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Advisor Insights

Will the SEC Promote Investors’ Best Interest?

The proposal leaves several questions unanswered.

In the August/September issue, we summarized the SEC’s proposed Regulation Best Interest. The proposal would require broker/dealers to act in the best interests of their clients and mitigate conflicts of interest. Broker/dealers would not have to operate under the same fiduciary standards that apply to Registered Investment Advisors, but the rule would raise the standard of care for broker/dealers.

Before the period for public comments closed in August, we submitted suggestions to improve the final rule. As the SEC evaluates thousands of comment letters in response to its proposal, we take a step back and summarize what we think are the most important matters the commission needs to consider as it crafts a final rule. We offered suggestions to the SEC for each of the following issues:

  • The requirements for broker/dealers to ensure rollovers from 401(k) accounts or IRAs to other IRAs meet the best-interest standard.
  • The extent to which broker/dealers must mitigate conflicts of interest as opposed to merely disclosing them.
  • Whether the customer relationship summary will truly help investors comparison shop between broker/dealers and RIAs.

Should Rollovers Get Special Treatment?
We urged the SEC to pay special attention to rollovers. In the absence of a clear standard in the regulation to assess whether a rollover should occur from an ERISA plan, which is subject to some of the highest standards of care in law, to a non-ERISA plan, many financial professionals will naturally want to use as lax a standard as possible.

We think the proposed best-interest rule leaves open several important questions about the extent to which broker/dealers must demonstrate that a rollover is in a client’s best interests. For example, are broker/dealers required to examine the investment options and fees prospective clients pay in their 401(k)s when they evaluate whether a rollover is in clients’ best interest? What if potential clients do not bring their 401(k) investment and fee disclosures (often called 404a-5 disclosures) when they discuss a rollover with their broker/dealer? In those cases, can broker/dealers rely on benchmarks to complete their analyses, or should they try to track down the fees in a plan from other sources of data, such as public plan filings?

We hope the SEC will answer these questions by requiring broker/dealers to make a reasonable effort to obtain plan-level data before recommending a rollover because we believe that there is no way to assess whether a rollover meets a best-interest standard without such data. At a minimum, the SEC should require an analysis of the reasons a broker/dealer is recommending a rollover from an ERISA-covered retirement plan to an IRA and why that rollover is in a participant’s best interest. From our experience analyzing such rollovers, the increased fees many investors will pay must be offset by the value of advice. Showing prospective clients such analysis will make them better informed about the services they should expect from their broker/dealer.

Does Conflict Mitigation Require More Than Disclosure?
It is not clear in the proposed rule when broker/ dealers must disclose their conflicts of interest. It’s also not clear which conflicts need to be mitigated and which ones can simply be disclosed. The SEC should clarify these requirements. Further, we think that broker/dealers should also disclose how they mitigate conflicts of interest. Some firms may have more effective approaches to mitigating conflicts than others, and such disclosures would illuminate these differences.

For example, the SEC could require broker/ dealers to disclose whether they “levelize” charges from fund sponsors, credit excess above a certain level back to investors, or take another approach. And if as an intermediary the broker/dealer restricts funds from joining its platform or recommends preferred funds because of revenue-sharing arrangements, the broker/ dealer should disclose how it monitors these relationships to ensure it continues to make best-interest recommendations.

We also think that investors and third-party aggregators should be able to compare conflict-mitigation steps across broker/dealers based on their disclosures. To this end, it is extremely important for disclosures to be standardized. Related to this, the SEC is missing a vital opportunity to require more disclosure of potential conflicts of interest, such as load-sharing and revenue-sharing data.

Regardless of what the SEC requires, broker/ dealers should mitigate conflicts on their own (and distinguish themselves from the competition) with policies that separate compensation from product recommendations as suggested as a best practice in the Financial Industry Regulatory Authority’s “Report on Conflicts of Interest.”[1] We agree with Finra that broker/dealers should take measures to mitigate biases based on compensation and that firms should have strategies in place to detect when broker/dealers provide recommendations to meet bonus targets or other compensation thresholds. The web of common law and Finra recommendations has offered some protection to investors, but rules are too often applied inconsistently, putting investors at risk based on an individual firm’s interpretation of the law. Investor protections also fall behind what we observed in the 2017 Morningstar Global Fund Investor Experience Study.[2] Approximately half of the 25 countries in the study do not allow incentives such as accelerating volume bonuses, gifts, and sales competitions. In the markets that do allow these practices, the regulations and disclosure requirements governing them tend to be stricter than what exists in the U.S. securities market.

Making Comparison Shopping Easier
Making disclosures understandable to ordinary investors is extremely challenging. This is particularly true when trying to explain to investors the difference between financial professionals who operate as RIAs and those who are broker/dealers.

Given these challenges, it is not surprising that the SEC has faced tremendous confusion and criticism regarding its proposed customer relationship summary, the so-called Form CRS. Consumer advocacy groups—the AARP, Consumer Federation of America, and the Financial Planning Coalition—through the Kleimann Communication Group, conducted a survey on the usability of Form CRS.[3] Most of those surveyed found it confusing.

The form failed to clearly explain the differences in meanings of terms such as “fiduciary standard” and “best interest,” the differences in legal obligations between advisory and brokerage accounts, and differences in payment models and fees.[4] Based on these findings, the study’s sponsors requested that the SEC revise Form CRS before finalizing the Regulation Best Interest package.[5] In addition, investor roundtables hosted by the SEC found similar concerns. Participants reported that the text of Form CRS needed to be more concise and that it was unclear about the fees they would be paying to their financial advisor.[6] Investors suggested creating an online calculator that allows users to compare the costs of different types of financial professionals.[7] The SEC also has considered creating an explainer video to help investors choose between a broker and an RIA.[8]

Online calculators and videos might help, but we think what’s really needed is a simple, standardized table that lists all the relevant fees financial professionals charge, making the costs of opening and maintaining an account transparent and comparable. Making this information publicly available would allow third parties to gather and analyze this critical information and put it in proper context for individual investors.

Financial and regulatory technology firms have long used disclosures to help clarify and contextualize financial information for individual investors, but disclosures about fees and conflicts of interest are not as robust as they should be. This lack of publicly available information not only impedes the abilities of third parties to help average investors, it also hinders regulators from identifying harmful conflicts of interest at financial-services institutions.

We hope the SEC’s final version of the Form CRS is more individual-investor-friendly and allows for more third-party analysis. At a minimum, it should make clear what services investors are receiving from the broker/dealer.

Form CRS should also note the significant services not provided by the broker/dealer but that would be provided by an RIA (such as ongoing advice and account oversight). For clients of dual-registrants, this is important because investors are already confused about the implications of working with an investment advisor or a broker/dealer. As it’s written now in the form, the service differences between transaction-based and fee-based accounts are only lightly implied by the description of account-based services.

What’s Next
SEC Chairman Jay Clayton says he wants commissioners to finalize the Regulation Best Interest rule quickly, but the commission is undergoing a transition that could delay matters.

The commission that will vote on the final rule will be different than the one that proposed it earlier this year. The five-member commission could be down one commissioner if Kara Stein’s replacement is not confirmed before her departure in December. Commissioner Elad Roisman was confirmed after the proposal of the rule, and the other two commissioners—Robert Jackson and Hester Peirce—have expressed concerns about the proposal.

We hope the commission takes the time to address our questions and make the necessary modifications and clarifications to improve the best-interest rule. We expect the rule to accelerate the trend of the financial advice industry moving away from a sales model toward a relationship model in which advisors provide advice in the best interest of their clients.

[1] Financial Industry Regulatory Authority. 2013. “Report on Conflicts of Interest.” October. White Paper.
[2] Serhan, A. 2017. “Global Fund Investor Experience.” Morningstar White Paper.
[3] Kleimann Communication Group. 2018. “Final Report on Testing of Proposed Customer Relationship Summary Disclosures.” Sept. 10.
[4] Waddell, M. 2018. “SEC’s New Customer Relationship Form Confuses Consumers: Study.” ThinkAdvisor. Sept. 13.
[5] NAPA Net. 2018. “Consumer Groups Push Back on SEC’s CRS Draft.” Sept. 14.
[6] Schoeff, M. 2018. “Investors Want More Information About Financial Advisers’ Fees.” Investment News. Aug. 6.
[7] Britton, D. 2018. “Reg BI Disclosure Does Not Pass Readability Test.” WealthManagement.com. Sept. 19.
[8] Schoeff, M. 2018. “SEC Ponders Creating Video to Help Investors Decide Between Investment Adviser and Broker.” Investment News. Aug. 10.


This article originally appeared in the December/January 2019 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.