Cost to play bigger role in investment recommendations

Large firms are well-situated to comply with the cost standards in the SEC's Reg BI given changes they made to prepare for the DOL fiduciary rule

Aug 19, 2019 @ 1:41 pm

By Greg Iacurci

Cost will soon play a more important role in the investment recommendations brokers make to clients.

The Securities and Exchange Commission, as part of its recent overhaul of investment-advice standards for brokers and financial advisers, explicitly stated that broker-dealers must weigh cost when making a recommendation to a retail client, which legal experts say is a departure from prior rules.

"There's no doubt now. The SEC literally said it has to be considered in every recommendation," said Fred Reish, a partner at law firm Drinker Biddle & Reath. "That's millions [of recommendations] every year. That strikes me as a pretty big deal."

The SEC's discussion of cost in Regulation Best Interest, approved by the agency's commissioners June 5 in a 3-1 vote, applies to a broker-dealer's obligation to use "reasonable diligence, care and skill" when making a recommendation.

While experts say many broker-dealers had considered cost under former suitability rules for brokers, many believe brokerage firms will have to adapt their systems and processes to account for the new standard. The SEC itself said the explicit requirement to consider costs ups the ante for firms, which must comply with the rule by June 30, 2020.

"The final regulation, which is an enhancement from the proposal, explicitly requires the broker-dealer to consider the costs of the recommendation," the SEC said in a news release accompanying the final rule.

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While that doesn't mean a broker must recommend the lowest-cost product every time, or even that cost will be the predominant factor each time, it does mean cost has to be considered, Mr. Reish said.

That has broad implications for brokerage firms, from their training and supervision of brokers, to the range of investment products they offer on their platforms and the software they use to evaluate mutual funds, annuities and other investment products, Mr. Reish added.

'Wake-up call'

"I think to the extent there were broker-dealers not taking costs into account, this really serves as a wake-up call," Kevin Walsh, a principal at Groom Law Group, said of the SEC's cost language in Reg BI.

Cost has moved to the forefront of investors' consciousness over the past several years. Assets in index mutual funds have swelled over the past decade, to $3.3 trillion last year from $619 billion in 2008, according to the Investment Company Institute.

Partly in response to investor demand, investment firms have substantially reduced fund costs. The average expense ratio for an actively managed equity mutual fund dropped to 0.76% in 2018, compared with 1.06% in 2000. Similarly, the average cost of an index equity fund fell to 0.08% from 0.27% over the same time period, according to ICI.

Investors have filed scores of lawsuits accusing their employers of including high-cost investment funds in their 401(k) plans. The Department of Labor also issued a fiduciary rule in 2016 that sought to rein in what the agency perceived as inappropriate, high-cost investment recommendations being made by brokers to retirement clients to earn high commissions. The rule took effect for a brief period in June 2017 before being overturned in court.

"I think a lot of the tools developed for the DOL's fiduciary rule are proving to be helpful here," Mr. Walsh said of the SEC investment-advice rule.

One general approach has been making cost information appear more prominently in the investment-comparison software brokers use, Mr. Walsh said, though he added that there hasn't been "a cookie-cutter, one-size-fits all approach" to costs.

Raymond James & Associates Inc., for example, made changes to things such as disclosures and product commissions to prepare for the DOL fiduciary rule. The firm kept those changes in place and they may prove sufficient from the standpoint of compliance with the SEC rule, said Scott Stolz, SVP of private client group investment products and wealth solutions.

One change related to cost that Raymond James kept in place is a level-commission structure. A broker receives the same commission when recommending like products (such as a mutual fund or variable annuity), no matter the product being offered, so as to eliminate any perception of selection bias toward higher-commission products within similar investment categories.

The firm is still reviewing the SEC rule to see what, if any, additional compliance steps are needed, Mr. Stolz said.

Large brokerage firms made substantial progress toward complying with the DOL fiduciary rule and therefore are well situated to handle the SEC rule, Mr. Reish said. But that's not the case for many smaller firms.

"Most of them are still doing work the way they did 10 years ago, like the DOL rule never happened," he said.

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