Every once in a while the government passes a regulation that completely alters the landscape. The new standards proposed by the Labor Department for ERISA participants and their advisers will have the biggest impact since the deregulation of the securities industry a few decades ago. That shift created independent brokerage firms, independent advisers and the custodians and platforms to serve them. This bill will change all of our lives.
The smart money is betting that the new law will come to pass, though with some amendments. When it does pass, the bill will hold all advisers to ERISA participants (including IRAs) to the fiduciary standard.
This means that the suitability standard (ensuring that individuals understand the investments they have been sold and that they are appropriate) will be replaced by the far more rigorous fiduciary standard (have advisers placed clients' interests ahead of their own.) Here are four predictions on how our world will change:
1. Brokers will be forced to adapt or vanish
For most brokers, a meaningful portion of their assets are linked to IRA accounts, but they are seldom standalone accounts. An adviser might have a million-dollar client, but invariably that client has a significant portion of his or her liquid net worth in an IRA. Brokers who rely on generating commissions on IRA accounts will have to adjust from an upfront product sale to ongoing management of the portfolio, and will have to move existing underlying investments to lowest-cost alternatives. Goodbye commissions, hello low-cost fee management for all.
Since you can't be half a fiduciary, there will be many uncomfortable explanations and discussions as to whether the client's remaining assets outside their IRA should be changed to meet the fiduciary standard, as well. Many brokers simply won't be able to make the change because of implementation difficulties and costs, and will leave the industry.
2. The independent brokerage channel will be completely altered
A large percentage of brokerage assets inside IRAs are served by independent broker-dealers. It is not an unreasonable assumption that the typical broker-dealer has as much as a third of its assets inside of IRAs, and that the vast majority of their brokers have clients with an IRA. That's especially true in the independent channel, where many of the smaller clients reside.
Full service wirehouses are already spending a fortune adapting their businesses to the new reality. However, independent broker-dealers, already operating on razor-thin margins, depend on packaged product providers to support their marketing efforts and provide commissions to their brokers. The application of the fiduciary standard will mean no more expensive mutual funds or variable annuities sales to IRA owners. How will that revenue be replaced?
Many of the suboptimal broker-dealers will simply collapse or be folded into those that have figured it out and adapted successfully (and will grow exponentially as a consequence).
There will also be a rapid shift in the way insurance companies and mutual funds work with the retail client. With a large portion of their market at risk, they will need to rethink how they approach distribution. The world of the product wholesaler is going to be very different.
3. Competition surges for existing fiduciaries
Initially, there will be a washing out of the product-centric, non-relational brokers and their firms; however, hundreds of thousands of investment professionals will become fiduciaries very quickly and the firms they work with will have adapted and created scalable, low-cost managed investment solutions. The survivors will become a threat to independent advisers, muddy the market and drive pricing down for everyone.
Since all brokers will become fiduciaries, the existing fiduciaries will either have to differentiate or compete in a far more cluttered (or lower-cost) marketplace. Many advisers will expand from being investment-focused to financial life management focused to maintain pricing.
Many firms are already helping clients with their entire financial lives but few have found a way to charge for it. The future revenue and viability of many currently successful firms might depend on a dynamic financial guidance experience and charging a fee for what clients really value.
4. Pricing transparency and fee compression become the standard.
One of the focuses of the bill is reducing the cost of the underlying investments and an apparent bias toward low-cost index investing. The bill also requires transparent disclosure of all costs. When most clients have their entire retirement account indexed and all fees disclosed, that approach will invariably spread to the rest of their portfolio. This will inexorably lead to a race to zero for simple investment allocation and rebalancing. Active management will struggle for relevance and shelf space among packaged product.
And the winners of the new future …
The DOL will accomplish its goal to drive down the costs for retirees. The transition will be messy in the interim for individuals, brokerage firms and existing fiduciaries.
The big industry winners? Drum roll please … low-cost index funds, exchange-traded funds and technology firms that help scale investment implementation. Among advisers two types of winners will emerge:
1. Firms that concentrate on scale and find ways to profitably deliver engaging, fiduciary-level, ongoing investment advice and implementation at very low cost.
2. Firms that offer differentiated service at a premium. These firms that charge clients to help them with their entire financial life and provide guidance beyond money in an engaging and omnipresent way will successfully maintain premium pricing and hold on to larger clients.
The Collins dictionary describes a "watershed moment" as “a critical turning point in time where everything changes that will never be the same as before.” As is the case in all seismic shifts, many will not adapt, but many will thrive by leading change into a new world. And a rare few will become the new dominant brands for this new world. Watershed moment indeed!
Joe Duran is chief executive of United Capital. Follow him @DuranMoney.