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What Broker/Dealers Need to Know About the SEC's Regulation Best Interest

A closer look at what we expect from compliance with the final rule

The SEC has adopted Regulation Best Interest, raising the standard for brokers above the current suitability standard to act in the best interest of their clients. The rule passed with a 3-to-1 vote on June 5, 2019, as part of a larger ruling.

Below, we explore key elements of this rule and its possible impact on broker/dealers.

What Regulation Best Interest means for conflicts of interest

The rule stipulates that broker/dealers will either have to eliminate, or disclose and mitigate, material conflicts of interest. This requirement will have significant impacts on broker compensation and advice models, though it does not force broker/dealers to upend their business model to the extent that the Department of Labor’s regulation would have.

A couple of ways this rule takes shape include:

  • It explicitly prohibits contests, quotas, bonuses, and noncash compensation that reward sales of a particular security or type of security in a limited period of time.
  • Firms will likely need to eliminate incentives that encourage individual broker representatives to sell certain products.

The preamble discusses product reviews and tests of representative knowledge about products as potential means of mitigating conflicts. Also, in some cases, products should simply not be recommended if a conflict cannot be resolved. Thus, it is difficult to know what forms of mitigation combined with disclosure for material conflicts of interest—short of elimination—will be considered sufficient under the rule. Future enforcement may clarify this.

Firms will need to evaluate their business models, asking questions such as:

  • What conflicts do they have?
  • What advice are their models putting out and what incentives are driving that advice?
  • Can the advice be justified when scrutinized under a best interest standard?

We believe it will be challenging for brokers to adhere to this rule of being clear and concrete in their disclosure of conflicts. They may start to look for business models that simplify compensation and revenue-sharing in ways that eliminate conflicts.

What Regulation Best Interest means for rollovers

The final Regulation Best Interest rule confirms that rollovers of employer-sponsored plans into IRAs are considered a type of “account recommendation” to which the best interest standard applies. This is an improvement from the proposal, which was ambiguous on this topic. Morningstar strongly advocated for rollovers to be included under the SEC’s Regulation Best Interest in our comment letter to the SEC.

For broker/dealers, this rule raises questions about how to advise on rollovers, and how to demonstrate to a regulator that a rollover is in the best interest of the client. For instance:

  • The benefit of a rollover may in part be due to the value of advice or asset-allocation recommendations that match a client’s goals.
  • Morningstar research shows there is a clear, quantifiable benefit to advice, which means that in some cases moving assets to a higher-cost IRA from a lower-cost, employer-sponsored plan might make sense if the advice adds more value to the customer than it costs.
  • If this is the only transaction a client is making under the broker’s advice, and the client plans to self-direct the account afterward, demonstrating that a rollover is in a client’s best interest would be based largely on the investment mix in the old and new accounts.

Ultimately, brokers may need tools to help evaluate the cost of the employer plan versus the value of putting the individual into an IRA, which offers more flexibility and potential for advice but at higher costs.

What Regulation Best Interest means for client relationship summaries

The rule requires broker/dealers to provide clients with a Form CRS that discloses their services and fees in a simple-to-understand format. The SEC mandates that a client relationship summary:

  • Be produced in a machine-readable format and not exceed four pages in length.
  • Include certain narrative and graphical requirements, such as a table with a side-by-side comparison of advisory services and brokerage services, and hyperlinks to external references.

The flexibility that the SEC provides for audio, visual, and other types of content creates opportunities for broker/dealers to differentiate themselves from the competition. On the flip side, different formats will make it difficult for investors to compare fees and services.

We at Morningstar look forward to analyzing Form CRS data and how it can provide better information to investors.

What comes next for Regulation Best Interest

We expect implementation of Regulation Best Interest and Form CRS to require sufficient resources from broker/dealers. However, we also believe that this will drive changes in the industry toward greater simplicity in revenue-sharing, compensation arrangements, and fees.

Read Morningstar’s full analysis of Regulation Best Interest.
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