The Impact of the BROKER-DEALER FIDUCIARY STANDARD on Financial Advice

Transcription

1 The Impact of the BROKER-DEALER FIDUCIARY STANDARD on Financial Advice Michael Finke, PhD, CFP Thomas Landon, JD, LL.M., MBA, CFA, CFP Texas Tech University Department of Personal Financial Planning Evidence of Self-Interest in Advising (Mullainathan, Noth and Schoar, 2012) Treatment Company stock: 30% of the funds invested in company stock Treatment Index portfolio: 100% low cost, efficient, age dependent allocation in US stocks & bonds COMPANY STOCK INDEX FUNDS DISCOURAGE CURRENT STRATEGY What s Special About Advice Professions? The Right Amount of Agency Costs Advice is a credence good Information Asymmetry (by definition) Advisors can easily make self-serving recommendations They will always exist, but can be reduced CONTRACTING how advisors are compensated (best align interests) MONITORING government, SRO, DIY BONDING accept penalty for bad behavior to increase demand Principal hires Agent Advice and Market Inefficiency Asymmetric Information Either demand too much low quality advice Or fear of getting ripped off reduces demand Self Interest Self Interest The Akerlof lemon problem AGENT PRINCIPAL Agent performs 1

2 Suitability versus Standards Problem SUITABILITY = you re OK if you re in the zone Where do you pitch? FIDUCIARY = Can you defend low and outside? Enforcement, legal precedent matter Many registered representatives use terms such as FINANCIAL PLANNER or FINANCIAL CONSULTANT that suggest planning or consulting services that involve the provision of expert advice (Hung et al. 2008). Consumers can t tell the difference & ASSUME advisors are FIDUCIARIES Advisors can use greater latitude of 1934 Act to extract greater agency costs Torts vs. Suitability/Arbitration Motivation Who decides what advice violates a fiduciary standard of care? Early version of Dodd-Frank would have ELIMINATED B/D EXCEPTION under Investment Advisers Act SEC study recommends adoption of UNIFORM FIDUCIARY STANDARD for broker-dealers and investment advisers Chairman Schapiro calls for additional relevant data or empirical analysis prior to regulatory action Background Opposition to Standard INVESTMENT ADVISERS are Any person who, for compensation, engages in the business of advising others as to the advisability of investing in, purchasing, or selling securities Section 202(a)(11)(C) of the Advisers Act excludes from the definition of an investment adviser any broker or dealer that meets the following requirements: 1. the performance of investment advisory services is SOLELY INCIDENTAL to the conduct of its business as a broker-dealer, and 2. NO SPECIAL COMPENSATION is received for advisory services. National Association of Insurance and Financial Advisors Terry Headley (2011): negatively impact product access, product choice, and affordability of customer services for those customers who are in most need of these services may create the potential for market disruption and reduced choices for investors when it comes to who they work with and how they pay for services concerned that the additional regulatory requirements and potential legal implications of a fiduciary standard could significantly increase their compliance costs 2

3 Testing Those Hypotheses No Standard Can we see whether the imposition of a stricter fiduciary standard: A. Affects product choice B. Reduces affordability C. Limits compensation D. Limits access to advisor services by less wealthy clients E. Increase compliance costs Arizona Arkansas Colorado Hawaii Massachusetts Minnesota Mississippi Montana New York North Carolina North Dakota Oregon Washington Wisconsin Common Law Differences California courts have held that a broker s fiduciary duty requires that he or she act in the highest good faith toward the customer Hobbs v. Bateman Eichler, Hill Richards, Inc., 1985 Missouri courts have held that, stockbrokers owe customers a fiduciary duty. Quasi- Standards Impose standards that exceed the suitability standard set forth under FINRA rules, but do not expressly classify broker-dealers as fiduciaries. Wyoming Alabama Alaska Connecticut Delaware Florida Georgia Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Michigan Nebraska New Hampshire New Jersey New Mexico Nevada Ohio Oklahoma Pennsylvania Rhode Island Tennessee Texas Utah Vermont Virginia West Virginia South Dakota and South Carolina Empirical Analysis South Dakota courts hold that brokers owe clients the same fiduciary duties to customers as those owed by real estate brokers, including a duty of utmost good faith, integrity, and loyalty, and a duty to act primarily for the benefit of another (Dismore v. Piper Jaffray, Inc., 1999). South Carolina has imposed fiduciary duties, including a duty to refrain from acting contrary to a customer s best interest, avoiding fraud, and communicating information to the customer that would be in the customer s advantage (Cowburn v. Leventis, 2005). 1) Compare frequency of registered representatives (saturation) in states applying fiduciary, quasi-fiduciary, nonfiduciary standards 2) Survey registered representatives in fiduciary and non-fiduciary states to estimate differences in ability to conduct business 3

4 Survey Questions SURVEY RESULTS: Serve lower wealth/income clients? What percentage of your clients have incomes of less than $75,000? What percentage have investable assets of over $750,000? Are you able to serve the financial needs of low to moderate wealth clients? Do your state s security regulations limit your ability to recommend a broad range of financial products? Do you offer your clients a choice of financial products that meet their financial needs and objectives? Question % clients income < $75,000 % clients inv assets > $750,000 Serve needs of low/mod wealth Less affluent avoid due to cost Non- Difference ( NF) P-Value Equal 28.0% 27.9% 0.1% % 34.5% -5.0% % 79.8% -0.9% % 29.2% -5.6% More Survey Questions SURVEY RESULTS: Recommend Variety of Products? Do you provide advice tailored to the specific needs of your clients? Do you feel that less affluent clients avoid obtaining your services due to cost? Are you able to recommend products that provide a commission? How significant is the cost of compliance? Do you feel that you make product recommendations that are in the best interest of your client? Question Regulation limits product range Products meet client needs Advice tailored to client needs Non- Difference ( NF) P-Value Equal 21.3% 17.4% 3.9% % 97.3% -1.5% % 90.1% 1.6% Data & Methods SURVEY RESULTS: Affects Ability to Conduct Business? BROKER-DEALER SURVEY Random sample of registered representatives in nonfiduciary and fiduciary standard states between November 28 and December 23, valid responses Frequency comparison test (chi-squared) Exclude RIAs or those with out Series 6&7 exams SATURATION ANALYSIS Population of registered representatives active in November ,000, 51 states and DC Multivariate Analysis using income (log) as control Question Able to recommend commission Cost of compliance significant Act in best interest of client Non- Difference ( NF) P-Value Equal 88.5% 88.2% 0.3% % 61.9% 9.0% % 96.3% 1.5%

5 Broker Saturation Rates Predictors of B/D Saturation Registered Representatives Households (000s) Saturation Total 69,120 16, Total Non- Non- W/O New York Total Other 186,802 29, ,940 22, ,246 68, Predictor Impact Significance Non Log Income Adj. R-Square 0.39 Non- Saturation and New York Results with New York Effect Non- New York 96,862 7, North Carolina 15,094 3, Washington 6,605 2, Massachusetts 16,207 2, Arizona 7,280 2, Wisconsin 10,164 2, Minnesota 8,644 2, Colorado 14,168 1, Oregon 5,291 1, Arkansas 1,787 1, Mississippi 1,728 1, Hawaii Predictor Impact Significance Non Log Income New York Adj. R-Square 0.65 Montana North Dakota 1, Comparison of 2-3 million household states State Regulation Reps/ Hhlds Median Income Mean Income % High Income % College Education Missouri ,829 60, Washington Non-Fid ,911 73, Massachusetts Non-Fid ,961 85, Arizona Non-Fid ,214 65, Wisconsin Non-Fid ,814 64, Minnesota Non-Fid ,456 72, Virginia Other ,090 82, Indiana Other ,529 60, Tennessee Other ,612 58, Maryland Other ,017 90, Discussion No statistical evidence of difference in: Ability to service lower-wealth/income customers Ability to provide variety of products Ability to conduct business No significant difference in saturation rates when income controlled New York saturation inflation = 8.3 Empirical evidence suggests fiduciary standards have little impact on Broker-Dealers 5

6 Belmont vs. MB Investment Partners (2013) Compensation by Client Wealth Deciles The federal fiduciary standard requires that an investment adviser act in the "best interest" of its advisory client AUM only (21.6%) Under the "best interest" test, an adviser may benefit from a transaction recommended to a client if, and only if, that benefit and all related details of the transaction are fully disclosed. In addition to the clear statutory prohibition on fraud, the federal fiduciary standard thus focuses on the avoidance or disclosure of conflicts of interest between the investment adviser and the advisory client st 2nd 3rd 4th 5th 6th 7th 8th 9th 10th Commission (12.7%) Performancebased fee (16%) Hourly fee (47.9%) Advisor Compensation & Client Wealth Likelihood of Compensation by Wealth Will compensation regulation impact services to lower-wealth clients? AUM Commissions Only Account Size Deciles (vs. 1st quintile) Hourly Charges Fixed Fees Performance Based Fees 2nd * *.014 3rd th th *** -.349** th *** -.464*** *** 7th *** -.504*** ** 8th *** -.773*** *** 9th *** *** *** 10th -.757*** *** *** *** Is Compensation Related to Account Size? 2011 ADV Disclosure Deciles Average Account Size Median # of accounts 1st < $148, nd $148, , rd $218, , th $292, , th $396, , th $541, , th $779,221 1,171, th $1,171,259 2,083, th $2,083,535 6,259, th > $6,259, Source: Dean and Finke, 2012 Thank you! 6