Revenue Sharing Set for a Revolution
May 9, 2005
ORLANDO, Fla. - Are you going to be paying for shelf space in the future?
The fate of revenue sharing is an important question for insurance companies and broker/dealers alike and a keenly attended topic at various sessions during the Broker/Dealer Conference of the Financial Services Institute of Atlanta.
Conceptually, regulators are concerned with payment arrangements from mutual funds, variable annuity carriers and other manufacturers that would induce brokers and broker/dealers to sell more of their products. The Securities and Exchange Commission has already banned the practice of directed brokerage, where mutual funds allocate securities trades through broker/dealers based upon the volume of fund sales through that broker/dealer.
However, the SEC and NASD are still examining other practices, especially 12b-1 fees, which were designed to cover marketing costs but are a common revenue-sharing vehicle for mutual funds and variable annuity and variable life separate accounts. Also, the SEC came down hard on Morgan Stanley of New York and Edward Jones of St. Louis, for not disclosing broker kickbacks.
With regulators mulling new regulations and keeping an eagle eye on the industry, many wonder what measures the SEC will take to bring the hammer down on revenue sharing. "I don't think [regulatory changes] will have as much impact as people think," said Dennis Gallant, director at Cerulli Associates of Boston. "Disclosure seems to be the biggest factor here."
Although revenue sharing and other remuneration to the broker/dealer might sound like a simple payoff to many investors, the fact is that these arrangements are poorly understood or communicated, and disclosure would do much to clear the air on what product manufacturers are paying for.
Ticket to Ride
Manufacturers give distributors three types of revenue-sharing payments, which are those payments that go directly to the broker/dealer and therefore do not include 12b-1 fees, Gallant explained. Distribution support compensates broker/dealers for their own internal promotion efforts and comes in the form of direct marketing support, persistency payments and asset- or sales-based fees. Operational payments compensate for clearing, transfer agency fees and other operational services and come in the form of ticket-charge subsidies, account-based and other fees. Access fees are a flat fee for products to be sold on a platform or presented as a "preferred" vendor.
"Access fees are not pure pay-to-play," Gallant said, explaining that distributors incur costs associated with due diligence in selecting products for their platforms. Despite concerns over such fees, "short lists aren't going away," said Benjamin Poor, senior analyst at Cerulli.
Instead, distributors will likely have to provide disclosure that includes methodology behind the fees. Although the focus has been on the clamoring of regulators for such disclosure, he added that clients and shareholders will also apply a lot of pressure to see cleaner business practices.
One area that everyone may start looking at is over-reliance on one company for sales, Poor said. Edward Jones logged 50% of its mutual fund sales through American Funds, a statistic that is likely to continue to raise eyebrows in the future. One side effect of this type of oversight is that changes to compensation may cause registered representatives to jump ship, Poor added.
Hard Look at 12b-1 Fees
The charges that have engendered the deepest scrutiny are 12b-1 fees and ticket charges, Gallant said. Poor added that 12b-1 fees are likely to change and receive a new moniker. The new fee will probably split the disclosure of marketing costs versus shareholder servicing. "It will be more of a hassle than anything," he suggested, although some companies still may not want to disclose the fees.
One of the problems with the issue of revenue sharing is ignorance, on the part of regulators, clients and the media, Poor commented. Revenue sharing is an important source of income for all broker/dealers, so eliminating the practice would not necessarily save money for shareholders, who would otherwise end up paying higher fees somehow to the broker/dealer.
Because these fees are now virtually impossible for clients to discern, many people outside the industry perceive revenue sharing as a corrupt payoff. "I don't think it's dirty kickbacks," Poor said. However, appearances matter, especially in the absence of disclosure, creating "some concern that if management fees include profits, profits are artificially high."
As yet, however, regulators have not banned either preferred lists or 12b-1 fees, though the fate of both is unknown. In the meantime, broker/dealers and product manufacturers alike can voice their opinions safely through professional organizations, so no individual firms will get fingered for unpopular opinions, Poor said.
Regulators aren't the only ones who matter; the press wields enormous power in forging public opinion. "The media needs education [about revenue sharing] as much as the regulators," Poor added.
There is no doubt that, as the result of new awareness about revenue sharing, broker/dealers will change how they receive compensation from manufacturers. Although the shape of future regulation is a paramount concern to the financial services industry practically speaking, the fear of the stick is not the only impetus for change. The implementation of new regulations will be more a reflection of internal changes than externally imposed ones, Gallant said.
For one thing, early adopters initiate change that the rest of the industry must eventually buckle down to as a competitive matter. Gallant concluded that broker/dealers were already moving in the direction of revenue sharing reform, since "the industry does correct itself."