Reverse Churning | IIROC is watching ( we hope)

According to the 2018 PriceMetirx report, revenues from fee accounts grew by 17% in 2018 over 2017, while revenues from transactional accounts declined by 5% year over year. Revenue growth was further propelled by the fact that fee assets are more productive than transactional assets. Average revenue yield (revenue over assets) for fee accounts was 0.91% in 2018 compared to 0.37% for transactional accounts. The (asset-weighted) average client age stands at 67.6 years. For the household segment (those with $1 million to $1.5 million in assets), the top 10% of clients (based on rate paid) pay 1.40%, while the bottom 10% pay 0.73%, or half as much as the top 10%. For those households, fee account pricing dropped 2 bps (from average 1.08% in 2017 to 1.06% in 2018), compared to a drop of 5 bps the previous year.



The PriceMetrix report further shows that 52% of advisor-client relationships included a fee-based account in 2018, up from 31 % in 2015. Investment dealers value fee-based accounts because they are much more predictable and reliable as a revenue generator than charging clients sales commissions. In a fee-based account, clients pay roughly 1 % to 2 % or more of their total invested assets (including cash, GIC’s and bonds)  per annum depending on account size.



When you consider these statistics, it is abundantly clear that conflicts-of-interest will come into play and seniors / retirees will be prime targets. Fee-based accounts are very lucrative arrangements for salespersons (aka “advisors”). There is a very real danger that reverse churning will rear its ugly head particularly under the low suitability standard for advice giving. 



Given the rapid rise of fee- based accounts, regulators should take action to address reverse churning.  First, firms should be required to ensure that there is an adequate supervision system in place to guarantee that accounts are handled properly.  IIROC should make it clear that it will hold firms accountable if there is no system in place for supervision.  Second, salespersons should take care to monitor their client’s accounts.  Advisory service going beyond the provision of statements, such as fulsome conversations confirming the client’s goals and objectives (and appropriate documentation of such conversations), is both prudent and necessary.  Finally, decisions to hold or stand pat in any account, and decisions to move from commission-based accounts to fee-based accounts, should be documented carefully with an eye towards avoiding claims that the move was reverse churning.



We expect and hope that IIROC is particularly concerned with : (1) accounts in which securities are purchased and portfolios are designed in commission paying brokerage accounts and then transferred to a fee-based account in which the same trades could have been initiated without paying commissions; (2) accounts that consist primarily of cash or bonds that are transferred to fee-based wrap accounts in which the fees are higher but the investments do not  materially change; and (3) accounts that are fee-based accounts in which few if any transactions are made.


Additional concerns include including embedded commission funds in these accounts (double billing) as well as defining how IPO’s are to be treated.



IIROC should not depend on general principles to regulate the choice of proper account type. Rules and guidance are required to give dealers the IIROC perspective on reverse churning. The controversial IIROC principle that conflicts -of-interest are to be resolved in the best interests of clients is too vague for operational application.



Kenmar look forward to regulatory actions to protect retail investors from the latest threat to their retirement income security.