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| Sales Insight - July, 2005 |
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What to Do About Fee-Based Brokerage
Do you have client relationships set up in fee-based
(non-advisory) brokerage accounts? Or, are you converting from a
transaction-based model to a fee-based model in a way that may involve these
accounts?
If you answered yes to either question, STOP!
It is time to rethink how these accounts fit into
your long-term strategy. As a result of recent and ongoing regulatory actions,
the future of fee-based brokerage has become more uncertain. Using these
accounts effectively now requires a combination of regulatory knowledge and
strategic planning.
In this column, I’ll explain: 1) what is
happening with these accounts; 2) why it may not be productive to
aggressively expand activity in these accounts at this time; 3) my best thinking
on how you should handle existing client relationships based on these accounts.
What’s Happening?
Let’s begin with some mile-high background on
fee-based (non-advisory) brokerage accounts. For several years, these accounts
have been an important and fast-growing part of the “fee-based wave” in
financial services. According to Cerulli Associates, they held $270 billion in
total assets at the end of 2004, representing about one-quarter of all fee-based
(non-institutional) assets in the U.S.
The average fee-based brokerage account has about
$200,000 of assets and pays a fee of about 1.0% to 1.5% ($2,000 to $3,000 per
year) in lieu of commissions on brokerage transactions. Typically, the broker
provides only “incidental” investment advice to these accounts and must obtain
client approval for each trade.
There are several advantages embedded in
fee-based brokerage accounts that work to the advantage of both financial
professionals and clients. For example:
- These accounts do not offer brokers incentive
to trade excessively (i.e., “churn”), since compensation is linked to assets,
not transactions or commissions. The only way the broker can earn more is to
help clients grow assets over time
- These accounts have enabled financial firms to
expand investment choices. For example, it can make sense to include
buy-and-hold bonds, no-load mutual funds and exchange-traded funds (ETFs) in
these accounts. In commission-based accounts, these choices may not be offered
because they don’t generate attractive commissions.
- By having a predictable flow of fee-based
income, financial professionals can offer clients more consistent services,
such as annual or semi-annual portfolio reviews, in addition to recommending
investment purchases and sales.
The securities industry created these accounts to
expand client services at a time when traditional commission revenues were under
pressure. In 1995, an industry committee published a series of recommendations
on broker compensation in a document called the “Tully Report.” Among them was
the finding that an asset-based fee for brokerage account services could
represent “best practices” by better aligning interests of clients and brokers.
In June of 1999, Merrill Lynch took the initiative by launching the first such
account, which it called Unlimited Advantage. It just three months, Unlimited
Advantage captured $40 billion of assets – mostly from transaction-based Merrill
clients who willingly switched to fees. This was perhaps Merrill’s most
aggressive effort to protect its retail system from the emerging threat of
low-cost online discount brokers. Today, Merrill continues to lead the industry
in fee-based brokerage assets. The top four participants – Merrill, Morgan
Stanley, UBS, and Smith Barney – together hold more than half of all fee-based
brokerage assets.
While large wire houses were the first to move,
recent asset growth has been driven by regional member firms, independent
broker-dealers, and bank broker-dealers.
Regulatory Clouds
Over their six-year existence, fee-based
brokerage accounts have lived under regulatory clouds on two horizons:
- Exemption from RIA requirements – From
the inception of these accounts, the SEC has shown concern about whether they
should be offered subject to terms of the Investment Advisers Act of 1940,
including the registration and fiduciary requirements that apply to Registered
Investment Advisers (RIAs). One section of that Act provides an exemption for
broker-dealers who perform advisory services that are “solely incidental” to
their normal business. In a rule first proposed in November of 1999, and later
re-proposed in January of 2005, the SEC gave a tentative green-light to the
practice of offering non-advisory fee-based brokerage accounts. However, the
SEC’s re-proposal would require these accounts to be advisory if the broker
exercises any discretion over the account. The SEC also indicated that it
might restrict firms’ ability to offer financial planning services in
non-advisory fee-based accounts. You can read that SEC release here:
http://www.sec.gov/rules/proposed/34-50980.htm
For several years, the Financial Planning Association (FPA) has argued that
the exemption from RIA rules should not apply to fee-based brokerage accounts.
Also, the FPA has aggressively lobbied for the SEC to create a bright line of
distinction in the public’s mind between full-service brokerage accounts and
fee-based RIA advisory business, whether delivered by an investment adviser or
financial planner. You can read their position here:
http://www.fpanet.org/member/govt_relation/federal/securities/120701_bd_letter.cfm
- NASD Disciplinary Action – In recent
years, the NASD has focused increased scrutiny on these accounts, including a
2003 Notice to Members (03-68) that reminded broker-dealers of the need for
“reasonable grounds” in recommending these accounts. In February of this year,
Morgan Stanley voluntarily disclosed that it was the subject of an NASD
investigation involving these accounts. Then, in April, the NASD announced that it had settled with Raymond James, among the
largest regional member firms, in a disciplinary action. Raymond James
agreed to an NASD fine of $750,000 and customer restitution of $138,000. But
the bombshell was the announcement that Raymond James would dissolve its $5.5
billion fee-based brokerage business, with 27,000 accounts, by July 1.
The NASD’s News Release announcing this action is located at the URL below. If
you have any fee-based brokerage relationships, you definitely should read it:
http://www.nasd.com/web/idcplg?IdcService=SS_GET_PAGE&ssDocName=NASDW_013876
Raymond James’ press release of the same day noted that this matter affected
only fee-based brokerage accounts, not its fee-based advisory services – to
which the firm remains committed. You can read it here:
http://www.raymondjames.com/pr/050427.htm
Why You Should Stop and Consider
Raymond James said its combined firms have 5,000
financial advisors serving 1.3 million accounts, and fee-based brokerage
represented just 2% of its clients. Yet, if you divide $5.5 billion by 5,000
advisors, fee-based brokerage represented more than $1 million per Raymond James
advisor – a meaningful amount.
Making a commitment to a fee-based business model
is one of the most important decisions a financial advisor can make. It’s not
something you should attempt by “cherry-picking” one client at a time. Also, it
is well known that the “transition process” from commissions to fees requires
financial sacrifice on the part of advisors – because commissions dry up right
away, yet it takes time to build fee-based assets. Some Raymond James brokers
who made the sacrifice now face another setback with the dissolution of the
firm’s fee-based brokerage business.
Of course, the NASD’s investigation of fee-based
brokerage practices is far from over. The scrutiny announced by Morgan Stanley
has yet to culminate, and no securities firm in this market can say with
certainty what will happen next.
It is clear that the news is spreading to the
investing public, and more arbitration cases are focusing on unhappy clients who
were converted to fee-based brokerage at higher cost. A chillingly honest
account of a securities attorney who represents plaintiffs in these actions was
published recently by Business Week Online and can be accessed here:
http://www.businessweek.com/magazine/content/05_19/b3932117_mz020.htm
In this environment, it may be risky to tell
clients (new or existing) that it’s in their best interest to convert from
transaction brokerage to fee-based. At some firms, fee-based brokerage
ultimately may become a concept that sounded good but just didn’t fly.
Even if you still believe in the concept and are
delivering it professionally, and even if your clients are happy with it – it’s
time to consider your strategic options.
What Are Your Options?
Suppose you already have several million dollars
in fee-based brokerage, representing some of your best client relationships. The
best solution is to be honest about what’s happening and explain the
alternatives, as follows:
1. Go back to commissions – This will cost
you more than clients. It’s a well known fact that you can sell a practice based
on recurring fee income for up to twice annual revenues. For a commission-based
business, you’ll be lucky to get one-times revenues. However, it’s important to
be open with clients and maintain relationships now. Otherwise, you may not have
a viable business to sell later.
2. Convert assets to separate accounts or
advisory accounts – In a separate account, the clients will pay an RIA to
manage assets, and you can earn a portion of the advisory fee. Your role in
providing investment ideas may be limited, but you can still offer planning,
analysis, and ongoing portfolio monitoring. This is a way to maintain the value
of fee-based assets you’ve already captured. It’s the way that Raymond James and
several other large firms are expected to go. Of course, you also could become
an RIA yourself and charge a fee for advice. Some individual brokers may see
this as an attractive way to maintain fee-based assets under management.
3. Keep the business and boost the activity –
The NASD is focusing close attention on so-called “reverse churning” fee-based
brokerage accounts. In these accounts, investors basically buy-and-hold, with
few trades. It doesn’t mean the advisor isn’t executing investment strategy
professionally, but it is risky business in light of recent regulatory actions.
To protect yourself, make sure that any fee-based brokerage accounts execute
several trades per year. Create sound investment strategies that can benefit
from frequent trading.
4. Keep the business and build the
relationship – It is not (and never will be) known how many of Raymond James
27,000 fee-based brokerage clients were happy. Having some satisfied clients
didn’t spare the firm a disciplinary hit. However, if you do nothing more after
reading this column – make a pledge to work harder than ever providing service
to fee-based brokerage clients. Ask them if they are happy with all facets of
the relationship. If not, offer one of the three choices above.
It’s not easy making a living as a professional
financial advisor these days, and your compensation is not a priority concern of
regulators. This is just another example of a regulatory obstacle that will have
greatest impact on financial advisors who can’t adapt to a changing environment.
The strongest advisors will make necessary changes in their fee-based business
models quickly and, as always, they will survive and prosper.
Discuss this and other issues in the new
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