Brokers brace for tighter standard on retirement accounts-By Michael Wursthorn

Firms say change will drive up compliance costs and could force them to drop middle-class clients

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Thousands of small brokerages are bracing for a tighter rule governing investments they recommend to retirement savers, a change they say will drive up compliance costs and could force them to drop middle-class clients.

The idea of the regulation, which could be released this month by the Labor Department, seems unobjectionable enough—that brokers would follow a “fiduciary” standard when making investment recommendations. Currently, brokers’ advice only has to be “suitable,” which critics say is a weaker standard that allows the sale of expensive products that eat into returns.
The rule’s opponents, including many in the brokerage industry, say it will increase their costs and make providing investment advice to small-balance retirement accounts less profitable.
Already, anticipation of the rule is pushing some companies to scale back their business in the brokerage area. The associated compliance costs were a key motivator, among other factors, behind American International Group Inc.’s decision in January to sell its brokerage unit, AIG Advisor Group.
About $3 trillion of more than $7 trillion in individual retirement accounts is expected to be affected by the rule, according to research firm Morningstar Inc. About $19 billion in revenue related to those IRA assets could be affected, and operating margins on IRA assets could fall up to 30%, Morningstar said.
The rule, provisions of which would be phased in over time, could add costs at industry giants such as Morgan Stanley, which has nearly 16,000 brokers, and Bank of America Corp.’s Merrill Lynch, with more than 14,000. But it is expected to weigh far more heavily on small and midsize firms, which make up the bulk of the industry.
Even before the Labor Department’s proposal, the number of brokerages in the U.S. had been shrinking as firms grappled with rising operating and regulatory costs. Another challenge: shifting trends in the investment business, including the emergence of “robo” automated online advice services.
Major consolidation took place around the 2008 financial crisis, with the recent number of firms regulated by the Financial Industry Regulatory Authority, or Finra, down 21% from just over 5,000 in 2007. Some industry watchers expect the Labor Department rule to spur further consolidation.
The smaller brokerages “are firms already struggling in a competitive market,” said Bing Waldert, a managing director at research firm Cerulli Associates.
Labor Secretary Thomas Perez has repeatedly defended the rule and has called dire predictions by industry executives and trade groups overblown. In a speech in October, he said a lot of smaller securities firms support the proposal, rejecting the notion that it will “slam the door on small savers.”
“It is important to remind ourselves that this is a multitrillion-dollar market,” Mr. Perez said then. The “industry can and will adapt in order to serve it.” Labor Department spokesman Michael Trupo added that the final rule is expected to “enable firms of all sizes to provide advice that is in the customer’s best interest.”
AIG Chief Executive Peter Hancock said on a conference call in January that even though its brokerage unit had $40 million in earnings annually, it “consumed a disproportionate amount of our compliance costs.”
He said the transaction, expected to close in the second quarter, will simplify governance at AIG “and obviously, with the new [Labor Department] rules, that was a big factor in thinking whether this was better owned by somebody independent of us.”
Brokerage-industry executives and analysts say the rule is likely to accelerate brokerages’ shift toward fee-based accounts and away from commissions, a trend in which smaller firms generally lag behind their bigger rivals. Smaller firms also tend to have more small accounts that might be uneconomical to serve in a fee model, and they have fewer clients across whom to spread added compliance costs.
At D.A. Davidson, which has about 400 brokers, nearly $9 billion of its $35 billion in private-client assets reside in IRAs. William Johnstone, chairman of the Great Falls, Mont., brokerage, said the firm would likely shift many commission-based retirement accounts to a fee-based arrangement under the rule. Those conversions will “almost certainly” force investors to pay higher fees to their brokers, Mr. Johnstone said, such as in accounts that consist of mutual funds and exchange-traded funds that aren’t traded much.
Mr. Johnstone said he expects some increase in fee-based revenue but isn’t sure if it will make up for losses tied to smaller investors whose accounts are too small to be converted. “It’ll clearly change relationships we have with clients and we’ll have some clients who are pretty frustrated,” Mr. Johnstone added.
Among the big firms focused on affluent investors, Morgan Stanley got about 70% of its wealth-management revenue last year from asset-based fees, while recurring fee income accounted for roughly 63% of 2015 operating income at UBS Group AG’s U.S. brokerage.
By contrast, among the smaller brokerages, “many are still commission-heavy firms with less-productive advisers and less-wealthy clients,” said Mr. Waldert of Cerulli Associates, referring to advisers who generate little in revenue.
Under the Labor Department rule as last publicly proposed, brokerages would be able to charge commissions on retirement accounts only if they follow procedures that the industry has generally deemed unworkable. Before any sales discussion, for instance, an investor would have to be given detailed information about the seller’s compensation, which brokers say isn’t easily predicted, and would have to sign a contract spelling out the adviser’s obligation.
Based on what they have seen of the rule so far, brokerage executives say much of the IRA assets in commission accounts will likely be shifted into accounts where the firm serves as a fiduciary and charges an annual fee based on the invested assets. With that arrangement, there are fewer conflicts of interest and potentially less regulatory complexity than continuing to charge commissions in an environment with the fiduciary rule.
However, that shift may not be practical for small IRAs. Brokers would have to spend more time understanding a client’s full financial situation to fulfill their responsibilities as fiduciaries, industry officials say. And that might not be profitable on an account of, say, $50,000, where a standard 1% fee would be just $500 a year.
Investacorp Inc., a brokerage that provides services to roughly 500 independent advisers for a fee, expects many of its advisers will be forced to drop smaller clients. “[Adviser] revenues will drop, which means our revenue will drop as well,” said Pat Farrell, Investacorp’s head.
Morningstar estimates that wealth managers will lose three commission-based IRA accounts for every two converted to fee-based arrangements.
Mark Cresap, head of a 40-person brokerage firm that bears his name outside of Philadelphia, said he would allow each broker to decide how to best handle accounts affected by the rule.
He called the rule an additional compliance complication that will pressure smaller brokerages like his.

“It’s just layer upon layer of regulation when the population of smaller broker-dealers has already declined sharply,” Mr. Cresap said.

Culled from The Wall Street Journal