Quarterly Review 05-31-2017Submitted by CHARLES CARROLL FINANCIAL PARTNERS on June 5th, 2017
On May 22nd, the U.S. Secretary of Labor Alexander Acosta stated that the fiduciary rule governing retirement account handling would go into effect on June 9th, 2017. No further delays were anticipated.
The implementation of the Department of Labor fiduciary rules concerning all U.S. based retirement accounts means that those working with investors, with regards to the investor’s retirement accounts, must act as a fiduciary when delivering education and advice to customers. In addition, all conflicts of interest must be disclosed to the client with regards to compensation.
While the rules go into effect June 9th, 2017, the enforcement of the rules will not occur until January 1st, 2018. This delay before the enforcement date is to ensure that all broker/dealers have implemented new procedures with regards to the “education,” “advice,” and “sales” of financial service products to retirement account holders. These rules even go to the handling of “rollover” accounts from other institutions and current 401K plan participants.
This change is significant. One way that I see this change is in the number of independent small financial services firms that are either selling their practices or merging with larger investment management groups or platforms. It is expected that in the next 5 years the total employment associated with financial services firms will drop by 15 to 25%.
Why such a large drop? Commissions.
The fiduciary rule states that you must avoid or disclose all conflicts of interest associated with the sale of financial service products to the client at the time of the financial decision. Commissions, and commissionable sales will be the big losers here and their use will be curtailed significantly. Currently in the U.K., a similar fiduciary rule has eliminated commissionable financial service products altogether. It is expected that these new U.S. rules will eventually have the same effect.
Current sales of Variable Annuities and other Annuity based products have plummeted since the fiduciary rules were first suggested last year. (Almost all insurance and annuity products are heavily weighted with commissions. It is also why we have been encouraging clients to move their annuities to Jefferson National, a low-cost provider of variable annuities.) The expectation is that insurance and annuity sales will drop even further before the January 1st, 2018 deadline.
Firms like Fidelity Investments, J.P. Morgan, UBS, Merrill Lynch and Morgan Stanley have been scrambling to implement the new fiduciary rules with their accompanying new advice and selling practices. Why?
Before now, financial service firms have been held to a “suitability” standard for the sale of financial service products, not a fiduciary standard. Basically, this is a buyer beware type of standard. If a financial services product was “suitable” (in the brokerage world this usually meant “did they buy it?”) it could be presented, discussed, and sold to the client without a need to have a conversation around whether there was a different or cheaper alternative. The driver in the “suitability” world has been salesman compensation. Those days, for investments in retirement accounts, end June 9th.
Usually Fidelity Investments is not considered part of the broker/dealers’ world that is known to employ commissionable financial “products.” However, Fidelity’s own website states the following:
In addition to base pay, Fidelity representatives may also be eligible to receive variable compensation. Variable compensation typically constitutes from 7% to 68% of a representative’s total annual compensation, but may, in some cases, be significantly more of the representative’s compensation. Branch Financial Consultants’ variable compensation typically represents approximately 66% of total compensation. (https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/repre...)
One way that these firms will avoid dealing with these new fiduciary rules entirely will be to place as many retirement and non-retirement accounts as possible into “managed accounts.” (It is why we have been holding Symbol:AMG in portfolios) Why managed accounts? Managed accounts, like your account at Charles Carroll Financial Partners, have always been held to a fiduciary standard. It would not be surprising to see a proliferation of managed accounts over the next few years. Expect more calls and discussions with broker/dealer representatives as to why you should be in a managed account.
What is the difference between a managed account at the firms above and Charles Carroll Financial Partners?
Perhaps the most significant difference is cost. Many managed accounts at the firms like Fidelity, Merrill Lynch, JP Morgan, and others utilize mutual funds to provide return to their clients. These mutual funds carry management fees. The management fee is the fee that the mutual fund investor pays the fund manager for the expectation of return. It pays for the employees associated with that mutual fund. Every mutual fund has a management fee, as do exchange traded funds (ETFs) which is another story. (https://www.bloomberg.com/view/articles/2017-06-05/it-s-smart-to-worry-a...)
In addition to the fund management fee for managed accounts is the asset management fee. This fee is the fee for managing the selection of mutual funds to go into the managed account as well as the distribution of the managed account to the public. More than likely, this fee is larger than the management fee of the mutual fund.
Some “managed accounts,” like those at Charles Carroll Financial Partners, use individual equities to create return for their clients. From the standpoint of cost to the client, these managed accounts are the least costly providers of their services to the client. Why? Because equities do not carry management fees. The only fee that a client incurs is the execution cost of a trade which currently stands at $4.95 per equity purchased or sold. A comparison of a typical mutual fund management fee to equity trades on a $250,000 account is below.
Account Size Management Fee Trading Fees Cost per year Equivalent Trades
$250,000 65 basis points $0.00 $1,625
$250,000 $0.00 $4.95/trade @$200.00 50
Normally, there are less than 50 trades per year in a typical managed account lowering the cost of an individual equity “managed account” versus a mutual fund based account by well over $1,000 per year.
In addition to the cost savings from management fees, mutual funds must distribute 80% of their accumulated dividends and capital gains annually. This creates further cost to the non-retirement mutual fund based managed account as the distributions create taxable income to the investor.
Taxes are another drawback when considering managed accounts using mutual funds. A managed account that utilizes mutual funds may not use the individual fund management fee as a deduction for itemized tax returns. This basically means that up to 50% of the fees paid for a managed account using mutual funds cannot act as a tax deduction. Contrast that with a managed account using only individual securities. This type of asset management product can utilize 100% of the management fee as an itemized tax deduction as long as the client is eligible.
Finally, for those clients that take advantage of Charles Carroll Financial Partners reimbursement policy for the preparation of tax returns, the overall total expenditure that you make to manage your wealth and tax obligations goes down as well.
Over the course of the next 7 months you can expect to see major changes at firms like Merrill Lynch, Fidelity Investments, JP Morgan, and the rest. Expect to see tremendous consolidation of financial services firms as well as more emphasis on managed accounts.
Already, these same firms are establishing new customer interaction policies that will curtail or eliminate recommendation conversations between “financial advisors” and investors. Many of us have already experienced the phone call cubbyhole system that directs you into different phone extensions before dropping your call, or the voice recognition system that does not recognize anyone. In the future, it will not be out of the question to encounter a conversation with a financial services firm where the interaction comes from Artificial Intelligence based systems so that any recommendation of a financial services product meets the new fiduciary rules and standards.
We believe that financial services firms will take this governmental edict as an opportunity to reduce cost throughout their organizations. For any company, when revenue is hampered or curtailed, the natural inclination is to reduce cost. Unfortunately, this means looking at the heaviest burden to a firm in retaining profitability, employees.
Client interactions with most financial services firms will change in 2017. Expect the first phase of that change to occur in June.
Here are the major index results for the latest quarter ending:
May 31st, 2017 February 28th, 2017 % Inc/ (Dec
S & P 500 2411.80 2363.64 +2.04 %
DJIA 21,008.65 20812.24 +0.94 %
Nasdaq 6198.51 5825.43 +6.40 %
Here are the major index results for the full year ending:
May 31st, 2017 May 31st, 2016 % Inc/ (Dec)
S & P 500 2411.80 2096.96 +15.01 %
DJIA 21,008.65 17,787.20 +18.11 %
NASDAQ 6198.51 4948.06 +25.27 %
Your Black Diamond segment of the Quarterly Report will reflect your specific portfolio returns. If you are having trouble understanding the reports, please don't hesitate to call us at 508-830-0600.