First published on Family Wealth Report on May 16, 2019
As part of a continuing series of articles produced by the UHNW Institute, with which Family Wealth Report is the exclusive media partner, here is an outline about how the wealth management sector in the US got to be where it is today. Amidst all the debate about this or that business model, it is good to have the chance to stand back and look at the journey so far. McLaughlin is chief executive of J H McLaughlin & Co, a member of FWR's editorial advisory board and a founder of the UHNW Institute. His co-author is Robert Casey. He is a member of the Institute’s editorial board and senior managing director for research at Family Wealth Alliance. (More details on the authors and other UHNW Institute people here.)
This article follows yesterday's overview of business models - and the challenges around them - published here yesterday and written by McLaughlin.
Any attempt to understand the contemporary US wealth management landscape requires a step back to look at how we got here. Regulation and technology were the drivers of change and evolution.
Regulation had its biggest impact under the New Deal. Since then, it has played a more secondary role as technology has been the primary driver of change. At key junctures, disruptors employed technology to get around regulatory barriers or they capitalized on openings created by regulatory change and used technology to build successful businesses. The focus here is on the principal historical developments that gave form to today’s wealth management industry.
Our founding fathers engaged in a tortuous debate over states’ rights, resolving in Article 10 of the Bill of Rights (i.e. the 10th Amendment of the US Constitution) that any power not given to the federal government is given to the people or the states. Despite Alexander Hamilton’s plea for a national bank as a stabilizing force for the emerging nation, it took nearly 50 years for the adoption of a true central bank as leading critics such as Thomas Jefferson and James Madison warned of any centralized authority that would serve merchants and investors and not “the people.”
Nineteenth century economic cycles and ensuing wars ultimately settled the debate over a strong national bank. There was a general understanding that a government system of monetary and fiscal policy would be useful, if cumbersome, and that a dual state/federal chartering system for banks should be retained. While dual chartering remains in place, we’ve largely moved to a federal system of regulatory oversight in response to various events.
The modern era of regulatory history was shaped by the seminal events of the stock market crash of 1929 and the Great Depression. Financial institutions had failed to serve the common good. Prior to 1933, the regulation of securities was chiefly governed by state laws. Those days were over. The Securities Act of 1933 (the 1933 Act) clamped down on fraud and misrepresentation in the securities markets. The Banking Act of 1933, known as the Glass-Steagall Act, separated commercial banking activities from much-riskier investment banking activities. The Securities Exchange Act of 1934 (the 1934 Act) established the Securities and Exchange Commission to ensure greater financial transparency and combat fraud.
Additional New Deal legislation - the Investment Company Act of 1940, and its companion, the Investment Advisers Act of 1940 - provided frameworks for the regulation and oversight, respectively, of pooled public funds such as mutual funds and unit trusts, and of investment advisors. Advisors at the time numbered only a few hundred firms nationwide and were generally known as investment counsel.
The Advisers Act was seen in Congress as a patch. Banks had their new regulatory structure, broker-dealers had theirs. The independent advisors were falling through the cracks. Abuses in their tiny new industry were said to be widespread, but in hearings Congress found essentially none that the states weren't already addressing.
The new law was attached as a sort of addendum to the Investment Company Act. It essentially codified the business practices of the leading investment counsel firms. The bill was written by the lawyer for the investment counsel trade group and, of course, proved anything but onerous. Advisors willingly took on the yoke of federal regulation and as a group kept a low profile going forward. The emergence of the modern registered investment advisor industry would take another four decades.
In 1974 at a time of both staggering inflation and plunging stock and bond markets, Congress passed the Employee Retirement Income Security Act (ERISA) giving the federal government authority over pensions and largely setting the retirement plan landscape as we know it today. Individual retirement accounts were introduced by ERISA, as were the burdensome regulations that would ultimately doom traditional private sector defined-benefit pension plans.
The Revenue Act of 1978 caused further retirement plan upheaval. It had a sleeper clause, known as Section 401(k), that was spotted by actuarial consultant Theodore Benna. He developed a structure using the provisions of Section 401(k) for a new form of defined-contribution plan with greatly enhanced contribution limits and much more flexibility. It got regulatory approval forthwith and stormed the market of large private employers, welcomed by those who wanted to shed their defined-benefit plans and also those reluctant to start new ones. The result would be nothing less than revolutionary for the world of financial services.
By the early 1980s, after two decades of no net gain in the market, stocks began an unprecedented upward march and investment management as a business flourished. Prompted by a few corrections (the crash of 1987, the 2000 tech bubble) and business cycle turns, investors sought out institutional-quality managers. Separately, asset managers built distribution networks targeting “retail” or high net worth clients, heretofore served by trust companies and trust departments of commercial banks. The latter responded to market demand by changing their high net worth consumer banking divisions to “private banks” and competing aggressively in the evolving wealth management space.
Concurrent with the stock market’s rise, financial institutions consolidated. Money-center banks, super-regionals and regional banks merged at unprecedented rates with combined state and national banks going from 14,000 in the mid-1980s to fewer than 10,000 in 2000. An entire class of banks, the savings and loan associations, went extinct in the early 1990s.
In contrast to the dizzying pace of consolidation and financial re-engineering among the largest financial institutions was the slow but inexorable emergence of independent registered investment advisors. Their self-identity and market appeal were their Mom and Pop structures with access to their owner-principals, their implied independence and strict if not at times militant adherence to a fiduciary duty of care and loyalty to their clients. As David was to Goliath, they lacked the capital and operating scale of big firms. But their adoption of open architecture for investments and their cultural ethos of client allegiance stood in stark contrast to the big public companies that were part of a larger manufacturing and distribution complex. A new industry force was awakening.
Growth among independent registered investment advisers was kickstarted by the advent of financial planning. This new profession came to adulthood in the early 1970s, having been incubated in the insurance industry, where sales agents developed rudimentary planning techniques to gauge a client's need for life insurance. It became a full-fledged profession by the end of the decade, complete with its own Certified Financial Planner (CFP) credential.
Financial planning was client centric, as opposed to the product centric service model then widely used in the financial services industry. It focused on understanding the client's needs, developing financial goals to be provided for, then making the inevitable trade-offs to align those goals with available financial resources. Its time horizon was lifelong, not just pegged to the stock market's next twist or turn. It paid heed to risks of various kinds, and to mitigating those risks. It was holistic, comprehensive, and integrated.
If all that sounds familiar, it is because financial planning provides the structure of wealth management today. The numbers in wealth management may have extra zeros because the clients have a lot of money, but the essence is comprehensive financial planning, not investments. The range and complexity of the services offered by wealth managers are simply a function of the greater needs of highly affluent families. The difference between a wealth manager and a financial planner, therefore, is the length of the service menu, not the modus operandi.
That said, financial planners still needed a way to offer investments to their clients. Financial planning per se was largely unregulated, but not so the investment business. Their vehicle of choice was to register as investment advisors under the 1940 Act, and as the ranks of financial planners swelled, so did the population of independent investment adviser firms.
As chief driver of change in wealth management, regulation began to give up its primacy to technology. Technological changes took many forms. Some helped break down barriers to entry and open the way for more competition. That meant better products and better prices. Others delivered information on a faster, more useful, more comprehensive, more easily accessible basis. The result was often more transparency, better-informed decision making, and more convenience for investors.
In some instances, technology would be used to get around regulatory restrictions, as was the case with money market mutual funds. In 1972, retail bank deposit rates were capped by regulation at 5 per cent. Money managers Bruce Bent and Henry Brown that year devised a mutual fund invested in short-term money market instruments such as commercial paper that featured a constant net asset value of $1 per share and check writing privileges. It worked just like a checking account but paid much more than the rate of interest offered by banks on savings deposits.
A marvel of the day's back-office technology, the money market mutual fund was soon followed by an even more marvelous tech-enabled product, the cash management account. Pioneered by Merrill Lynch, the cash management account swept cash balances into money market fund shares. It also offered checkwriting and all-in-one access and reporting on the client's stocks, bonds, and other securities holdings.
Meanwhile, more regulatory history was being made by the SEC. In 1975, the agency abolished fixed brokerage commissions and opened the door for the discount brokerage industry. Few other regulatory moves before or since would have more impact on today's wealth management industry landscape. Consider this partial list of benefits from the demise of fixed commissions:
-- Open architecture. Discount brokers introduced retail clients to the concept of open architecture, both the appearance and the substance thereof. In one account, investments could be aggregated from all over the landscape, not just from approved buy lists. For the first time, individual investors were in control.
-- Price discovery. Full-service brokers did not compete on price and were happy not to discuss their (high) commission levels. The discounters plastered their (low) prices all over the place.
-- Empowered do-it-yourselfers. Full-service brokers were never happy with this crowd, and the feeling was mutual. With the end of fixed commissions, do-it-yourselfers emerged as a force in the marketplace. Today, even some of the wealthiest investors eschew full-service brokers and advisors and do it all themselves; and
-- Back-office platforms. The discounters, led by Charles Schwab, became the back offices where independent advisors obtained their client trading, custody, and account reporting services. Many leading wealth management firms use such platforms at discount brokerages to this day.
Growth in the independent RIA sector began to accelerate. Introduction of the IBM Personal Computer in 1981 and rapid improvements in the PC's power and data communications capabilities fueled a rocket-like takeoff. Portfolio management software helped firms scale their businesses. Financial planning and customer relationship management tools did the same. By the 1990s, it was not uncommon for small PC-based firms to have technology tools that were superior to those of their huge competitors.
Sometimes a good idea for one thing opens the door to an even better idea for something else. That was the case with the no-load mutual fund marketplace concept introduced by Charles Schwab. The idea was to give clients direct access to a broad range of no-load fund providers through Schwab retail brokerage accounts. At the time, no-load funds had to be bought directly from each fund company, with separate account-opening rigmarole, separate statements, etc., from each. This was an inconvenience for retail customers but a serious impediment to financial planners wanting to use no-load funds
If only they could find a way to get access to Schwab's no-load marketplace for their clients. Soon some did. Schwab noticed that a growing number of discount broker clients were signing powers of attorney giving third parties the ability to trade their accounts. The third parties, it turned out, were typically financial planners investing clients' money in no-load funds from Schwab's fund marketplace. The Schwab people wondered: could this become a business for us?
And so it happened, quite serendipitously. Already a two-time disruptor in the wealth management space, with its discount brokerage leadership and no-load fund marketplace, Schwab pulled a hat trick by inviting independent advisors to custody client assets within its doors. Schwab now provides custody, trading, and recordkeeping of client accounts to more than 7,500 advisory firms, still dominating a marketplace it pioneered almost by accident more than three decades ago.
The burgeoning competition from independent firms drew pushback from the big banks and broker-dealers. To enable themselves better to offer comprehensive, integrated services in a client centric manner, the biggest brokerages, known as wirehouses, encouraged formation of multi-disciplinary broker teams. Team members provided investment consulting, planning and other non-investment services, as well as liaison with outsource providers of such services. As part of their pushback, brokers started charging fees instead of commissions to better align their compensation with client interests (and better compete with their fee-charging rivals.)
In 1999, the Securities and Exchange Commission gave its imprimatur to this latter practice, causing a fierce regulatory turf fight. Under the 1940 Act, brokers enjoy a limited exemption from also having to register as advisors as long as 1) any advice they give is solely incidental to brokerage transactions, and 2) they don't receive any special (i.e. non-commission) compensation. Critics of what became known as the SEC's Merrill Lynch Rule cried foul, saying the fees charged by brokers amounted to special compensation and the brokers needed to register as advisors.
The agency ignored the critics for several years until it was sued by the Financial Planning Association, which triumphed when the US Court of Appeals eventually ordered the SEC to throw out the new rule and abide by the letter of the 1940 Act. One result was further proliferation of what are known as dual registrants, firms that are both broker-dealers and registered investment advisers. Another result was further proliferation of confusion among the investing public. The dispute also set the table for the impending debate on the fiduciary standard.
The market tumult of 2007-2009 shook central banks, financial institutions, and private investors to their core, doing particular damage to the largest banks and broker-dealers whose balance sheets were impaired, and brands sullied. Many became extinct, merged or were reorganized. Trust companies, with their conservative capital requirements, and registered investment advisors emerged largely unscathed with their reputations intact.
Cries for fundamental regulatory reform were heard before the dust settled. Congressional action was swift in the form of the 2010 Wall Street Reform and Consumer Protection Act (i.e. Dodd-Frank). Its primary focus was on cleaning up the large institutions, but the massive new law touched on the world of wealth management as well, in particular the issue of fiduciary responsibility. Advisors have a fiduciary obligation to put the interests of clients first. Broker-dealers need only ensure that investments they recommend are suitable for a particular client.
Dodd-Frank gave the SEC power to impose on broker-dealers a standard of conduct “no less stringent than the standard applicable to investment advisors.” A later SEC staff study recommended that very action. However, any possible SEC action needs to be meshed with an ongoing effort by the Department of Labor to impose fiduciary standards on retirement account managers. As a result, the fiduciary standard issue has not been settled and can be expected to be debated for the foreseeable future.
Certainly, “harmonizing” the application of a fiduciary standard across various business models appears unlikely. Regardless of the regulatory outcome, the debate between various financial institutions has raised the issue as a matter of public discourse for investors. Clients are beginning to ask questions about their advisors’ alignment of interest with their own interests and about their advisor compensation systems and the incentives that those systems create.