As firms race to get ahead of the Labor Department's fiduciary rule, they should think twice before switching their clients’ brokerage accounts to fee-based accounts.

They could find themselves in regulatory hot water for "reverse churning," the practice of placing a client's money in a fee-based account that does not require much in the way of monitoring or ongoing service.

In such situations, the firms and their registered reps are not doing enough to justify their annual fee, says Blaine Aikin, executive chairman of fi360, a company that helps firms implement fiduciary practices.

[Image: Bloomberg]
[Image: Bloomberg]

While the Labor Department’s new rule aimed for the moral high ground by trying to eliminate incentives that might have caused brokers to recommend products that were not in the clients’ best interest, it might lead to the unintended consequence of potential reverse churning issues, Aikin says.

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Unintended consequence
The rule restricts the charging of commissions by making it onerous for brokers to do business that way. As profusely reported, the concern was that brokers would steer clients toward products that earned them higher commissions. By removing commissions and “levelizing" compensation for brokers through fee-based arrangements, the thinking was that the interests of clients and advisers would be better aligned.

But in certain situations, it may not work out that way.

For example, if a brokerage account is static or has little investment activity, it's clearly not in the client's best interest to have it move over to a fee-based account.

"It's more in the client's interest to stay put," says Aikin. In this situation, the adviser would be required to "take on a fiduciary stance" and enter into a best interest contract, allowing the adviser to charge commissions provided he or she comply with the disclosure requirements outlined in the fiduciary rule.

If, on the other hand, the account is actively traded, it would make sense to move to a fee-based account because ongoing advisory care is required, says Aikin. "With an actively traded account, you know there is going to be a need for services. There are transactions, there's more volatility, there's more oversight required and probably more regular meetings."

Anticipated rush to fee-based accounts
Aikin anticipates that many firms will change their commission-based brokerage accounts to fee-based accounts to avoid having to enter into a best interest contract, which they view as costly and burdensome. "There are more hoops to jump through," he says.

Whatever they do, firms should be aware that the Labor Department does not want to see reverse churning. "They do not want to have this exploited as an opportunity to move to a new ongoing revenue source at a higher level," Aikin warns.

"The DoL in effect is waving a red flag and saying 'be careful'." Duane Thompson, senior policy analyst, fi360.

"The DoL in effect is waving a red flag and saying 'be careful'," adds Duane Thompson, a senior policy analyst at fi360.

Rollovers likely to slow
Reverse churning issues are most likely to occur when rolling over 401(k)s into IRAs. If a client is put into a fee-based account and there was no fee prior to the rollover, the adviser must be vigilant.

"If you are charging a fee on portfolio, you are responsible for monitoring that account and the services that are being provided for an ongoing fee," Aikin says. "It's important to compare services provided in new account versus the old and compare the fees between the two, including recent commission transactions."

"If you are charging a fee on portfolio, you are responsible for monitoring that account and the services that are being provided for an ongoing fee." -- Blaine Aikin, executive chairman, fi360

Aikin added that advisers need to explain why the overall change is best for the client and document the entire decision-making process.

Firms with robust rollover businesses need to be especially cautious, according to Aikin. "Those who have built business on doing rollovers in a much more systematic and widespread way are going to need to probably slow down a bit and make sure it's in the client's best interest," Aikin says. "When they do rollovers, they better be justified from the standpoint of the client's best interest."

Aikin anticipates that there will be fewer rollovers as a result of the new rule. "Without fiduciary accountability, the incentive is to recommend a rollover because the rollover will create a business opportunity for the recipients of the funds," he says. With the new rule and the fiduciary responsibility it entails, however, money that should remain in 401(k) plans is more likely remain in the plans rather than being rolled over.

All too often today, says Aikin, "anytime the question is asked 'should I rollover?', the answer is always, 'of course, by all means, I'm here for you'."