As investors demand increased transparency, we continue to see new regulations introduced that aim to protect consumers. Regulation Best Interest, or REG BI, was introduced in 2019 to ensure broker/dealers put forward investment recommendations that fall within their clients’ best interests. In 2020, the Department of Labor enacted the Prohibited Transaction Exemption (PTE) 2020-02 to protect retirement plan participants as they consider rolling assets into Individual Retirement Accounts. In December 2020, the U.S. Securities and Exchange Commission, or SEC, took another step by significantly amending the advertising and solicitation rules applicable to advisory firms. As firms adjust to this latest rule, many may be tempted to apply a Band-Aid approach that simply addresses current regulatory requirements. However, these point solutions prove to be more time-consuming and costly in the long run. Instead, companies should be proactively managing regulation as a core component of their operating strategy.
Those who embrace regulation not only mitigate risk but may gain a competitive advantage. After all, for advisors to provide value, they must be able explain how a portfolio lines up with their clients’ preferences and goals. The advisor-client relationship must be built on trust and clear two-way communication of goals, risk tolerance, and other preferences. With a transparent view of how the advisor is acting in their best interest, investors can be reassured that they’re receiving optimal recommendations amid the range of reasonable alternatives. While some will do the bare minimum to adjust to regulatory requirements, those who wholeheartedly align their practices with ongoing regulation may receive an advantage in both trustworthiness and communication.
Unpacking the Latest Rule
The SEC’s marketing rule became effective in May 2021, and advisory firms were given 18 months to implement it. The marketing rule impacts both how advisors enter solicitation/referral arrangements and their advertising activities. It replaces its decades-old predecessors, reflecting the changes in modern advertising and referral practices, technological advancements, and investor expectations.
A brief recap of the updates:
- Redefining advertising: The new rule expands the existing definition of “advertisement” to any advisor communications and aims to mitigate the use of untrue, misleading tactics and information in advertisements as well as to promote fair and balanced communication between financial professionals and their clients.
- Testimonials and endorsements: While paid testimonials and endorsements are allowed under the new rule, advisors who use them must meet high standards. At the time of dissemination, the advisor must disclose whether the source is a current client or investor, whether compensation was provided, and whether there’s a conflict of interest.
- Third-party ratings: Advertisements may include a third-party rating if the underlying surveys are not designed to produce any predetermined result, and if the proper disclosures are observed. The ratings must be from an independent third party, issued in its normal course of business.
- Performance information rules: Additional rigor is required when utilizing returns (actual or hypothetical) to propose investment strategies. Advisors must present net performance and results for one-, five-, and 10-year periods. In most cases, performance results must reflect all “related portfolios.”
A Note on Hypotheticals
Morningstar has been powering investment analysis and proposals for decades. We understand the importance of aligning the performance of investments to the best interest of the investor. To that end, we uphold hypotheticals as a helpful facet of performance information. Hypothetical performance, according to the marketing rule, is defined as performance results that were not actually achieved by any portfolio of the advisor--this includes model performance, back-tested performance, and targeted and projected performance. As consumers expect greater transparency from their advisors, it makes sense that there will be an evolution of scrutiny on the use of hypothetical performance, and indeed the marketing rule puts greater limitations around the use of hypothetical performance in advertising to protect investors from being unduly or accidentally swayed by biased information. To that end, the marketing rule intends that hypothetical performance information only be distributed to investors who have access to the resources to independently analyze the information and have the financial expertise to understand the risks and limitations of these types of presentations.
Advisors are prohibited from showing hypothetical performance in an advertisement, unless the advisor meets several conditions:
- Policies and procedures are in place to ensure that the hypothetical performance is relevant to the financial situation and investment objectives of the intended audience.
- The intended audience has sufficient information to understand the criteria used and independently analyze the assumptions made.
- The intended audience has the financial expertise to understand the risks and limitations of using hypothetical performance in making investment decisions.
What to Expect
Given the changes outlined in the marketing rule, how are companies rallying around these changes? Based on our conversations with clients, we don’t expect the use of hypotheticals to end, but rather for the industry to adapt their use of hypotheticals around the marketing rule. It’s important to note that the restrictions on hypothetical performance do not include interactive analysis tools. To qualify as an interactive tool, the investor must use the tool either by inputting information themselves or providing information to their advisor to input. The advisor must also:
Provide a description of the criteria and methodology used, including limitations and key assumptions.
Explain that results may vary with each use and over time.
Describe the universe of the investment considered in the analysis, explain how the tool determines which investments to select, disclose if the tool favors certain investments, and, if so, explain the reasons for selectivity.
Disclose that the tool generates outcomes that are hypothetical in nature.
Recent Morningstar polling suggests that interactive analysis tools may not be that exciting to firms at the moment, as most seem focused on advisor-facing tools. But we are certain that firms will continue to explore alternatives in response to the marketing rule. Gathering appropriate performance data continues to be difficult as it includes advisor-managed accounts. As a result, firms are expecting a greater push to co-advisory, which they feel may allow them to rely more heavily on third parties that provide management services. The third-party co-advisor could then provide compliant materials for advisors to use with clients. Companies would need to create processes to ensure that their materials are not altered after receipt from third parties. Some firms are also considering requiring investor attestation of necessary assumptions and discussions to ensure their understanding of any materials received.
On the Horizon
As focus has shifted quickly, financial professionals who are dual registrants can expect that harmonizing both the new SEC and FINRA rules may create an operational challenge. We also expect new regulations to emerge that aim to safeguard consumers, modernize legacy rules, and address evolving investor preferences. To stay ahead of the changing regulatory landscape, preparation can be broken down into four steps that distill obligations across the workflow:
- Understand obligations
- Focus on speed to market and scale
- Ensure interoperability across systems
- Deliver quality assurance
To stand out in today’s market, financial professionals should view compliance as a competitive advantage and prioritize providers to help them integrate the new regulations.
Matthew Radgowski leads client solutions for the Morningstar Business Development group.