August 26, 2004
As a Certified Financial Planner Professional tm, and practicing as an independent advisor both under my state RIA and as an IAR through affiliation with LPL Financial Services, Inc., I am very familiar with the incredible confusion that is foisted upon the public regarding the nature of services, relationship to advisors, compensation involved and most importantly, the level of professional standards and obligations to the recipient of services rendered through the labyrinth of channels available to consumers.
The fiduciary responsibility is a clear standard that must be adhered to whether under the advisors own RIA or as an IAR. The accounts must be managed individually on behalf of each client. The proposed rule, expanding exemption to fee-based brokerage accounts has done great harm to the public and will continue to do so should it be allowed to continue. I strongly believe it should never been allowed in the first place having been made operational by the SECs own public notice recommending non-enforcement action for brokers choosing to operate under the proposed rule.
The damage has been done by allowing the brokerage industry to transform the window of transparency associated with fee based advisory accounts into a curtain behind which the representative can pretend to be managing accounts while in fact he or she has no need and nor incentive to do so.
Independent advisors believe strongly that the commission form of compensation had evolved into a shell game and that a remedy could be promoted by simplicity, transparency and by raising the level of practice standards to that of a fiduciary through fee based advisory accounts. Discretion is at the heart of this issue.
Under the current circumstance, the public is worse off than before the development of fee based advisory compensation because the typical client has been led to believe that this method of compensation is better aligned with his or her interests.
This is true, if and only if, the service offered is discretionary management and fiduciary liability. Absent these components, which is not at all disclosed by the requirement to point out that the account is brokerage the representative has no obligation nor incentive to manage the account which the customer has typically chosen themselves. This choice exercised by the client shifts the responsibility to the client and typically involves 5-8 options, all of which are typically limited in asset classes and usually are rebalanced on an automated basis.
Automated rebalancing is not management offered by the individual receiving the fee-based compensation. Instead, it allows the representative to operate freely in other areas of business and further offers incentive to the rep. to simply gather more assets, which can hardly be described as under management by that rep.
In my circumstances, it would be easy and very tempting to take up one of these model portfolios among LPLs brokerage offerings and spend most of my time marketing rather than tending to client accounts. I make this potential very clear to prospective clients emphasizing how easy this would be to do without them ever knowing, in order to educate them about the industry and how dangerous it is to select an advisor without understanding exactly who is being paid by whom and for what services rendered.
Fortunately, LPL has developed model portfolios within the advisory area which can be automatically rebalanced but still require fiduciary monitoring. These can be used for smaller accounts whose need for diversity across multiple asset classes is less and exposure to cost considerations is greater than that of larger accounts. In both cases, discretion and fiduciary liability are still at the core of the issue and nature of the relationship.
In closing, I wish to submit a stunning and alarming example of a specific manner in which this rule has contributed to the deterioration of public trust and more importantly, significantly damaged client portfolios unnecessarily.
Clients who opened this type of fee-based brokerage account during the past 5 years in which we experienced the worst bear market in history measured in terms of realized losses across the largest invested population in history were subjected to a practice which unintentionally, yet unnecessarily ravaged the accounts of those taking income.
Automated brokerage accounts, typically distribute income to investors on a pro-rata basis, thereby destroying the protective nature of widely diversified portfolios where rebalancing has been shown to minimize volatility. Pro-rata distributions necessarily distribute realized losses from shares sold that are down in value. This practice assures realized losses for every distribution and is augmented during downturns across 70-80 percent of the asset classes.
By contrast, fiduciaries armed with discretion, were in a position to carry clients accounts throughout the bear market period without distribution of any shares representing realized losses by carefully monitoring and managing of the distributions.
In other words, no clients taking income were necessarily forced to suffer realized losses and therefore could have been positioned absolutely for potential recovery. This is exactly the case for those clients accounts which we managed through the bear market of 2000-2002.
This rule has served to protect the brokerage industry from liability for those unnecessary losses. If it were up to me, beyond the withdrawal of this offensive and destructive rule which has unwittingly lead to serious damage and a lack of accountability, I would call on the SEC and the NASD to strictly prohibit the use of auto-rebalancing in connection with pro-rata distributions as an inherently destructive practice one which I believe is limited to the brokerage and not the advisory industry.
I strongly urge the SEC not only to rescind this rule in its entirety, but further, to open an investigation as to the damage done through the functional operation of the rule prior to its formal adoption through the SECs public announcement recommending non-enforcement action for brokers operating under the proposed rule.
David L. Maurice, CFP r