD) stand to benefit from the rule. However, we've already seen competitive adaptation from the full-service wealth management firms.
Our assessment that discount brokerages will benefit is based primarily on our estimate that full-service wealth management firms currently have $250 billion-$600 billion of client assets in small-balance IRA relationships that may become unprofitable after the fiduciary rule takes effect. Wealth management firms have begun adopting solutions to address small-balance accounts, and to the extent that these initiatives keep assets in-house, there will be less for discount brokerages to pick up. That said, capturing just a fraction of the potential assets would be value-accretive to the discount brokerages.
On the operational front, the discount brokerages aren't fully immune from the rule. For the do-it-yourself side of their businesses, we see primary issues being related to IRA rollover and general investment education that IRA investors might access from the firms, as the firms generally don't want education to cross the line of being considered a financial recommendation. For their RIA businesses, they'll probably have to add to their compliance and support systems. There are also company-specific issues, such as if they employ branch advisors that fall under the fiduciary rule, usage of proprietary products, or any additional responsibilities of providing a retirement plan platform.
Index and Exchange-Traded Product Providers
Index and exchange-traded product providers like BlackRock, Charles Schwab, London Stock Exchange (LSE), MSCI (MSCI), State Street (STT), and Vanguard are already benefiting from the secular trend toward lower-cost passive investment products, but the shift will accelerate after the fiduciary rule for five reasons: reduction in potential conflicts of interest stemming from third-party payments; increased adoption of robo-advisors and digital advisory services; total cost balancing; inclusion in platforms with previously more-closed architecture; and use of index-based target date funds in defined-contribution plans that will retain more assets.
We estimate that the total market opportunity is in excess of $1 trillion in assets and that a reasonable estimate of the additional ETF allocation from broker/dealer advisors moving to a fiduciary standard is upward of $140 billion. High incremental margins on passive investment products and index licensing can translate into noticeable bottom-line growth for well-positioned firms. Because we believe robo-advisors will benefit from the rule and are a major emerging distribution channel for financial products, firms with direct ties to a robo-advisor, such as BlackRock and Charles Schwab, are competitively advantaged compared with nonvertically integrated peers.
Active Asset Managers
While the effect of the fiduciary rule on active asset managers-- AllianceBernstein (AB), BlackRock, Cohen & Steers (CNS), Eaton Vance (EV), Federated Investors (FII), Franklin Resources (BEN), Invesco (IVZ), Janus Capital (JNS), Legg Mason (LM), T. Rowe Price (TROW), and Waddell & Reed--is less direct than on full-service wealth management firms, it could still be significant. On the operational side, it's likely that payment structures such as revenue-sharing agreements and 12b-1 fees will need to be reworked and the number of share classes will need to be adjusted based on how the wealth management industry adapts to the rule. Active asset managers with vertically integrated wealth management businesses or a direct business with call center employees who interact with retirement investors are likely to be more directly affected by the rule.
We expect the larger established active asset managers with higher-quality products and niche managers with top-tier investment performance to be more likely to gain market share from their disadvantaged peers as a result of the new rule.
We also expect some of the other characteristics that serve as the foundation of asset manager economic moats--such as product mix, distribution channel relationships, and brand and reputation--to shift the balance to certain active managers at the expense of others. We believe that rating well on these factors will become increasingly important as payments for distribution are curtailed.
Broadly speaking, certain business mixes or product characteristics will lead to more challenges or opportunities for the active asset managers. Those that distribute more heavily through the full-service wealth management channel as opposed to the self-directed or institutional channels, or those that do a lot of subadvisory business for variable annuities, will face more headwinds. High-fee, low-performing funds will also be much harder to justify under a best-interest obligation. With robo-advisors, outsourced fiduciaries, and defined-contribution platforms all expected to benefit from the implementation of the rule, we expect a greater focus on top-performing funds, relatively low-cost funds, products that can work well within fee-based advice arrangements, and funds that fill a distinct role from a portfolio perspective.
Full-Service Wealth Management Firms
While the finalized Department of Labor fiduciary rule is in many ways more lenient than the initial proposal, it will still require that substantial changes be made to the financial sector, and full-service wealth management firms--including Bank of America (BAC), Morgan Stanley, Raymond James Financial, Stifel Financial, UBS (UBS), and Wells Fargo (WFC)--will be the most affected. For most wealth management firms and advisors to continue operating in any semblance of their current form, they will have to comply with the requirements of the best-interest contract exemption, or BICE, to receive prohibited direct or indirect compensation, such as securities commissions, 12b-1 fees, and revenue sharing. The BICE relies on an actual contract that states that the financial institution has a duty to act in the best interest of its clients. As with any contract, its breach opens up the financial institution to legal claims.
We believe the fiduciary rule will affect taxable accounts in addition to tax-qualified accounts. The BICE is administratively feasible, but it will be a task to implement. Many firms will choose to apply the same policies and procedures to tax-qualified and taxable accounts to avoid having two different sets of workflows and systems. Additionally, wealth management firms may treat both tax-qualified and taxable accountholders in accordance with the Department of Labor's fiduciary standard, to avoid the actuality or perception of differing service levels.
Firms can run two separate systems, but it may require much work. The fairly typical ratcheted compensation schedule may have to be revised to not factor in tax-qualified account-related revenue. Compliance departments may also choose to create different lists of financial products that are more suitable for either taxable accounts or tax-qualified accounts.
RIAs are already under a fiduciary standard, but it's a Securities and Exchange Commission standard that isn't wholly congruent with the prohibited transaction-based structure of the Department of Labor's standard. The two more prominent areas where RIAs will have to be careful is with IRA rollovers and if they receive commissions or third-party payments as a hybrid advisor. There is a "level fee fiduciaries" streamlined BICE primarily for rollovers and RIAs. However, while the streamlined BICE does away with the actual contract, it still has the impartial conduct standards of the BICE and requires documentation justifying the move to the level-fee arrangement.
Investment banks with advisors will take an additional hit to their fixed-income business from a less-mentioned modification that came with the fiduciary rule package. An exemption for principal transactions was also released with the rule that is meant to allow the receipt of conflicted compensation mainly related to fixed-income securities. However, the finalized exemption cannot be used for securities underwritten by the advisor's financial institution and certain other securities that may be sold on a principal basis, such as asset-backed securities that aren't guaranteed by an agency. The Department of Labor delivered a jab to the chin of investment banks whose fixed-income businesses are already on the ropes from government regulations on capital and proprietary trading.
Because of the costs of implementation, we expect consolidation in the full-service wealth management industry. Barclays, Credit Suisse, Deutsche Bank, and MetLife all entered into agreements with other U.S. advisor forces. Spreading the fixed costs of the fiduciary rule over a larger head count will reduce the operating margin compression on full-service, commission-based IRAs that we previously estimated at 4-6 percentage points. We also believe those that are considering being or already hybrid advisors may choose to become fee-only RIAs as they weigh the additional compliance costs compared with commissions.
We don't see the Department of Labor's fiduciary rule as uniformly negative for all full-service wealth management players; we believe some firms, particularly those with economic moats, will weather the rule better or even profit from less competitively advantaged peers. Firms may gain from industry consolidation in two ways. The first is through clients consolidating assets at their preferred wealth management firm. No firm has 100% wallet share of their clients, and potentially increasing account minimums will lead clients to bring more assets to a service provider to meet account requirements. The wealth management firms with strong customer relationships built on brands and unique services will be advantaged, such as Bank of America Merrill Lynch, Morgan Stanley, and UBS. The second form of consolidation is of firms. We believe that firms such as Raymond James, Stifel Financial, and Wells Fargo that have both employee and independent channels along with room to fill in geographic footprints are poised to be major consolidators.
There are also revenue and expense offsets to the fiduciary rule for wealth management firms. Fee-based accounts have upward of a 60% higher revenue yield than commission-based accounts. While moving an IRA account from a commission-based to a fee-based arrangement will now require documentation on why that's in the best interest of the client, we expect the fiduciary rule will accelerate this movement and offset some of the compliance costs. Digital advice solutions, process streamlining, outsourcing fiduciary responsibilities, and meaningful analysis justifying that transactions are in the best interest of clients can also increase productivity or reduce costs.
Our overall conclusion regarding full-service wealth management firms is that the Department of Labor's fiduciary rule will disrupt their business operations, advisors will have to substantiate that their actions are in the best interest of their clients, and advisors will, more than ever, have to justify their value to clients.
Alternative Asset Managers
We believe the fiduciary rule will have a negative effect on alternative investment managers. While some alternative products are technically allowed under the best-interest contract exemption, we think that pragmatically speaking, their use by advisors will decline. Many of these alternative products come with relatively high fees, and the bar for justifying them in a retirement account under a best-interest obligation is much higher than for standard products such as mutual funds and exchange-traded real estate investment trusts. The Department of Labor also said it would pay particular attention to the recommendation of these products, that advisors should document why their use is in the best interest of the client, and that continued monitoring of the investment past the initial recommendation may be needed to satisfy the best-interest obligation. The degree to which alternative asset management firms will be affected by the fiduciary rule therefore depends on the willingness and ability of full-service wealth management firms to substantively justify these products in client portfolios.
Among alternative asset managers, we believe Apollo Global Management (APO) will be the most affected via its stake in Athene, but the ultimate impact is mixed. Athene, with about $45 billion in fixed-index annuities is the fourth-largest player in the U.S. after AIG, Allianz (AZSEY), and New York Life and obtains about $3 billion in retail sales annually. With fixed-index annuities included under the best-interest contract exemption, it must work with its distribution partners to adapt. Adapting to the rule is no small task, as industry estimates put about 60%-65% of fixed-index annuity sales within qualified investment accounts affected by the rule.
Life Insurance Companies
Life insurance companies like Ameriprise Financial (AMP), MetLife, Principal Financial Group, and Prudential Financial (PRU) were hit with one of the more negative surprises of the finalized rule, as fixed-index annuities are being put in the best-interest contract exemption along with variable annuities. This probably forced some insurance companies to make a 180-degree shift in their contingency plans, as some were contemplating fixed-index annuity volume replacing variable annuities. A major adaptation that we expect in the life insurance industry is more annuities being made that work well with fee-based accounts. According to Morningstar data, only about 4% of variable annuity sales are structured as fee-based instead of commission. We also believe there will be a greater emphasis placed on benefit riders with variable annuities to validate their compensation payments, as the Department of Labor has expressed skepticism regarding the tax benefits of certain products when used within tax-qualified accounts.
Michael Wong does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.