After announcing earlier this year the final approval of its new Code of Ethics and (fiduciary) Standards of Conduct for CFP certificants, the CFP Board recently announced that it was creating a “Standards Resource Commission” – a new assemblage of 13 industry leaders formed for the purpose of providing formal guidance and supporting resources for the CFP certificant community to better understand how to comply with the new CFP fiduciary standard.
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we discuss why this was a good and needed move by the CFP Board, why it’s necessary for even simple “principles-based” fiduciary regulation to have formal guidance on how to comply, and how the industry tends to wind up with very long and very complex regulations to support fiduciary regulation – not because a fiduciary rule is complex, but because the industry is a complex beast to which even simple fiduciary regulation isn’t simple to apply.
To understand why the CFP Board’s new Standards Resource Commission is a good idea, though, it’s important to recognize that one of the key issues that many raised in Public Comment letters when the Board’s Standards were proposed was its heavy reliance on the notion of “reasonableness”. For instance, the Standards of Conduct stipulated that advisors should act in a “reasonable” manner when addressing everything from data security to avoiding material conflicts of interest. Yet unfortunately, the very definition of “reasonableness” can potentially be quite subjective… which is why the new Standards Resource Commission is so important; their job will be to determine from the advisor community, and more importantly communicate back to the advisor community, what are our generally accepted professional practices that are recognized as industry standards and therefore “reasonable”.
For some, though, frustration remains that there is a need in and of itself to define what it means to be “reasonable” in the first place. Why isn’t the fact that CFP professionals are required to act in the best interest of their clients enough? What’s so hard about that? Why do we need all this other guidance stuff?
The answer is that in reality, simple concepts, as appealing as they are, aren’t always easy to apply to a complex system… and there aren’t many industries more complex than the financial advice industry! For example, fiduciary advocates often suggest that advisors should be banned from using only proprietary products, so that they can implement a potentially-lower-cost alternative like a Vanguard fund if it’s in the clients’ best interests. But what happens if the advisors works at Vanguard; would the Vanguard advisor be banned from using best-in-class Vanguard funds because they happen to be a proprietary product for the Vanguard advisor?
The sheer complexity of the industry means that simple rules aren’t always so easy to apply to the multitude of situations… and that’s exactly why we end up some very long and complex regulations.
However, it’s crucial to recognize that while the regulatory guidance can be quite long, the actual fiduciary and best-interests standard rules that the regulators have proposed in recent years are quite short. The Department of Labor’s fiduciary rule was not actually a 1,023 page rule; the actual rule that applied directly to advisors was just 3 simple pages… followed by 800 pages of guidance for a complex industry. Similarly, the SEC’s advice rule is not actually a 917 page rule, but a 7 page rule with over 900 pages of guidance for a complex industry. And even the CFP Board’s new 16-page Standards of Conduct is actually a half-page fiduciary rule (that’s it!), and 15+ pages of guidance regarding the Code of Ethics and conduct that is expected to comply with that rule.
And unfortunately, this tendency for long regulatory guidance for a complex industry will likely continue, until and unless the financial services industry is forced to actually become less complex – for instance, by separating out the different business lines - so that companies that create and sell financial products aren’t allowed to own advisory businesses, as is the case in the medical industry where doctors aren’t paid by drug companies to sell specific products, and is now being considered in Australia in the aftermath of their initial fiduciary regulation several years ago.
Until then, the key point remains that the complexity of regulatory guidance doesn’t stem from the fiduciary rules themselves… it stems from the complexity of the industry trying to follow them. Because being a fiduciary isn’t confusing in and of itself… but it does start getting a little messy when you begin to apply simple concepts to the real-world complexity of the financial services industry.
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Welcome, everyone. Welcome to Office Hours with Michael Kitces.
For today's OfficeHours, I want to talk about the recent announcement that the CFP Board is forming a new Standards Resource Commission. A new 13 person panel of volunteers that will work with the CFP Board to create fact sheets, FAQs, videos, webinars, and more, all to provide guidance to us, the CFP certificant community on how to comply with the new Code of Ethics and Standards of Conduct rules that were approved earlier this year and take effect in October 2019.
And personally, I think it was a great decision of the CFP Board to create this new Standards Resource Commission. This was actually when the issues I raised repeatedly in comment letters on the proposed standards last year; that the concern about how much the CFP Board's rules relied on "reasonableness"... like literally that word.
The guidance said, "CFP certificates must diligently respond 'reasonably' to client inquiry. They must take 'reasonable' steps to protect client information. They must use 'reasonable' care when selecting technology vendors. They must adopt business practices that are 'reasonably' designed to prevent material conflicts of interest," where material conflicts of interest [themselves] were determined based on whether a "reasonable" client would have considered it "material". Now, frankly, the whole point of using these reasonableness-based principles is that it actually helps to cut down on abuse, because the alternative is the FINRA style approach, what's known as a rules-based approach, where every rule has a very specific, clear dividing line that says, "Here, exactly, is what you are not allowed to do."
Now, the problem is that when the line is so perfectly defined, it does tell you exactly what not to do, but it also tells you exactly what you can do... right up to the limit, right? Because if the line is "here", I can step up right to the edge of the line and still be confident that, "I'm safe and I'm not going over the line," which, in essence, begs a lot of borderline situations where people really push the limits of the rules. Now, by contrast, with a principles-based standard around "reasonableness", we don't know where exactly that line is. You know, reasonable is kind of around here somewhere.
So, the best way to handle it, if you're not sure, is you just don't go anywhere near that line. You stay way over here where you know it's safe and reasonable, and you don't even risk by pushing the limits; where if you go right up to the line, you might, oops, suddenly find yourself on the wrong side of it. That's one of the virtues of principles-based regulation.
Nonetheless, part of the problem is that reasonableness is still something that's largely in the eye of the beholder, and different people can have pretty different views about what is reasonable based on their perspective, which is why, ultimately, these kinds of standards are typically based on what are called, "generally accepted practices or principles of the entire professional community". So, it's not what one person thinks would be reasonable – which might not actually be reasonable because we all have different perspectives – it's what the community of professionals thinks is reasonable that actually defines what is reasonable based on what is a typical and standard practice.
And that's why the CFP Board is forming their new Standards Resource Commission to be that well-diversified body of professional peers who can help set forth more clearly what really are our generally accepted professional standards that are reasonable that we, as CFP professionals, can rely upon for guidance.
Why Simple Principles Still Require Long, Complex Guidance [4:28]
Now, I know what many of you are thinking because its already come out as a criticism of the CFP Board's new Commission on Standards – is why is it so hard to figure out what's reasonable in the first place? I mean, the principle is pretty simple: professionals must act in the best interests of their clients. What's so hard about that? Why do we need guidance? Since you can't legislate and rule-make your way to moral and ethical behavior anyways.
But the reality is that even if the principles are rather simple and straightforward – as the CFP Board's Standards of Conduct states very explicitly, "At all times, when providing financial advice to a client, a CFP professional must act as a fiduciary, and therefore acts in the best interest of a client." That is a direct quote, but that's not always simple to apply in an industry that just isn't simple to begin with.
So, I'll give you some examples. One of the core obligations of a fiduciary duty is the duty of loyalty; to be loyal, first and foremost, to the client, which means putting the client's interests ahead of the advisor's and avoiding material conflicts of interest that might subvert that duty for the client. So it's the duty of loyalty that's often used as the basis for saying that advisors should not be allowed to use their company's proprietary products.
Because, if your company binds you to just one product, and that company's product generates a nice profit for the company, but doesn't necessarily have the best benefits for the client compared to the alternatives, you may be steering the client in something that's in your company's best interest but not in the client's best interests. And if that's the only product your company makes available to you, you have a very material conflict of interest, and even have a temptation to convince yourself and your client that your company's product must be the best solution for every situation because it's the only solution you've got... even if objectively it's not really the best.
It's hard to really evaluate objectively if your compensation depends on that one and only one proprietary product being sold to every client because that's all your company offers, and you don't have access to low-cost investment solutions like Vanguard. But let's say, for a moment, you're a Vanguard advisor, part of the Vanguard personal advisor services division. So if we ban all proprietary product for CFP professionals under the guise of enforcing a fiduciary duty. What happens if you're a Vanguard advisor and you proprietary product actually is the lowest cost solution that was in the best interest of a client?
Would you force a Vanguard advisor to sell a higher cost non-Vanguard alternative just to prevent any advisor from ever selling proprietary product? That's one of the winny ways that simple rules suddenly get less simple. It's easy to say, "Let's ban proprietary products because there's a lot of high-cost proprietary product out there being sold in conflicted situations when simple or cheaper alternatives like Vanguard funds are available." But if you don't want to ban Vanguard advisors from using the Vanguard funds themselves, you can't just ban proprietary product. The principle is simple, but the reality of the marketplace is much more complex.
Now, just to be clear, I'm not trying to say that Vanguard funds are the only or absolute fiduciary best interest recommendation in all situations. This is just meant to be an example, but I think it's a good one, because it makes the point that not every advisor using proprietary product is necessarily using "bad" proprietary product. The industry is just way more complex than that.
Another example in this context is the part of the CFP Board standards where it says, "At all times when providing financial advice to a client, the CFP professional must act as a fiduciary," which led a number of advisors to raise the question, "Wait, why just when providing financial advice? Doesn't this open up a loophole for CFP certificants to market as CFP professionals and just sell products and avoid being fiduciaries when the time comes?"
Now, this is a fair concern to raise because the prior version of the Standards of Conduct did have a loophole like this. The rules at the time – and which are actually still in force now because the new standards don't take effect until next October of 2019 – the rules now state that a CFP professional owes a fiduciary duty to clients when providing financial planning or material elements of financial planning, which meant that if a CFP professional did not actually provide financial planning, they could avoid the fiduciary even though they have marketed to the client as a CFP profession, which certainly implied the recommendations are going to be sound financial planning recommendations.
Now, the origin of this constraint, the CFP professional would only owe a fiduciary duty to clients when providing financial planning or material elements of financial planning was born of good and reasonable intentions. It simply was meant to recognize that sometimes CFP professionals are not actually engaged to give comprehensive financial planning advice in the first place. Sometimes the client really does just want to talk about one product.
Now, if it's a complex product like Indexed Universal life – which is an insurance conversation, and an investment conversation, and a tax conversation – it necessitates more comprehensiveness. But if it's truly simple advice, "Hey, I need a 30-year term insurance policy for my family because I just had my first child and I need you, my CFP professional, to help me buy the right term insurance policy," that doesn't necessarily amount to comprehensive financial planning advice.
There may not be much of any advice at all beyond the advice, "This term insurance product cost $300 and is cheaper than this term insurance product that costs $310, so I recommend the $300 policy because 300 is less than $310." The policies are the same. I don't really need to do a comprehensive financial plan or apply a fiduciary duty to figure out that when there's two identical products, the one that costs $300 the other costs $310, the $300 one is probably the right one for the client.
In addition, there's also the classic order taker scenario. Sometimes the client isn't asking for any comprehensive or advice at all. They just want a financial services professional, who might happen to be a CFP certificate, to help them fulfill an order for a product they already want to buy. They know what they want to buy, they just literally need someone to sell it to them and provide the implementation service. I call this the cashier doctor scenario. So imagine you're a doctor – a trained MD – but times are hard these days. You find yourself working as a cashier in a pharmacy, ringing up people's orders for the drugs they bought that the pharmacist filled, and they're now picking up.
And someone comes to counter and picks up a prescription, you ring up the order, take their money, hand them the drugs, and it turns out they have a bad reaction to the prescription – a dangerous allergic reaction or some harmful lasting side effects. And they say, "Wait a minute, a doctor sold this to me. He took my money at the cash register. I'm going to sue that doctor for malpractice," because technically the doctor did sell the drug to the patient, handed over the drug and took the money, but the doctor wasn't engaged as a doctor. The doctor was acting as an order-taker, as a cashier, simply fulfilling the client's requested order.
And that's why it's so important to define the scope of services that actually trigger a fiduciary duty in the first place. Otherwise, just filling someone's order whether it's their pharmacy prescription, or a stock they want to buy, or some insurance policy they want to buy of their own accord, of their own decision, and what may even be a dumb decision for themselves shouldn't trigger a fiduciary duty if you didn't actually give the advice to buy it in the first place, you simply took the order.
Or similarly, without defining the scope of advice, you could potentially be held liable just for mentioning at a cocktail party, "I love Amazon. My family orders deliveries there five days a week." And all the other person hears is, "That financial adviser says he loves Amazon. I'm going to buy some Amazon stock," and then if the stock has declined, there's bad news, they sue the advisor for a bad investment recommendation.
Or you say, "Bitcoin is never going to replace the U.S. dollar as the world's reserve currency," and someone hears that and decides to short bitcoin, and that moves against them, and they lose money, and they sue. These may sound like silly situations, but never underestimate what someone might try to sue you for, as a professional, if a decision they made went bad and they're just really looking for someone else to blame. These are real human complex situations and are figuring out, "When does order taking and advice begin? What actually constitutes advice? What's the occasional statement?"
If we're going to limit proprietary products so people, don't sell high-cost funds, just sell lower-cost solutions, then what happens if your proprietary product is the lower cost solution? Does it have to be your company's product to be conflicted? What if it's a sister company? What if there's a parent holding company that owns the product business and the advisory business but they're not otherwise related? If you're a fee-only RA that's owned by a bank and the bank has a mortgage business in another state, are you no longer fee-only because the parent company sells proprietary mortgages for a commission even though all of your work with clients is compensated solely by fees?
Most “Long” Regulations Are Actually Short Regulations With Long Guidance [12:54]
The industry is complex and that's why we usually end up with some very long and complex regulations for which the various fiduciary proposals and rules in recent years have been a case in point example... from the CFP Board's new Standards of Conduct, Department of Labor's fiduciary rule and the SEC's advice rule. I think the Department of Labor fiduciary rule is a particularly good example of this. When the DOL fiduciary rule came out, it was lambasted for the fact that it was a 1,023 page rule proposal, covering a retirement advisor's fiduciary duty to clients, and the introduction of this new best interest contract exemption.
But did you know that the actual rule, like the regulatory text of the new best interest contract exemption and the impartial conduct standards that all advisers would be subject to, was three pages? It was three pages... that's it. Then there were a separate eight pages of actual rules, just for the scenarios where firms engage in what are called principle transactions where investment banking firms are giving advice but then they also trade in the securities themselves.
So if they you put all of those together, the whole rule was 11 pages, and two-thirds of that didn't even apply to the overwhelming majority of advisers who don't work at investment banks and aren't engaged in principal transactions. The core fiduciary rule for advisers was 3 pages plus about 800 pages of explanation about how to apply a simple 3-page rule to a really complex industry.
In fact, it was the lobbying organizations like Siphon and FSI that were begging, during the rulemaking process, for "thorough guidance" about how to apply the DOL's fiduciary rule to their very complex and sometimes conflicted businesses. It was supremely ironic that – though actually a deliberate lobbying tactic – that the industry insisted that the DOL issued guidance on how to apply the rule of their complex business models and then criticize the rule for being so long because the DOL gave them all the long complex guidance they requested.
But the key point here is that the DOL fiduciary rule was not 1,000-page rule, it was a 3-page rule with 800 pages of explanation followed by a couple more pages for investment banks engaging in principal transactions and the guidance for them. And the SEC's advice rule was actually similar. Again, while they criticized that the core rule paperwork was 917 pages when it was released covering: regulation best interests for brokers, new form CRS disclosures, and a couple of changes to RA regulation for harmonization with broker-dealers.
But the reality, again, is that the SEC advice rule is not a 917-page rule. The actual tax of regulation best interest? Four pages. The new form CRS? Three pages of regulations. So that's about 7 pages of rules and 900 pages of guidance for a complex industry and the same principle applies CFP Board standards of contract as well. The actual fiduciary duty for CFP professionals for their clients? Half a page of regulatory text for the CFP Board followed by another page or two of just high-level principles that CFP professionals should follow: integrity, competence, diligence, professionalism and each have their own clear definitions.
In total, CFP Board Standards of Conduct were 16 pages, now there's going to be a lot more guidance coming from the Standards Resources Commission. So the total length of the CFP board's fiduciary rule is about to get a whole lot longer, but the actual rule, like most actual fiduciary rules from regulators... very, very short, very simple. It's not fiduciary duties that are complex, it's the complexity of the financial services industry itself. And once you make a regulation with real-world consequences for violating them from audits, and regulatory inquiries, the risk of fines or losing your license... you have to care about how simple rules apply to a complex business, which is why regulatory guidance ends up being so long even though the regulatory rules are simple and short.
Eliminate Complexity To Get Simpler Regulations For Financial Advisors? [16:51]
Now, there is an alternative that we might end up with at some point, which is to force the financial services industry to make itself less complex by separating out all these various business lines and not allowing product companies to own advisory businesses under one roof.
That was the path adopted long ago by the medical industry. Doctors giving medical advice to patients just don't work for drug companies that manufacture products. The doctors may recommend the drugs, but they're not paid by the drug companies to sell the drug. So they can't be owned by the drug companies in the way that advisory businesses can be owned by financial product companies today.
So perhaps, at some point, we'll force that separation. In fact, after implementing its future of financial advice reforms that compose a fiduciary duty on Australian advisors, the Australian securities regulators are now beginning to question the vertically integrated model where the product manufacturing companies own the advisory businesses and sell their products through the advisors and are raising the question of whether vertically integrated financial services firms need to be broken up and separated into product companies and advice companies like doctors and drug companies in order to mitigate the conflicts of interest.
And if that happens, well, then the regulatory guidance is actually going to get a lot shorter and simpler because it's easier to apply the fiduciary principle to a simple and straightforward business rather than the complex ones that exists in most the financial services industry today. But the bottom line to take away from the discussion is just to understand that regulators aren't issuing complex fiduciary rules. The actual rules are not complex. They're simple, principles-based, and literally just take a couple of pages.
If the SEC and the Department of Labor used the same single space and font sizes that the CFP Board did, the entire SEC advice rule would fit on a single piece of paper printed front and back, and the Department of Labor's fiduciary rule would have been the same... one page front and back... that's it. The complexity of these rules is not a complexity of the fiduciary duty and the rule itself, it's what happens when you try to apply a simple fiduciary rule to a very complex business in industry like financial services where there are real-world consequences for violating that rule. So everybody wants to know, how do you apply a simple rule to their complex business?
So I hope that helps it a little and is some food for thought. This is #OfficeHours with Michael Kitces. We're normally 1:00 p.m. East Coast time on Tuesdays. Obviously, we're running here on Wednesday today because I was recording yesterday several upcoming episodes of our "Financial Advisor Success Podcast" at the normal time. But thanks for joining us, everyone, and have a great day.
So what do you think? Is the new commission a good move by the CFP Board, or is it overkill? Does the reliance on "reasonableness" make it easier to follow the common-sense guidelines, or does the CFP professional community need more specific rules? Should regulators seriously consider making the financial advice industry less complex by not allowing financial product companies own advisory businesses? Please share your thoughts in the comments below!