Revenue sharing is one of the wealth management industry's murkiest and most persistent conflicts of interest, with billions of dollars likely changing hands each year.
When a government watchdog
"So in the financial advice industry, there's a lot of conflict of interest," the financial professional said, according to the U.S. Government Accountability Office study, released last August. "First, you want to be wary of any commission-driven brokerage kind of advisors. There are some advisors out there like that, they might put you in the mutual funds that have a kickback fee to them, so they're getting paid through the mutual fund, so they might not be putting you in the lowest-cost, best possible thing for you."
But as other forms of product distribution payments taper off or disappear, revenue sharing payments keep streaming into some of the largest wealth management firms.
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The larger context of revenue sharing
Revenue sharing involves payments from fund managers to wealth management firms that recommend their products. The practice takes many forms and presents various risks to investors due to the incentive to sell products from issuers that pay revenue sharing to the so-called intermediary companies building clients' portfolio allocations.
When it comes to picking among mutual funds with similar strategies, holdings and performance, the considerations may begin with the expense ratio or any transaction or commission costs. Then there are questions about any third-party payments involved with one fund or another and whether and to what extent they may affect overall returns. Those questions remain hard to answer, despite Regulation Best Interest going into effect nearly five years ago and
An SEC enforcement push began with a
Some argue that revenue sharing should be eliminated entirely, while others see it as another closely scrutinized industry area subject to substantial disclosure requirements.
Conflicts of interest arise because revenue-sharing payments compensate the recommending intermediary firm out of the profits earned by a fund manager on their clients' investments.
The implications of those arrangements can be profoundly complex, thanks to the many factors involved with clients' fund decisions and the potentially blurry relationships between advisors' compensation models and their counsel to customers.
Revenue sharing is one of various industry arrangements that beg the need for advisors to have nonjudgmental, productive discussions through a "Socratic debate about the benefits of different providers and what the conflicts might mean for the clients," said Sara Grillo, an
She believes more advisors and other industry professionals would discuss practices like revenue sharing if they were not "scared to look stupid" about the complicated arrangements or afraid "to find out that I'm not as fair as I think I am." The planning profession should "bring it all out in the open" so that investors and advisors can decide for themselves, Grillo said.
"I think, if we do that, things will change. But we can't be scared to have the conversation," she said. "We have to be willing to look ourselves in the face and say, 'Am I really doing what I'm saying I'm doing for them?"
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The extent and origins of revenue sharing
Those conversations may prove anything but easy, though, when there are so many unknowns about revenue sharing.
To better understand current practices, Financial Planning reached out to nine of the largest wealth management firms in the industry that disclose revenue sharing arrangements. Two referred inquiries to the companies' disclosures, four declined to comment and the other three didn't respond to emails.
Only
The available totals added up to a small fraction of the firms' overall revenue but suggested revenue sharing payments across the entire industry likely reach several billions of dollars every year.
Revenue sharing payments began in the industry as much as 40 years ago, and the SEC has "never taken the position that they're inappropriate or shouldn't happen," according to Mark Quinn, director of regulatory affairs with Los Angeles-based
Asset management firms aimed to open sales distribution channels through the ranks of independent advisors. And wealth management firms sought revenue streams enabling higher payouts to retain advisors who receive a share of the business that they generate from their base of clients. Independent brokerage firms in particular "pay a very high percentage" of the annual revenue, Quinn noted. That's where revenue sharing from fund companies entered into the equation.
"We're looking to collect as much as we can, and they're looking to pay as little as they can, and somehow the market finds equilibrium," Quinn said. "It would be extraordinarily difficult for independent firms paying out that much to really be profitable without ancillary revenue sources."
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A point of contention over conflicts of interest
Others disagree with that perspective. The industry's current revenue sharing practices call for "aggressive enforcement of the rules that are in place — fiduciary duties and Regulation Best Interest" — alongside new legislation in Congress, according to Corey Frayer, the director of investor protection with the
"Congress could restore a lot of faith in markets by banning these arrangements entirely, the same way they could restore faith in government by making it illegal for members of Congress to trade stocks on non-public information," Frayer said in an email. "We know from experience that, not just investors but the entire market, benefits when transactions happen at arm's length, conflicts are weeded out, firms are in competition and not in cahoots with each other and everyone's incentives are transparent. When you're both providing advice and managing assets for investors with varied interests there are some unavoidable conflicts; it seems like common sense to eliminate the unnecessary ones."
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SEC calls for revenue sharing clarity, not elimination
Representatives for the SEC declined to discuss the topic in general or comment beyond the agency's public filings in
The industry has pushed back against what
Many wealth management companies in the RIA channel of the industry do no revenue sharing at all. Others accept the payments in both retirement accounts (for which advisors must abide by the fiduciary duty, placing clients' interest above their own) and in brokerage holdings (where the advisor is subject to Reg BI's lesser obligation to act in customers' best interests). A third group has explicitly ended the practice in retirement accounts but not brokerage ones.
In a 2022
"A firm's product menu can have a significant impact on the conflicts of interest present in its business model," the bulletin stated. "The staff believes that firms should carefully consider how their product menu choices — which could include limitations such as offering only proprietary products (i.e., any product that is managed, issued, or sponsored by the firm or any of its affiliates), a specific asset class or products that pay revenue sharing or feature similar third-party arrangements — comply with the firm's obligations to act in the best interest of retail investors when providing investment advice and recommendations and to disclose conflicts."
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A 'common' conflict of interest for investment advisors
Research relating to revenue sharing reveals why many experts see it as a cause for concern.
It's one of several conflicts that "are common in investment advice, including advice on transactions involving retirement assets" such as 401(k) plans and individual retirement accounts, according to
"Revenue sharing is one of a variety of financial interests that can be present when retirement investors are receiving recommendations on 401(k) or IRA savings," Nguyen said. "DOL officials told us employer plan fiduciaries may use revenue sharing in employer plans to defray other plan expenses in an economical way. However, revenue sharing is also one of the conflicts of interest that firms disclose. To receive additional compensation associated with IRA product recommendations, a fiduciary under the IRC might need to comply with prohibited transaction exemption provisions aimed to protect retirement investors."
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A range from most to least conflicted
Six years ago, research firm Morningstar used a spectrum to explain what it called "a variety of opaque arrangements" between fund and wealth management companies, characterizing the revenue sharing on a spectrum from the least to the most conflicted conduct, depending on the amount of the payments and the degree they're tied to sales.
Educational expenses for teaching financial advisors about the products showed up as the conduct that was "least likely to be conflicted," followed by fees for being listed on a wealth management firm's fund menu, for accessing its data on clients' investment choices or for placing vehicles on a select listing. The "most likely to be conflicted" form of revenue sharing stemmed from payments based on sales, client assets or the number of accounts investing in the fund companies' products.
The report also found that the industry is moving away from some of the most conflicted revenue sharing practices. That remains the case today as well, Mitchell noted in an interview. The "bundled" funds of yesteryear that included sales loads and 12b-1 distribution fees are losing out to cheaper "unbundled" products with no arrangements other than the underlying expense ratio and "semibundled" vehicles that have revenue sharing or subaccounting fees but no traditional sales and marketing payments to intermediaries.
But Mitchell acknowledged that revenue sharing and other incentives tied to fund recommendations could generate confusion among investors and advisors.
"It's, ultimately, how are you paying for the different services that are connected to the investment process?" she said. "I don't think it's that a bundled fund is necessarily worse for investors, but it can be less transparent."
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The hidden scale of revenue sharing
Still, the full picture on revenue sharing is unclear. Data about it is "notoriously difficult to obtain," given the varying amount of information about the size, payers and recipients of the payments in fund prospectuses and wealth management company disclosures, according to "
Boyson's study focused on firms registered as brokerages and RIAs — the form of affiliation
assets under management that are already subject to a fiduciary standard," Boyson wrote. Many "fall short of the spirit of the fiduciary standard," she concluded, citing the potential conflicts from revenue sharing as a key reason.
"Mutual fund management companies (families) may make revenue sharing (profit sharing) payments to advisors that sell their funds," Boyson wrote. "These payments are in addition to commissions and are at the discretion of the mutual fund family. Unlike commissions —
which are paid directly from the mutual fund's expenses — revenue sharing payments come from fund family profits. Revenue sharing payments can create a conflict of interest for advisers to sell funds from families that pay revenue sharing relative to families that do not."
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The revenue sharing case winding through the courts
Similar criticism pervaded the SEC's case against Commonwealth, which a federal district judge ordered to pay $93 million in disgorgement of revenue sharing income, prejudgment interest and a civil penalty based on the finding that the company failed to adequately disclose its conflicts.
Between July 2014 and December 2018, National Financial Services, a trade clearing and asset custody unit of Fidelity Investments, paid Commonwealth more than $189 million in revenue sharing and other payments that Fidelity collected from outside fund management firms then paid to Commonwealth based on its clients' investments, court documents showed.
"If Commonwealth had disclosed its economic self-interest to have clients hold more expensive share classes despite the availability of cheaper share classes in the same funds, then its clients would have had a clear economic incentive to convert to lower cost alternatives that would have paid less or no revenue to Commonwealth," the SEC said in a filing. "Instead, Commonwealth withheld this material information from deceived clients who continued to hold more expensive share classes while unaware of both the conflict of interest and the cost to their investments."
U.S. District Judge Indira Talwani ruled in a summary judgment that the company generated much more revenue sharing than it would have if Commonwealth had fully explained to certain clients that they could choose lower-cost funds.
"We trust this decision validates the fact that Commonwealth and its advisors prioritize their client's interests and make investment decisions based on what they believe is best for their clients," Peggy Ho, Commonwealth's senior vice president, general counsel and chief risk officer, said in a statement.
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Many in the industry will be closely following the case for any indication that their own revenue-sharing disclosures may be inadequate or could result in penalties related to their clients' choices of funds.
The
"FSI is product agnostic," spokesperson Allison Mutschler said in a statement. "Our amicus brief focused on the fact that the Commission sought to create specific disclosure obligations through a patchwork of staff guidance and settled enforcement actions as opposed to the established notice-and-comment rulemaking process. As stated in our amicus brief, this creates an opaque and unpredictable regulatory landscape where financial advisory firms that act in good faith — and the financial advisors who affiliate with and agree to be supervised by those firms — struggle to comply with shifting regulatory expectations."
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'Modern conflicts'
However that case turns out, some aspects of revenue sharing have emerged into the sunlight, while others stay in the shadows.
These "modern conflicts are much harder for regulators and the public to evaluate than traditional conflicts of interest," Mitchell and the other researchers wrote. "The SEC has not historically focused on revenue-sharing arrangements but rather on the once-typical practice of paying for distribution out of the expense ratio. Even though revenue sharing has not been heavily scrutinized, it has the potential to create a variety of distortions in the advice investors receive from brokers. Further, because of the lack of focus, the disclosures on revenue sharing are very limited and are presented in an open-end format that stifles efforts to summarize and quantify the wide variety of potential conflicts of interest they create."
Six years later, the disclosures still leave many advisors, investors and experts struggling to understand some aspects of revenue sharing, Mitchell said.
The advent of
"It's not just that the payment exists, but it's how much payment is there?" she said. "Those are important facets of this to consider, and that was not clear in the majority of the client relationship summaries, I would say."
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Investors should 'be suspicious,' while advisors should embrace transparency
The confusion surrounding disclosures and associated regulations means that when considering mutual funds, advisors and investors must examine the arrangements as closely as they can, Frayer said.
"Investors should be suspicious of revenue sharing the same way they would be suspicious of their doctor receiving commissions for prescribing a certain drug," he said. "These arrangements are too common, and they mean your financial advisor might be more interested in their compensation than your financial health."
It comes down to advisors figuring out how to fully communicate to clients the conflicts involved in revenue sharing, "so they understand fully what the effects may be," according to Grillo of the Transparent Advisor Movement. Doing so could feel strange, but clients can often be much more worried about whether they're on track for retirement, if they have enough money to take a vacation and the basic state of their investment portfolios, she said.
"The [advisors] that do recognize this and have the conversation with their clients, it's a little bit of a virtue signal, but guess what? Some of the clients may not even care," Grillo said. "We cannot eliminate every single conflict of interest, nor would we want to burden ourselves or our clients with that task."
Advisors are hardly alone in the need to address their conflicts. Professionals in any line of work — including doctors, lawyers and architects — have "a conflict with their client, because the professional has an interest in earning as much from the relationship as they can," according to Quinn of Cetera. In his view, the regulatory oversight of advisors has resulted in more disclosure and reduced conflicts compared with other fields.
Revenue sharing has "evolved a lot over the years," but the topic isn't going away anytime soon, he noted. In the end, the murkiness surrounding the practice offers one more opportunity for advisors to educate clients.
"When advisors bring this up, I say, 'Look, you should embrace this,'" Quinn added. "The more you tell people upfront about what you do and how you get paid and the potential conflicts it creates, it creates a healthier relationship and environment between you and your client."
