While fee-based brokerage accounts may make sense for a lot of investors, clients who trade infrequently may be getting the short end of the stick. Infrequent traders should beware ‘reverse churning,’ a situation in which an advisor sits back and collect fees without really managing your account.
The subject of reverse churning gained significant attention when regulators targeted brokerage firms that were promoting accounts with little regard to their customer’s interests. The main concern of regulators was that the clients would eventually pay more in the fee-based accounts than in the commission-based accounts –– with very little additional service or advice to compensate for the increased price tag.
There have only been two firms fined at this point; however, industry observers and regulators state that reverse churning is a primary item on the watch list of regulators in audits. In the previous year, there have been a number of broker-clients who received a deficiency letters from the regulators after an audit. In addition to a number of other things, the regulators requested explanations of why certain clients were placed in the fee-based accounts.
To answer these letters, a rationale has had to be given for putting the investors in to a fee, rather than, commission, brokerage accounts.
According to other participants and industry observers, once a regulator has taken action to censure or fine a broker, a wave of client arbitrations may follow.
As a result of this action, financial advisers must understand the often confusing rules and the various categories of accounts in order to adopt the best practices that will avoid drawing attention from regulators and even arbitrations from customers down the road.
The Development of this New Trend
Fee-based accounts were first introduced about two decades ago, and while the industry has come quite a way from this point, it is still a source of regulator attention. The first stand against churning was seen in the mid-1990s since it was believed the process was only working out for the trader helping to increase their commissions even on inactive customer accounts.
The entire concept of fee-based accounts was introduced in 1995 to try and resolve the conflict of interest related to commission based accounts. The simple explanation was that in an effort to reduce churning issues and minimize regulator attention, the industry started to request that brokers open the fee-based accounts. As a result of the success, many of the brokerage firms encouraged their advisers to open more of these types of accounts.
The Present State of Fee-Based Brokerage Accounts
Ten years later, the fee-based accounts business is still booming. By the end of 2005 these accounts held over $300.1 billion. This is an increase of over 1,665 percent from the 1197 total in these accounts of just $17 billion.
However, not everyone is attributing this increase just from the industry push. There are many who credit the surge, in a large part, to the stock market’s lift-off between 1998 and 1999, which was encouraged by an increased interest in technology stocks. In fact, by 2000 the accounts were up to $153 billion and after the 2000 and 2002 bear market, the accounts started to grow once again.
Today the $300.1 billion number makes up as much as 21 percent of the non-institutional, fee-based assets. The single average account holds approximately $233,000 and will pay an average fee each year of 1.08 percent. This works out to the total of about $2,500 in fees each year, for every account, which is a significant amount especially if the client is not using the account frequently and if there is very little advice from the broker to go along with it.
In order to ensure you are protected in cases of reverse churning – both brokers and traders – need to keep accurate documentation of everything. This is essential.
Just like with any other type of account, a fee-based brokerage account needs to be managed, monitored and rebalanced. Additionally, customers need to be aware of the changing market and economic conditions. If a broker does not provide assurance he is also on top of market trends, chances are he may be a target of regulatory scrutiny, as well. When you have the documentation offering proof behind the actions taken in your account, regulators should not be an issue.
In addition to remaining proactive about documentation, it is also important for brokers to continually check to see if the objectives and goals of their client have changed. This will help ensure that the fee-based brokerage account is still suitable. The bottom line is the customer and what is best for them.