A Cautionary Tale in the SRO Debate

Journal of Financial Planning: May 2011

Dan Moisand, CFP®, has been a practicing financial planner since 1991. He is a principal at Moisand Fitzgerald Tamayo LLC in Melbourne, Florida, and former president of the Financial Planning Association.

Pop quiz. It is the year 2000 and two 61-year-olds, Bob and Barb, are looking for help in planning for Bob’s impending retirement and managing their nest egg. They have been married 37 years and the kids are fully independent. They have a taxable account totaling $80,000 and a $700,000 IRA. They have this money because they have always lived within their means. Bob’s $40,000 pension check covers the bills. Any portfolio withdrawals would be for extras.

Likely you would discuss with them what they wanted their money to do for them, what Bob would retire to more than what he was retiring from, and how they envisioned living out their lives. You also would have talked to them about when to take Social Security, basic investment principles and their experiences, and what happens at age 70½, to name but a few topics.

They have lots of options, especially with the nine-year window providing the flexibility to withdraw as much or as little of the IRA as they wish before the required minimum distributions (RMDs) kick in. Now, it may very well be that if they worked with 100 different financial planners, Bob and Barb would get 100 different plans.

My question for you is how many of the plans would have looked like a variation of the following?

Because the RMDs are coming soon, they should immediately withdraw $200,000 and put it in a variable universal life insurance policy (VUL). This would cause some taxation initially, but they could later generate tax-free income by surrendering to basis then switching to loans. Since the death benefit of this policy is includable in the estate tax calculation, they should withdraw another $100,000 to buy a second-to-die VUL policy to cover the taxes. (Recall this is the year 2000 and $600,000 is the magic number.) If the premiums deposited earn enough, no further premiums would be needed. The premiums would be invested in several growth funds for “diversification.”

So, how many of you, dear readers of the Journal of Financial Planning, would have taken an approach similar to this? I believe the number is probably zero. Most readers of JFP take financial planning very seriously and provide services in a competent and ethical manner. They are loath to solve one problem in ways that can cause more issues.

Most planners would agree that the strategy of taking money out of the IRA before Bob is forced to make withdrawals at his required beginning date is worth considering, given the relatively low tax bracket that would apply. Beyond that basic concept though, the agreement should stop. For instance, a Roth IRA would have provided tax-free income later, also without much complication. I doubt most would have suggested a $200,000 withdrawal up front. Even if you go with the VUL concept, to have it included in the estate and then suggest the taxes be recovered via an additional policy is a dubious tactic in my view when a different ownership structure alone could exclude the proceeds from the gross estate.

Alas, my view of the situation came in early 2003 when I first met Bob and Barb and surveyed the carnage. With so much emphasis on growth funds, the cash value on both policies and the remaining IRA had plummeted, and the premiums the clients would need to keep them going were prohibitively high. They knew they had made a mistake or two when they filed their 1040 for 2000 and saw the final tax bill, but were so shaken it took them many months to gain the courage to see another “financial adviser.” They still express pain about the hard-earned money that disappeared so quickly.

Incompetent or Unethical

I tell this story because it is another example of what is wrong with our regulatory environment. Most everything Bob and Barb were told was true. At 70½, he is subject to RMDs; IRA withdrawals are taxable; if you surrender to basis and switch to loans from a VUL, there is no tax; life insurance on your life, owned by you, is includable in your gross estate; and if the cash value earns enough, no further premiums will be needed. It is all true and it is almost all rubbish.

I have my suspicions but in one sense it doesn’t matter whether it is an issue of incompetence or an ethical breach—Bob and Barb paid the price. Theoretically, regulations should provide a mechanism to determine whether the “adviser” was incompetent, unethical, or both and how much of that price is compensable. That’s just theory though. The “adviser” did not have the right to use the CFP® marks so CFP Board has no say in the matter. None of the designations the guy did have conduct any disciplinary functions. Of the three lawyers Bob and Barb contacted, two wouldn’t take the case at all and the other wanted such a high retainer, the clients decided not to pursue the matter. The high retainer was necessary because the case was weak.

Weak? How could that be when the strong majority of planners would say this couple got rooked? The answer is a regulatory structure that ignores the financial planning process and is rendered even more ineffective by FINRA. FINRA sets the standards for what is acceptable for the sales of these products. Their rules-based approach is what allows a disclosure document to be 100-plus pages. It allows “advisers” like this to use that title, or similar, and move on to the next couple because the “i’s” are dotted and the “t’s” crossed on the sign-offs. It allows the adviser to have little to no monitoring responsibility after the sale. It is FINRA suitability that allows “okay” or “good among what we offer” to reside where there should be an effort to find “best.”

The same lousy game plan could have been implemented with fixed products and it still would stink, but with FINRA you get the added element of cash value devastation from the variable options that tanked.

Product Sales Versus Planning Regulation

The Government Accountability Office (GAO) study missed just how important good planning is to consumer interests. It got some things right, like the need to bring some clarity to titles and designations, but it bought the FINRA/SIFMA line that with all the product-sales regulation currently in place, no planning regulation is needed at this time. In short, the GAO blew it.

The GAO won’t be alone in that for long. Congress is looking to cut instead of increase funding for the SEC. The SEC has the opportunity to reduce its workload by recommending an SRO for investment advisers, and the most likely candidate for that role at this time is good ole FINRA. There are plenty of chances coming for more groups to blow it.

Never mind that the S in SRO stands for “self.” FINRA is an SRO for brokerage firms—they regulate themselves. When the creation of that SRO was undertaken, the line between being a broker-dealer and an investment adviser was much clearer. So much clearer, in fact, that separate regulatory structures were constructed. The nature of the sales function is fundamentally different than the nature of the advisory function. Separate structures still make sense.

Over the ensuing decades, FINRA has allowed its members to hold out their services to be advisory in nature. The SEC has let this happen to such an extent that today we have the ludicrous argument that since in some cases the services of brokers are almost identical to advisers, a new regulatory structure is needed to “harmonize” regulations. If the SEC isn’t up to the job and wants an SRO to oversee investment advisers, FINRA would be a horrible choice. FINRA is controlled by broker-dealer firms, which means commercial interests. David Tittsworth of the Investment Advisor Association summed it up well when he said in an October 19, 2010, comment letter: “We oppose extending FINRA’s jurisdiction to investment advisers due to its lack of accountability, lack of transparency, costs, track record, and bias favoring the broker-dealer regulatory model.”

FINRA’s Track Record

Poor track record indeed. Forget all the scandals of the past and just look at the last few years. Remember Bernie Madoff? He joined FINRA’s (then NASD’s) Board in 1994 and was its vice chairman while his Ponzi scheme was under way. His brother Peter held the same office at one point. His son Mark found his way onto the National Adjudicatory Council, a regulatory body that reviews disciplinary decisions made by FINRA, thanks to an appointment by then-FINRA CEO, Mary Shapiro. Bernie’s niece, Shana Madoff, a compliance officer for Madoff until the firm’s collapse, was a member of a compliance advisory committee of FINRA.

One of the best examples of how fouled up FINRA has become is its actions regarding auction-rate securities (ARS). FINRA’s 2008 annual report describes the ARS mess as follows:

Auction-rate securities (ARS) traditionally had been a valuable source of market liquidity, targeted at investors seeking a cash-like investment that paid a higher yield than money market mutual funds or certificates of deposit. But in February 2008, the ARS market froze, leaving some investors unable to access their holdings. The episode prompted an investigation by FINRA that revealed some firms had sold these securities using advertising, marketing materials, or other internal communications with its sales force that were not fair and balanced and therefore did not provide a sound basis for investors to evaluate the benefits and risks of purchasing ARS.

What is omitted is that FINRA itself had a reported $647 million investment in these securities that they liquidated in 2007. Yes, this means that instead of warning the public or even its member firms to describe the securities more accurately, its leaders knew enough to bail out ahead of any trouble.

FINRA also has been criticized for paying seven-figure salaries and bonuses to its executives at a time when many of its larger member firms were getting away with securities violations that brought our financial markets to the brink of collapse. Those brokerage firms that managed risk so poorly they brought the world’s credit markets to a standstill and had to be bought out for pennies on the dollar just to continue operating now want to regulate the advice business. That’s a bad idea on every level.

Bob and Barb got lousy advice implemented poorly. FINRA’s mandatory arbitration system effectively shut them out, but take note that it was up to Bob and Barb to figure out there were issues and find a lawyer to pursue the matter. FINRA loves to pound its chest about the number of examinations it makes, but like FINRA’s failures when examining Bernie Madoff, Bob and Barb’s case shows quantity doesn’t mean much. The “adviser” was examined annually.

Getting America’s regulatory structure straightened out is going to take a long time. FINRA as SRO would be a huge step backward. It took the global financial crisis to serve as a catalyst to examine many regulatory issues. I suspect personal financial advice won’t get regulated in any sensible way without a catalyst of its own. Maybe a prominent congressman will have an elderly parent who gets a raw deal or something. In the meantime, the public pays a heck of a price when regulators think about their own turf instead of the public’s interests.

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