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DoL Proposal Could End Commissions, Morningstar Says

Without explicitly saying so, the federal government may be in the process of effectively banning commission sales of financial products.

That's the upshot of a detailed new Morningstar report that forecasts likely impacts of the Labor Department's proposed fiduciary rule, which could be implemented by the spring. Such a rule would "reshape the financial sector" and cause profit margins on IRAs to contract up to 30%, the authors write.

However, some firms will likely make up for potential losses by transitioning commission accounts to fee-based ones, according to the study. This could generate $13 billion in added revenue for them, due to much higher revenue yields in fee accounts, the researchers write.


While the rule "may look more lenient" than recent wide-reaching bans on commission sales of financial products in the United Kingdom and Australia, "it isn't," the Morningstar study says.

Although the rule provides exemptions to certain prohibited commission transactions – such as third-party commissions when insurance companies and mutual fund pay brokers for product sales – those exemptions look impossible to implement, says Michael Wong, a Morningstar equity analyst and the study's lead author.

"From an operational standpoint, it can't be done," Wong said in an interview.

"Kudos to Morningstar for saying that," says Knut Rostad, president of the Institute for the Fiduciary Standard, one of the organizations that support adoption of the fiduciary rule. "What that seems to be saying -- which is what many of us already know -- is that many firms exist to sell product, period."

If the rule forces these firms to remake themselves, so much the better, he thinks.

In the wake of the report's release, Wong says, large firms have been calling and emailing Morningstar with concerns. Although many have been publicly mum on the subject, most are furiously studying its potential impact, he says.


"I just saw someone yelling at the front of the auditorium stage, yelling about the fiduciary rule," Wong said on Friday, after walking past a group of insurance company employees who were meeting in a hall at Morningstar's Chicago headquarters.

In fact, insurers stand to be among the big losers if a fiduciary rule is implemented, along with asset managers and full-service wealth management firms like Bank of America, Morgan Stanley, Raymond James and Wells Fargo, Wong and his co-researchers write.

Raymond James’ Scott Stolz, the firm’s senior vice president of private client group investment products, expressed Raymond James’ opposition in a Labor Department hearing on the rule over the summer: "The rule as written is overly complex, would be incredibly expensive to implement, and would expose the hundreds of thousands of trusted and well-meaning financial advisors to unfair legal liability."

Winners will include discount brokerages like Charles Schwab and TD Ameritrade, ETF providers like BlackRock and Vanguard, and robo advisors, the report says.

In all, the rule will affect roughly $19 billion of revenue on $3 trillion of client assets, it predicts. Instead of costing $1.1 billion to implement, as the government and other sources have estimated, the likely cost will be closer to $2.4 billion, Morningstar says.


However, firms with strong economic moats will fare the best after such a rule is implemented, Wong says. And this group could include both full-service advisory firms as well as higher-end wirehouse advisors, he says.

"A financial advisor may be able to help with tax planning or insurance," Wong says. "They may be able to help with investment alpha. They may be able to help with charity work. … If you are with Merrill Lynch or Morgan Stanley, they may be able to get you access to IPOs or they may be able to get you into [a] hedge fund."

The fiduciary proposal is "part of a global rule-making trend during the past several years that has sought to increase retail investor protection," the report says. The U.K implemented its rule in late 2012 and Australia followed the next year.

The Morningstar cites other likely impacts of the rule:

  • It will accelerate three major trends: the shift to fee-based from commission-based accounts at wealth management firms; the emergence of robo-advisors; and the increased use of passive investment products over actively managed ones.
  • The rule would impact annuity trails, general mutual fund revenue-sharing agreements, 12b-1 fees and certain alternative investment product commissions, among other transactions.
  • The aggregate first-year cost estimates to implementing such a rule range from $740 million to $4.7 billion. Annual ongoing costs range from $390 million to $1.1 billion.
  • On the low end, $1.46 billion of 12b-1 fees will be affected by the rule.
  • The total amount of revenue related to full-service, non-fee-based IRA assets is $19 billion and the related operating income is $4 billion to $6 billion, Morningstar estimates. Of this, operating margins on full-service, wealth management firm IRAs could take a 20% to 30% hit from the rule.
  • Robos will gain where wealth management firms lose, as they pick up a portion of an estimated $250 billion to $600 billion of low-account-balance IRA assets from clients let go by the full-service wealth management firms. Capturing a fraction of these loose assets will bring stand-alone robo- advisors much closer to the $16 billion to $40 billion of client assets they need to become profitable.
  • More than $1 trillion of assets could flow into passive investment products from the Labor Department proposal. The increase would be from higher adoption of robo advisors and increased use of passive investment products, amid other factors.

A fiduciary rule will help bring about badly needed simplification of the financial services industry for customers, says Jon Stein, founder of Betterment. He cites mutual funds with 300-page disclosures needed to cover all of the current conflicts of interest as indicative of the industry's problems.
"The retirement services industry has evolved around the idea of very high-touch expert services that have been paid for with hefty and upfront fees," Stein says. "A lot of those services are just not worth anything."

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