The SEC wants to exclude the value of a client’s primary residence and any debt secured by the property when calculating a household’s net worth.

Financial advisors sometimes insist that the industry should ditch its knee-jerk tendency to weigh assets under management heavily when assessing the value of a practice. 

A preoccupation with AUMs, they say, trains professionals to be investment performance chasers, instead of the holistic wealth management and financial planning guides that clients really need.

Well, the Securities and Exchange Commission (SEC) has proposed several amendments to a rule governing investment advisor performance-based compensation. The changes would narrow the class of clients who would be considered so-called qualified clients who pay performance fees to financial advisors.

There are some practical and well-meaning changes in the proposal, even if they seem a little late.

The SEC wants to exclude the value of a client’s primary residence and any debt secured by the property when calculating a household’s net worth. If the outstanding debt exceeds the market value of the residence, the debt overhang would be treated like a liability in calculating net worth under the proposed amendments.   

“The value of a person’s residence may have little relevance to an individual’s financial experience and ability to bear the risks of performance fee arrangements,” the regulator said in the proposal issued on May 10.

The language in the rule is clear enough, but the timing and the scope are a little curious. Pardon the pedestrian question here, but shouldn’t this always have been the case, and for every investor? Investors cannot really tap into the cash value of a primary residence because the property is being used actively, not generating much revenue.

The only way to extract any cash is to incur debt, and a homeowner’s ability to repay that debt depends on how much revenue they earn from a job, other investment income, or, depending on the housing market, the sale of the house.

The SEC solicited comments on its proposals, wanting to know if the proposal is the right course. “Does such ownership evidence financial experience and the ability to bear risks associated with performance fee contracts?” 

As far as this writer can tell, the answer to that is no.

Without having run a practice, managed anyone else’s financial affairs or sat for any one of the industry’s investment management or financial planning designations, it seems clear that homeownership does not, per se, speak to an investor’s ability to bear risks for the wide range of products out on the market.

Many research firms, including Lake Forest, Ill.-based Spectrem Group, and brokerage firms like Merrill Lynch, exclude a household’s primary residence when calculating its net worth.

According to research from Spectrem Group, the recent recession taught many rich Americans that their homes are not stable investments. They also invest in mutual funds and exchange-traded finds in part to lower the costs of financial advice.

Investors these days, regardless of their level of wealth, hate risk for many reasons. Many are still nervous about how long the slow recovery will last, the severity of stock market fits and lurches, and whether their portfolios (and stomachs) can handle another severe downturn.

It is also interesting that the threshold for a qualified client is so low, given the types of investments -- including hedge funds and other forms of alternative investments -- offered to investors deemed qualified clients under Rule 205-3. 

That’s not to say that the wealthy don’t want to take any risks at all and are conservative to a fault about their investments. They are slowly moving back into stocks.

Another change to the rule is merely an effect of inflation. The regulator wants to raise the AUM threshold to $1 million, and the net worth limit was pushed up to $2 million. That edges past the previous dollar range, $1 million to $1.5 million, that had been in effect since 1998. The SEC also said that if it adopts the amendments to Rule 205-3, it would direct its staff to adjust the AUM and net worth thresholds according to the PCE Index every five years. 

The amendment would grandfather existing agreements, and apply only to new contracts between qualified clients and advisors. 







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