The Future of Financial Planning Regulation

In a study on financial planning regulation released in January, the Government Accountability Office ("GAO") recommended that state regulators address the inadequate standard of conduct that applies to insurance agents. GAO should be applauded for highlighting this gap in consumer protection under state insurance laws.

However, GAO did not complete its main assignment, which was to study the regulation of financial planning. Instead, GAO focused narrowly on securities and insurance regulation, which led it to conclude that financial planning was adequately regulated under existing state and federal laws.

It is not. GAO's findings notwithstanding, there is almost no regulation of financial planning as such, that is, the services that distinguish financial planning from narrow, product-based recommendations made by broker-dealers, insurance agents, and bankers. GAO should follow up its report with a bona fide look at how the financial planning regulatory gap should be addressed.

Financial planning regulation . . .
Section 919C of the Dodd-Frank Act required GAO to study "legal or regulatory gaps" in the regulation of financial planning. Although "financial planning" was reasonably well-defined in the Act as:

advice regarding the management of financial resources, including investment planning, income tax planning, education planning, retirement planning, estate planning, and risk management,

GAO's study paid only lip service to the essence of financial planning services.

As the Dodd-Frank definition suggests, financial planning comprises guidance regarding multiple aspects of a person's financial life. Here, "life" refers to decisions regarding health, education, retirement, leisure, philanthropy, family legacies, etc. Financial planning entails advice regarding the financial aspects of these decisions.

Remarkably, the GAO study includes no discussion of estate, education, or tax planning. The terms "mortgage," "loan," "529 plan," "credit card," "check," "checking account," "real estate," "IRA," "individual retirement account," and "savings account" do not appear anywhere in the study. The financing of children's college education is a frequent, often central part of real-life financial planning, yet the term "college" appears only in describing the education of financial planners.

There is no discussion of advice regarding retirement plans. The term "401(k)" appears only in a footnote that explains that the regulation of retirement plan advice is not covered in the study. "Home" and "tax" appear only once, in each case only in paraphrasing the Financial Planning Coalition's description of financial planning services.

GAO treats financial planning services as if they were a collection of independent silos. First, the financial planner recommends securities, to which securities regulation applies. Then the financial planner recommends insurance products, to which insurance regulation applies. And so on, as if each aspect of the client's financial life existed independent of the other. If this were financial planning, then a silo-based regulatory system would be adequate, but it is not.

The essence of financial planning is advice regarding the interrelationship of the multiple aspects of a client's financial life. A quintessential financial planning regulatory issue would be, for example, an insurance agent's incentive to recommend that a client sell mutual fund shares as a means of financing the purchase of an insurance product. Or a broker's incentive to steer customers into a real estate investment that was not subject to securities regulation. Unfortunately, GAO's study did not address the regulation of such scenarios.

. . . is not under the streetlamp
GAO's study recalls the proverbial man crawling under a streetlamp searching for his wallet--which he lost somewhere else--because that is where there is enough light to see. GAO looked for financial planning regulation where it was not to be found: in the well-illuminated alleyways of traditional securities and insurance regulation. To its credit, it found that the conduct standard under state insurance law was inadequate, but this is not a financial planning regulation issue.

Even the higher standards applicable to broker-dealers (suitability) and investment advisors (fiduciary) are inadequate as financial planning regulation because the standards apply only to securities-related activities. For example, failing to disclose a material conflict of interest in connection with the sale of term life insurance does not violate an investment advisor's fiduciary duty under the Investment Advisers Act. Securities laws do not regulate non-securities insurance conduct, and vice versa.

This gap has not prevented regulators from attempting to reach beyond their regulatory silos to establish financial planning standards. For example, FINRA's selling away rules generally prohibit broker-dealers from receiving compensation "as a result of any business activity outside the scope of the relationship" without providing prior notice to their firm. The prohibition applies to non-securities activities, including, for example, real estate transactions and sales of insurance. Under this rule, FINRA requires firms to consider whether the activity will interfere with or compromise the broker-dealer's responsibilities to customers.

The rule has some teeth because it forces firms to adopt procedures for the evaluation of their employees' non-securities activities. The mere existence of these procedures makes it more likely that a firm will actively supervise these activities (for an example, see FINRA Case #2007011393902).

However, the outside activities rule's teeth are not particularly sharp because FINRA cannot directly mandate supervision of non-securities activities, such as sales of equity-indexed annuities. Neither FINRA nor the SEC has direct jurisdiction over insurance and banking sales practices. Even investment advice that is unconnected to specific securities transactions is arguably beyond FINRA's jurisdiction. (FINRA has used this jurisdictional limit to shift blame for the Madoff fiasco.)

 

States also have attempted to step across traditional regulatory silos to regulate financial planning services. For example, Arkansas regulators provided guidance in 2001 and 2009 reminding insurance agents that a "recommendation to replace securities" with an insurance product is investment advice subject to securities regulation. They stated that the Insurance Commissioner intended "to take action against insurance agents who improperly engage in transactions involving securities."

The Iowa Insurance Commissioner's office just issued guidelines on what financial professionals who are subject only to insurance or securities regulation, but not both, may do in the areas in which they are not licensed. For example, "specifically prohibited" activities for "Securities-Only Persons" include "providing any insurance advice or recommendations" in connection with a securities transaction. The guidelines state that such persons may provide "insurance-only advice" if they do not sell insurance and their "insurance-only advice is incidental to the services they provide." There is no explanation of whether this "incidental" exception applies to the list of "specifically prohibited" activities, but that is the least of the complications that the Iowa guidelines create.

Illinois' Securities Department recently revoked the state registrations of a broker-dealer/investment advisor that made unsuitable recommendations to sell variable annuities (securities) and use the proceeds to purchase equity-indexed annuities (not securities). The firms reportedly are appealing, partly on the ground that the action violated the Insurance Department's jurisdiction. The defendant may have a point: How could the Securities Department conclude that the sale of the security was unsuitable without determining that the benefits of the insurance product purchased with the proceeds did not outweigh the costs?

Along similar lines, in 2009 the Financial Planning Association complained to the SEC that FINRA exceeded its jurisdiction in an enforcement action that covered financial planning advice (see the SEC's response). The FINRA member had recommended that clients take out home equity loans to fund the purchase of variable universal life insurance policies. Financial planners also have previously criticized FINRA's outside business activities rule and are now busy fighting FINRA's effort to become the self-regulatory organization for investment advisors. Financial planning regulation is becoming a jurisdictional battlefield, a development unnoticed by GAO.

Future of Financial Planning Regulation
Only lawyers will benefit if financial planning regulation evolves along the tangled lines suggested by the FINRA/Arkansas/Illinois/Iowa approaches illustrated above. Both industry professionals and consumers will suffer from the inefficiencies and ineffectiveness of overlapping and contradictory rules. Both will become collateral victims of turf wars between the federal government and the states, and among securities, insurance, banking, and other regulators.

GAO was correct to begin by studying the regulatory silos under which financial services are regulated, but even in that respect its analysis was deficient. It conceded reviewing only securities and insurance regulation. The study refers to banking regulation only once, where it apparently accepts at face value the American Bankers Association's statement that the financial activities of bank employees "were subject to a fiduciary standard and the applicable supervision of federal and state banking regulators." The existence of the Consumer Financial Protection Bureau is acknowledged, but the substance of its regulatory jurisdiction--and the scopious exemptions therefrom--are nowhere discussed.

If GAO had surveyed the full breadth of discrete regulatory regimes that intersect with financial planning services, it would have recognized that none of these regulatory regimes truly regulates financial planning. It failed to acknowledge that an insurance agent who makes personalized recommendations to purchase equity-indexed annuities is implicitly recommending that clients not use their funds to: (1) pay down their mortgages or credit balances, (2) increase their 401(k) contributions, (3) invest in mutual funds for retirement, or (4) invest in a 529 plan.

These four options implicate four distinct regulatory silos (five including the EIA purchase). None of them adequately regulates the conflicts of interest that cut across regulatory lines. The broker-dealer, banker, mortgage broker, insurance agent, and municipality all have incentives to recommend their particular products. When a financial services professional sells hammers, client problems tend to be diagnosed as nails. The heart of financial planning regulation--if it existed--would be the regulation of these conflicts. GAO did not recognize existence of these conflicts, much less analyze whether they are adequately regulated.

Conclusion
It is unfortunate that GAO had nothing to say about financial planning regulation as such. The role of financial planning services in our economy is not just expanding--it is expanding as an essential service. The standard of living of many low-income Americans, especially low-income retirees, increasingly will depend on the quality of their financial decision-making.

Some decry the immediate costs of additional regulation while ignoring the long-term social costs of poor financial decisions by low-income persons. Both concerns militate for paying greater heed to financial regulation. GAO deserves credit for calling out the subpar standard that applies to insurance agents, but it missed an opportunity to shed light on an important issue.

Mercer Bullard is president and founder of Fund Democracy, a mutual fund shareholder advocacy organization, an associate professor of law at the University of Mississippi School of Law, a senior adviser for financial planning firm Plancorp Inc., and a former assistant chief counsel at the Securities and Exchange Commission. The views expressed in this article do not necessarily reflect the views of Morningstar.com