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Beyond the FINRA Suitability Comfort Zone

Regulation Best Interest’s changes require brokers to bridge the gap in their current suitability process and rethink the role of the advisor.

Updated September 10, 2020 Out of the ashes of the Department of Labor’s Fiduciary Rule—vacated by the Fifth Circuit Court of Appeals in 2018—the Securities and Exchange Commission, or SEC, has finalized new standards of conduct for broker/dealers and their affiliated financial representatives.

After 10 years of back-and-forth policy discussions on whether brokers should have a fiduciary duty to their clients, follow another set of elevated standards, or simply stick with the Financial Industry Regulatory Authority’s suitability rules, the SEC’s Regulation Best Interest, or Reg BI, took effect on June 30, 2020. The regulation aims to solve a long-standing problem for policymakers: ensuring investors have access to unbiased and effective advice.

Reg BI elevates the duties and standards of care of the broker/dealer beyond FINRA's suitability requirements. It aims to ensure investment recommendations are in the best interest of the retail customer and that financial representatives are placing the financial interest of the client above that of their own. The scope of the regulation includes recommendations surrounding account types, rollovers, and transfer of assets.

Furthermore, the notion of best interest is identified as a consideration of potential risks, rewards, and fees associated with recommended securities or investment strategies. The full expression of the rule indicates that “the broker/dealer must then consider these factors in light of the retail customer’s investment profile and make a recommendation that is in the retail customer’s best interest.“

The effect of the regulation is extremely positive. It elevates the client engagement process from a simple, basic attempt to understand an investor’s objectives, to a comprehensive understanding of that individual’s investor profile, including risks, risk tolerance, goals, costs, and time horizon.

How Reg BI Goes Beyond the FINRA Suitability Rule

Reg BI goes further than FINRA’s suitability rule in several ways. For instance, broker/dealers are required to:

  • Eliminate, or disclose and mitigate, material conflicts of interest. This goes beyond existing FINRA rules and has a significant impact on broker compensation and advisory programs.
  • Provide new disclosures on conflicts of interest, services, and fees. Morningstar head of policy research Aron Szapiro breaks these down in the white paper “How Regulation Best Interest Affects Brokers.
  • Specifically evaluate a product’s cost to determine its reasonableness.
  • Evaluate investments relative to reasonably available alternatives, or RAAs, for performance, risk, and cost. They do not necessarily need to consider every possible alternative, or to recommend the single “best” of all possible alternatives that might exist, but they need to reasonably limit the universe of alternatives as appropriate for a particular retail customer or category of customer.
  • Scrutinize the product shelf of RAAs based on data surrounding investment categories, performance, risk, and fees. For this, broker/dealers would benefit from an intuitive screener tool for increased efficiency and codification of process.
  • Ensure the series of recommended transactions, even if suitable when viewed in isolation, is not excessive for the client when taken together at the portfolio level.
  • Evaluate how they advise on rollovers and demonstrate to a regulator that a rollover is in the best interest of the client. 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.

Ultimately, brokers may need tools to help evaluate the cost of the employer plan against the value of putting the individual into an IRA or the appropriateness of a variable annuity, which may offer more features or flexibility and potential for advice but at higher costs. A technology-enabled, well-documented process for the evaluation of alternatives and consideration against the investor profile goes a long way in communicating and executing best interest advice.

How Strong Solutions Can Help Brokers Take the Next Step

As participants in the defined-contribution system mature and approach retirement, their need for financial advice becomes more prescient. To provide this advice, brokers need to rethink how to systematize and document investor-first recommendations and also empower their financial representatives to lean into more personalized client engagement. Data and digital innovation are an effective way to do this, far beyond the enforcement of Reg BI on June 30.

Broker/dealers may seek increased support for financial representatives to provide investment recommendations across product categories. The goal is to provide representatives with data and information so they can perform their own analysis and determine RAAs, while also maintaining flexibility and autonomy.

At the same time, the increasing accessibility of complex processes (as they become automated, digitized, and lower in cost) is enabling more client engagement across the industry. To support this effort, broker/dealers may benefit from more robust solutions that offer:

  • additional analysis and insights,
  • guidance for best interest-based decisions with curated product shelves,
  • integrated third-party models, and
  • increased support surrounding building the investor profile, connecting goals to investment plans, and documenting and archiving reports.

Implementing these new tools that effectively integrate Reg BI obligations, policies, procedures, processes, and controls to existing technologies can help reduce institutional inertia surrounding change management and workforce readiness.

Broker/dealers may also try staged implementation, such that a first step to meeting compliance standards may not be the end-goal business model. For instance, they might want to rethink the role of the financial representative as an agent of client engagement and personalized value by looking for ways to concentrate representatives’ time on matters like:

  • goal management,
  • account aggregation,
  • risk management,
  • financial planning,
  • tax management,
  • withdrawal strategies, and
  • generational planning.

This solution restructures the traditional representative role by integrating third-party investment selection, asset allocation, and portfolio management. It can help reduce risk and free up time for attracting new clients and digging deeper with existing clients.

A New Frontier for Broker/Dealers (Updated September 10)

Now that June 30 has passed, broker/dealers will need to determine how these new SEC requirements will impact their strategic vision as part of phase 2 considerations for Reg BI. And finding technology solution providers that are investor-centric and tailored to support Reg BI obligations is crucial to setting themselves up for success.

Understandably, we have found that many firms focused on the Disclosure Obligation first, primarily centering around the delivery of Form CRS to their clients as well as new prospects. This was driven by a looming deadline falling amid a global pandemic, along with some remaining doubts and questions as to what the SEC and/or FINRA would explore during their examinations. The SEC's Risk Alert in April, along with a recently released examination information request, have clarified that the key elements of the Care Obligation, including the evaluation of Reasonably Available Alternatives and IRA Rollovers, will be tested. With the Disclosure obligation met and more clarity on the obligations achieved, many have now turned their attention to these other important obligations included in the regulation. A quick reminder that our three key Reg BI workflows focus on meeting the Care Obligation requirements surrounding:

  • Investment Recommendations
  • Investor Profiling & Portfolio Assignment, and
  • IRA Rollover & Annuity Recommendations

These easy to deploy workflows ensure that: a) all investment recommendations consider Reasonably Available Alternatives on the basis of performance, risk, and cost, b) an investor's profile, including their goals, are understood, documented, and aligned with a model portfolio or other advisor-designed investment solution, and c) specialty recommendations such as IRA Rollovers and Annuity Purchases include an evaluation of plan, product costs, as well as other services provided. These tools have been embedded into our Advisor Workstation application but can also be delivered as components for integration into your firm's homegrown systems and platforms. In addition, our Manager Research and Selection Services can be employed to develop your firm's product shelf. This offers a sound foundation to the RAA analysis. Finally, our discussions and client implementation projects have highlighted the need to support upstream and downstream data integrations, reducing data entry redundancy, as well as closing the compliance loop from a process documentation perspective. We recognize that technology deployments are expensive and complex. It is therefore imperative that solution usage and ROI are maximized across the enterprise. It is our view that solutions should not simply meet your regulatory requirements but should also support your firm's broader objectives around financial planning as a focus, the shift from brokerage to advisory relationships, as well as broader need for efficiency and growth. We are happy to share our experiences to date, as well as assist in the design of a Reg BI solution set that not only meets your regulatory requirements but reinforces your firm's long-term strategic objectives.

Finally, firms will need to bear in mind the prospect of examinations by the SEC and FINRA. The consequences of inaction in the face of Reg BI pose potential short-term and long-term effects: Insufficient workflows could result in public and financially punitive outcomes, and long-term failure to act poses competitive risk as brokerages pushing more toward the advisory business model may set the future standard. Morningstar has provided the steps firms should consider when preparing for an eventual SEC or FINRA examination in the white paper “Ensuring Firm Preparedness: A Checklist to Help Your Firm Prepare for a Regulation Best Interest Examination.”

Firms left behind may face challenges recruiting and retaining talent as well as clients, and the time is ripe for them to pursue incremental change.

Situated at the center of the investing ecosystem for the last 35 years, Morningstar seeks to champion investor success by promoting engagement. We believe putting the investor first enables financial representatives to grow their practices while continuing to act as stewards of capital. We also embrace the notion that efficiency is driven by consistency, integration, and connectivity of advisor tools. Our team can support your firm by helping to implement new operating models and workflows that balance Reg BI obligations with existing business strategy objectives. Our common data, research, and technology solutions are designed to meet your firm’s regulatory requirements and enhance productivity in a way best suited to you and your advisors.

Matthew Radgowski leads client solutions for the Morningstar Business Development group, and Jill Axline is a content manager for Morningstar’s data and research product group.

To learn more about how the role of the advisor has changed now that Regulation Best Interest is in effect, watch our Reg BI Insights video.
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