Brokers fret over loss of fee-based choices

IRVINE, Calif. — After building businesses through fee-based brokerage accounts and mutual fund trail fees, many brokers are anxious about looming changes to these sources of revenue.
Fee-based brokerage accounts appear to be dead after a March court ruling ended their exemption from the Investment Advisers Act of 1940. Meanwhile, SEC officials and some lawmakers continue pushing for major changes to 12(b)-1 fees.
“There are two things I worry about: Clients dying and the government putting me out of business,” said a rep with Merrill Lynch & Co. Inc., who asked not to be identified.
This rep gets about 80% of his revenue from 12(b)-1 trails and the New York-based firm’s Unlimited Advantage fee-based brokerage account.
“We all have some income from trails or fee-based [brokerage] accounts,” said a broker with New York-based Citigroup Inc.’s Smith Barney unit, who asked not to be identified.
“I’m in trouble” if 12(b)-1 fees are eliminated, said Graham Parsons, an Erie, Pa.-based rep affiliated with LPL Financial Services of San Diego and Boston.
“They could literally legislate me out of business,” said Mr. Parsons, who has built his practice around mutual fund C shares that pay roughly 1% in continuing trails.
“I’ve had sleepless nights over this,” he said.
Loss of the fees “would make me wonder whether I should stay in business,” said Curtis Mohr, a Pasco, Wash., broker affiliated with Royal Alliance Associates Inc. of New York.
He handles many small investors with A shares and relies on the 0.25% service fee from the products.
Most firms have or are developing advisory versions of their fee-based brokerage accounts, which are priced about the same as brokerage versions. But advisory versions tend to have more-limited investment options, brokers say.
Clients who can meet the minimums for separately managed accounts will almost certainly pay more than they do now when using C shares or fee-based brokerage accounts.
Alternatives for smaller mutual fund investors aren’t so clear.
A system to charge trail fees separately from a fund — an idea known as “externalizing” the fee — could be developed, but there is a good chance that small investors would end up paying more, because large mutual fund accounts subsidize smaller ones, observers say.
If service fees are separated from the product, “there’s a strong reason to believe costs for large investors will come down, and costs to small accounts will go up,” said Barbara Roper, Pueblo, Colo.-based director of investor protection for the Consumer Federation of America in Washington.

Cost illusion
“It’s an illusion that if you externalize fees, you end up with lower costs,” due to the benefits of more competition, said Avi Nachmany, director of research at Strategic Insight Inc., a New York consulting firm.
That theory is “completely naive,” he said. “If you look at places where the cost of advice is [already] externalized, like SMAs … the costs are significantly higher.”
Not including costs embedded in underlying products, fee-based brokerage accounts charge 0.98%, on average, according to Cerulli Associates Inc. of Boston. Brokers can use individual securities, as well as some funds, in most of these programs.
Mutual fund wrap programs average 1.16%, plus the internal costs of the funds used, Cerulli data show.
The total expense ratio on the average level-load equity mutual fund (C shares) is 1.95%, according to Lipper Inc. of New York.
Fees for separately managed accounts, which are all-inclusive, average 1.68%, according to Cerulli.
But SMAs require a larger investment and are out of reach of many investors who want to diversify among managers and styles, brokers say.
High and dry
With brokerage-based fee options restricted, brokers may find it harder to service smaller investors. Many reps rely on the 0.25% trail fee for handling clients who need continuing help.
No similar low-price servicing option exists under an advisory platform.
“The 12(b)-1 fee structure … allows advisers to have relationships with lots of small accounts,” Mr. Nachmany said. An adviser doesn’t “have to be a collection agent.”
“12(b)-1s make it easy to sit down with the little guy,” Mr. Mohr said.
Compared with SMAs, a portfolio of C shares is simple to manage and easy to re-balance among different mutual fund groups, brokers say.
Externalizing the current system of 12(b)-1 fees will force brokers to evaluate what they charge each client, Mr. Nachmany said.
“The market will tell them they’d be right to charge more than they’re charging now,” he said, and as a result, some small accounts might be dumped.
“It looks to me like the little guy is getting the squeeze” as a result of changes to fee-based options, Mr. Mohr said.
Wirehouses have already moved to get rid of smaller clients, and more independent reps might have to move in that direction, he said.
But Ms. Roper doubts that significant changes are in store for 12(b)-1 fees, other than improved disclosure.
To eliminate conflicts of interest, the SEC should undertake a comprehensive review of broker compensation from all types of products and platforms, she added.
But compensation issues are complicated, and any changes “could have unintended consequences,” Ms. Roper said.