DOL Fiduciary Rule Will Accelerate Broker-Dealer Closings
February 22, 2016
By Jon Henschen, as featured on ThinkAdvisor and FSI NewsBrief
Since 2008, we’ve seen a steep and consistent drop in the number of broker-dealers. As reported by data aggregator Fishbowl Strategies, we were down to 4,578 BDs in 2010. By February of 2014, that number was down to 4,181. We ended 2015 with 4,034 broker-dealers, with the largest segment of firms closing by far being equity trading firms. September 2015 turned out to be a false flag of hope where we had 14 new firms admitted and only 5 firms withdrew. Nevertheless, fourth quarter results continued the downward trend.
Looking at the fourth quarter of 2015, we had 16 new firms that were admitted and 53 firms that withdrew. Of the 53 that withdrew, 32 were equity trading firms, 12 were private placement firms and 5 were mutual fund firms. Of these 53 firms closing, 37 of them had fewer than 10 reps.
As discouraging as these statistics look, this could very well be the tip of the iceberg. The DOL fiduciary standard will bring about a perfect storm if it coincides with a potential U.S. recession. Besides the lower revenue associated with a down market, a recession will put an end to Fed Funds interest rate increases, which will kill hopes of higher money market revenue for broker-dealers.
The DOL fiduciary standard will also lower revenues for broker-dealers due to fewer product choices, lower commissions and higher rates of litigation.
Variable Annuity Revenue
Variable annuities in qualified accounts will likely have two options: either a 2% to 3% upfront commissions with a trail option, or a no-load VA as the only option for ERISA accounts. VA volume has been fading since living benefits have been made more realistic for insurance company profitability; so more representatives are doing fixed index annuities. There is definitive talk that fixed index annuities and index universal life will likely need to fall under FINRA scrutiny. This would cause legions of fixed insurance reps needing to get their securities licenses in order to sell indexed products.
This potential influx of new reps into broker-dealers has mixed appeal because these types of products, along with the reps that sell sizable amounts of these products, are perceived by many broker-dealers as the red headed stepchildren of financial services.
Stock and Bond Trading Firms
Since 2008, by far the largest percentage of firms closing has been the stock and bond trading broker-dealers in the retail channel. The DOL fiduciary redefinition under ERISA will quicken their demise, as the new rules are expected to disallow commission-based trading of stocks and bonds in qualified accounts. This will force advisors to convert these accounts to a fee-based structure, which will result in substantially lower revenue.
For an advisor making $500,000 trading $25 million of AUM, they will see their income cut in half when going to a 1% fee model. During a recent conversation with a stock transactional BD president, I explained to him that his reps would need to convert to an advisory model on their qualified accounts. He responded, “they don’t do fee based.” He has no clue what lies ahead.
Private Placement Firms (REITs, BDCs, Alternative Investments)
We see two issues for firms focused on this product segment. First, the DOL fiduciary standard won’t allow illiquid investments in qualified retirement accounts. Second, FINRA Rule 15-02 requires these products to lower commissions paid to advisors and for the pricing on statements to reflect actual values, i.e., mark-to-market pricing.
Since 2008, BD conferences have received large portions of their sponsorship revenue from REIT, business development company (BDCs) and alternative investment vendors. Now, with illiquid investments no longer allowed in qualified accounts, advisors as well as broker-dealers will see a large decline in revenue.
For any new sales they do, the days of 8% commissions will be gone, with new commission rates likely in the 3% to 4% range with perhaps some trail paid. Broker-dealers will see a sharp decline in revenue sharing, which for many broker dealers has filled the void of revenue left by low money market rates since 2008.
FINRA Rule 15-02 brings a very scary scenario to light, as REIT and BDC actual values will now have to be reflected on client statements. Compliance departments are in a frenzy to get their advisors to communicate with clients that their REITs may no longer show a $10 per share value. Clients who are blindsided by a repricing of say $6.50 rather than $10 per share may very well call an attorney and file a customer complaint. The potential for advisors and broker-dealers to see a volcanic eruption of litigation is very real.
Mutual Fund Revenue
The new restriction on these products due to the DOL fiduciary standard means that only “C” shares will be available, or as with variable annuities, no-load mutual funds for ERISA accounts. One sizable revenue source for mutual funds is 12b-1 fees on non-qualified accounts. Some firms’ non-ERISA account qualified accounts pay advisors 12b-1 fees as well. Many broker dealers pocket 12b-1 fees as part of their profit center, while some credit 12b-1 fees back to the client. Following the track of regulators’ discussion leading to the DOL fiduciary rule (likely to be released as early as April), both broker-dealers and advisors will no longer receive 12b-1 fees in fee accounts.
For smaller BDs, the ability to weather the coming storm will be extremely challenging. The Financial Services Institute has been attempting to counter many of these challenges that are soon to be thrust upon us, but King Obama and the DOL are pushing back with regulatory fervor.
At the recent FSI conference, the president of a midsized broker dealer was quoted, “There’s an air of trepidation here, but we’re all being nice to each other since none of us knows if we’ll wind up working for each other in the next couple of weeks.” While this was said in a spirit of humor, it reflects underlying concerns over the future of our industry from even the more substantial broker-dealers.
The many forces at work against our industry could very well cause a major acceleration of broker-dealer closings.
As we saw in the fourth quarter of 2015, of the 53 broker dealer closings, 37 of those firms had fewer than 10 reps. According to Fishbowl Strategies, of the 4,035 total broker-dealers, only 500 have 100 or more reps. A large segment of the broker-dealers are small, one- to 10-representative shops, which are the most vulnerable segment to selling unless they have substantial capital backing.
Besides increased firm closings due to lower profits, it will make more sense than ever for smaller broker-dealers to go fee-only due to increasing restrictions on commission products, shielding them from higher litigation risks moving forward. However, the unintended consequence of broker-dealers going fee-only is less revenue for FINRA, with declining registration and FINRA assessment fees.
Don’t be surprised if FINRA insists on being the policeman for RIAs if the number of broker-dealers craters. Seeing the number of BDs dwindle down to 2,000 over the next three years may turn out to be an optimistic forecast.