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What Investors Need to Know About Regulation Best Interest

Aron Szapiro
Christine Benz

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. The Securities and Exchange Commission voted to adopt Regulation Best Interest on June 5. Joining me to discuss what you need to know about the regulation is Aron Szapiro. He's director of policy research for Morningstar.

Aron, thank you so much for being here.

Aron Szapiro: Thanks so much for having me.

Benz: Aron, let's start by just briefly outlining what Regulation Best Interest is about and what its major ramifications are.

Szapiro: Sure, absolutely. Just in a nutshell, this is the SEC's attempt to elevate the standards of conduct that broker/dealers have to follow when they're giving advice to retail customers. It's part of four different regulatory actions that the SEC took on June 5, and this is really the centerpiece of it. So it's elevating those standards of conduct above the current FINRA suitability.

Benz: Okay. So when you say broker/dealers, I think sometimes people outside of the industry might be confused about what you mean there. What type of person is that?

Szapiro: There's sort of two different channels for financial advice. There are broker/dealers who are selling securities, usually on a commission-based or transaction-based mode,l where they're paid when they make a recommendation and usually paid on commission. That's in contrast to the Registered Investment Advisor, the advice model, which is generally based on a fee that is in turn based on the assets under management. Although there's a variety of different models.

Benz: Let's get into this whole movement to exert a fiduciary standard over advisors. There's a history here, so let's talk a little bit about that, what the Department of Labor tried to do in relation to a fiduciary standard as well.

Szapiro: Yeah, let's just only go back as far as 2010 so we're not spending the whole interview on the history. But in 2010, Dodd-Frank gives the SEC the authority to promulgate what's called a uniform standard between broker/dealers and Registered Investment Advisors. I guess I should say right now, they haven't done that with this final rule. But that was sort of one of the first major policy actions that Congress took to say, "You know, we're concerned about the quality of advice that people are getting." A lot of this is a response to the rise of the defined-contribution system. I mean, if we were still in a defined-benefit world, you wouldn't have ordinary people with hundreds of thousands, maybe a million, dollars having to make complex decisions about asset allocation and where to invest their money. At any rate, the SEC at the time did not act. They did issue a congressionally required report. And in 2015, the Department of Labor proposed their second iteration of their version of a fiduciary rule. That was finalized in 2016 and ultimately vacated by the Fifth Circuit Court of Appeals. And so that rule has been thrown out. Then, just a few weeks after the courts threw out the Department of Labor's rule, the SEC proposed this rule. And they referenced the Department of Labor more than 100 times in the preamble of the draft rule. So I mean, I would just say this didn't happen in a vacuum. This is part of an ongoing conversation about enhancing the standards around advice that ordinary people get from their advisors.

Benz: Let's talk about the differences of this Regulation Best Interest relative to the Department of Labor rule. It seems like a lot of people watching this situation think that this is much less meaningful then what the DOL was attempting to push forward with.

Szapiro: Yeah, I mean I think that that is, as sort of a high-level statement, I think that's correct. We certainly don't want to minimize the fact that ... I think this regulation is a big deal, but the Department of Labor's rule would have fundamentally changed the business models for both broker/dealers and Registered Investment Advisors. It had a lot of bright-line prohibitions on common conflicts of interest, and it was very clear that you can no longer engage in this kind of of conflicted arrangement. That was a really big deal. We saw a massive industry response in the runup to the presumed effective date of the regulation with the introduction of new kinds of share classes and broker/dealers switching their business model. I mean it was really big; this is definitely a more incremental step. I don't think there's any other way to put it.

The other major difference here just stems from the authority of the Department of Labor and the authority of the Securities and Exchange Commission. An easy way to think about this is, the Department of Labor's authority was product-neutral but account time-specific. But they were only regulating things in qualified retirement. In contrast, the SEC's regulation will apply to any kind of investment account. But it is product-specific, so it doesn't include certain kinds of insurance products--although it does include variable.

Benz: Let's talk about the consumer angle on this. Say, I am an a consumer, an individual who works with a financial advisor. What should I expect to see? What changes, if anything, from my advisor in terms of disclosures, anything else?

Szapiro: Starting in June of next year, your advisor, you're working with an advisor who is a representative from a broker/dealer, will say, "Hey, I'm following Regulation Best Interest and I'm acting in your best interest." But that doesn't mean that they can't have some conflicts of interest. They will have to disclose them to you as a consumer or as an investor, and disclosure will not be enough in certain instances. There are certain bright-lines in the regulation, certain things that they do have to actually go ahead and and try to mitigate. You also get a new disclosure called the Customer Relationship Summary that will provide you with all kinds of new information on services you're going to get, fees, etc. That information--we asked for this--is going to be made available in a machine-readable format. My hope is that Morningstar will be able to aggregate it and assimilate it and sort of contextualize, make sense of all the information. We'll see what actually comes out and how comparable it is. But, anyway, there will be new information that you get as a customer, and there will be some new protection. 

That said, I think it's going to be important for people to understand that part of this best interest obligation can be satisfied with disclosure. And it's going to be incumbent on you as an investor to look at those disclosures and say, "Okay, I understand this business model. I'm comfortable with it. It makes sense to me."

The other thing I think is very important to emphasize is that this is meant to be a regulation that applies to a kind of one-time advice; so the person will be acting in your best interest at the point of when they give you advice--unless they say so, unless your advisor says so. It doesn't mean that they're engaged in ongoing monitoring of your account. And that's going to be an important thing for people to understand. I think that will be fairly clear in these disclosures as long as people read them. The disclosure should really elucidate that information. But it's going to be important to not just stop at the, "Oh, he's acting in my best interest," and sort of skip through the rest of the four or five pages that you'll get as a summary explanation of what the relationship looks like.

Benz: I know that you and your team tried to be very data-oriented in terms of your policy views and and how you approach things like this. What sorts of research have you and your team done in relation to this sort of standard?

Szapiro: We got really interested in what kinds of conflicts were out there, what we could measure, and whether the introduction of the Department of Labor's rule made a difference. And what we found--I think not that surprisingly--is, at least among the conflicts we could measure and without getting too far into the details, these are sort of like "conflicts of interest 1.0." And that's where we have good data. You know, we found that those do distort recommendations, and that those distortions are not great for investors. We also found that that's been attenuating over time just on its own. We do think that there has been just much more of a move toward advice that is in investors' best interest. And you know, we see that in the Morningstar data on asset-weighted fees, it's getting better and better to be an investor. There's no question we see that in the data, that the conflicts had less and less of a distortionary effect over time. And then the Department of Labor's proposal pretty much killed them off. 

Now that said, there's an element of ... there's this old joke about the drunk who's looking for his keys under the streetlight, and he'd lost him in the dark, but there was no light over there. You know, we've been advocating for more disclosures on modern conflicts of interest, and we're hopeful we'll be able to glean something about them from these new disclosures that come with Regulation Best Interest. I think there's still work to be done there. But the bottom line is, conflicts of interest do distort recommendations. You can see it pretty clearly. That's a trend that has been in decline for some time, and regulation can help reduce those effects. And so we'll see if this new SEC regulation kind of continues those trends. I'm optimistic that it will to some degree.

Benz: Just really quickly before we leave this topic: What's an example of a modern conflict of interest?

Szapiro: Modern conflicts of interest, I think of as sort of the revenue-sharing kind of of category. The traditional conflict of interest was you as an investor paid a load and then that load would go back to to the broker who was selling you a mutual fund. And because there was variation in the size of those load-sharing arrangements, there was an incentive potentially to recommend one product over another, regardless of whether that was in someone's best interest. And that stuff was pretty clearly disclosed on the form N-SAR until last year. So we actually had really good data going all the way back to 1993 on this, which as sort of a researcher, that's very exciting to me.

You know, modern conflicts of interest are usually more on the revenue-sharing side, and so they're not disclosed in a consistent way. We don't have clear information on whether or not there are payments that are higher or lower or what these payments are tied to. We have some kinds of higher-level disclosures in some of the fund prospectuses, but it's sort of harder to get a handle on. I think that that's the principle, and we're actually working on a paper right now just kind of going through all the different kinds of conflicts we can see from the disclosure language we see in mutual fund prospectuses, that I think will be quite useful and interesting.

Benz: Aron, always great to get your perspective. Thank you so much for being here.

Szapiro: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.