As the Smoke Clears...
Written by John M. Lefferts, CFP,CLU,ChFC
This past week, I had the opportunity to speak with some Congressmen and Senators on "The Hill" while in Wash DC for an industry conference. Intuitively, I've always known that politicians will be partisan as is the way with politics. But I was struck by how extremely polarized each side has become leaving little room for compromise. In the spirit of full disclosure, my political views tend to be fiscally conservative and pro-business while being socially moderate. Unfortunately, it seems that politics these days force you into either the camp as being a truck with gun rack driving and bible thumping red neck or a dope smoking, tie dye gown wearing hippie dancing with hands flailing in air. It doesn't seem like those who connect with both sides of the aisle have any representation at all. And it's this "all or none" mentality that causes me to wonder how anything ever gets done in Washington. That brings me to the central theme of this writing... We are in a unique point in time in the financial services industry where there is an opportunity for new regulations to truly re-shape the landscape for the benefit of consumers and the business. Not only is this long overdue, but we have the chance to align regulations closing the gaps that enabled the multiple Ponzi schemes to exist for decades and Credit Default Swaps to go virtually unregulated destroying much of the US economy. But as they say, never underestimate the status quo, which is a threat to getting anything meaningfully done at all. It's my hope that new regulation will be well thought through and eliminate the current patchwork of regulatory silos (SEC, FINRA,State Securities Dept's, State Insurance Departments, CFP board, etc). But then again, the status quo would lend to simply placing a new layer of "systemic" regulation on top of the existing regulatory patchwork not only keeping a bad system in place, but making it worse by having to answer to yet another regulatory body.
I've written before about why now may be the time to anticipate "where the puck is going" and how regulatory and economic changes are potentially reshaping the financial services business and business models for good. The company/individuals who have the foresight to get this right and act on it would be in the driver's seat to take advantage of the growing boomer demographics' financial needs as the economy eventually recovers. Let's not forget that even with the economic downturn, the amount of "money in motion" will reach all time highs in the next several decades as boomers retire and transfer their wealth to the next generation. It may be too early to call from what we know today, but the smoke on this crisis is beginning to clear and the resulting factors effecting the financial services business are starting to take shape. There are 3 primary factors driving change in the business. They are: 1) Updated regulation 2) New economic realities of business with beaten down balance sheets and 3) A shift in consumer attitudes and behavior. So, I'm going to go out on a limb and give it my best shot at what I see evolving...as smoky as it still remains.
Changes in regulation
It's been well chronicled how we got into this financial crisis and I won't rehash it here. But the other day I heard one politician (admission: I was watching the financial porn channel CNBC) proclaim with relative certainty that it was the repeal of the Glass Steagall Act allowing banks, insurers and investment banking walls to fall that caused this crisis. What a bunch of baloney! The repeal of Glass Steagall, which was built in a different era for different reasons, was not the cause of the mess. If you examine it more closely, you'll see that while the silo's between financial intermediaries came down, the regulatory silo's remained in place. It was this misalignment of regulation that caused many bad things (i.e. Madoff, CDS, Hedge Funds, Mortgage excess, etc) to slip through the cracks. What should have happened along with the repeal of Glass Steagall into a new era of financial services was a new era of financial regulation. Talk of a systemic regulator is about a decade too late. Meanwhile every regulatory body is lobbying for their respective relevance and survival while the consumer and those of us in the financial services industry stand by and watch. The quote, "The more things change, the more they remain the same" comes to mind which is why I fear that the ultimate solution of a total regulatory overhaul will give way to the status quo in more of the same.
Nonetheless, there is sufficient demand for at least some change that has momentum to get done in short order. One part I think will happen is that the life insurance industry will finally get differentiation from the Property and Casualty Insurance business and get the federal oversight they so desperately want. This will be a big win for the life companies who have had barriers to competition and are hampered with unnecessary costs as they've been hand-strapped by a mishmash of state insurance regulators. It's also a win for consumers with an opportunity for simplified and less costly products while additionally eliminating the seedy side of the insurance business selling 15% commissioned annuity products to all too trusting seniors. But in the "be careful what you ask for, you may just get it" department, FINRA and SEC Chief Shapiro have been making noise about "harmonizing" the regulations between Investment Advisors, Broker-Dealers and yes, Life Insurance. Further, there has been much talk about these new "harmonized" regulations holding Advisor/Broker/Agent to a Fiduciary standard of care. This is still being duked out in Washington, but think about the ramifications should this come about. And whether or not this happens, at least directionally it is where regulations are headed over time. It's a consumer centric way of looking at it. The customer doesn't know or care which hat an advisor/broker/agent is wearing when they present a financial solution. Much of what is being recommended today resembles professionally managed portfolio of securities in its purest form. But, if it is wrapped as an annuity, the states regulate it. If there a fee for advice is paid, the SEC regulates it (more or less). And if it's wrapped up as a mutual fund, FINRA regulates it. All the while, the consumer has a tough time distinguishing one from the other... they all look the same to them.
So, as a fiduciary, full disclosure is a requisite. That means the advisor/broker/agent will have to disclose all fees and commissions, not to mention the benefits of any alternatives. Think how red-faced that will make insurance agents when they must disclose in writing that close to 100% of the first year premium paid is gone. Without question, this will definitely lead to product design changes and a movement towards fee based products and services across all disciplines of financial services. This will also place the distribution models that are economically built on the sale of commission based proprietary products at a tremendous disadvantage since the financial solution won't always be one dimensional as is often the case today. Fee driven business will be the wave of the future.
Shift in Consumer Attitudes and BehaviorIt's been cited before that the average consumer spends more time planning their vacation than they do their financial futures. I think that changed In April when everyone opened their quarterly account statements and gasped at the balance. They (myself included) have been going through the range of emotions beginning outward with anger to blame to resentment then moving inward to acceptance. I hear people say, "I was too trusting" or, "It's all so complicated" or "I thought everything was taken care of"...Not anymore. As this crisis moves towards recovery, and there are signs that we are beginning that process now, the consumer will take more control of their financial futures. They will demand to understand what they are investing in, how it works, what the costs are and all the potential outcomes. The mystique of hedge funds, Madoff, Stanford and all the other "high brow" schemes will no longer be alluring. Regulation will require and consumers will demand to know what is in the "black box" of financial products. The veil of secrecy that the "Hedgies" enjoyed was the basis for their success. But with the light being shed on their practices, they'll scatter like certain insects (can't bring myself to say it here) do when exposed to daylight.
Having said that, as simple and transparent as financial products and services can get, the vast majority of the population will still need the help of a financial professional to assist them in sorting through it all. At the end of the day, American's have neither the time, training nor temperament to get their financial houses in order. While the doors may be closing for the transaction driven product hucksters, it appears to be opening for process driven financial planners. Financial Planning is a relatively new profession still trying to find its footing and gain acceptance on par with CPA's, Attorney's or medical doctors. Wall Street has summarily thumbed its nose at the profession relying more on their investment acumen with charting, timing, and all else that is typically confusing to the investing public. They viewed the planning segment as a whacky touchy-feely underworld that lacked the sophistication of Wall Street. (Yes, the emperor has(d) no clothes) But now, the consumer wants help and no segment of the financial services world is in a better position to give it than a financial planner who can coach, counsel and hand hold while caring less about a sales commission because they receive a fee for their services. While there is much talk about the end of Wall Street, there is little attention being paid to the part of the financial services business best positioned to take over the throne: Fee based or fee only Financial Planners.
New Economic RealityWe've almost become numb to the staggering news that comes at us daily to recognize the magnitude of what has happened in the financial services business over the past year. If we step out of the box and take ourselves back a couple years, who would have believed that the "thundering herd" of Merrill would be subservient to Bank of America, The largest insurance company in the world, AIG, is being sold off in parts to raise money for the government and household names like Bear Stearns, Lehman Brothers, WAMU and Wachovia cease to exist as stand alones. As Will Farrell says in one of his spoof movies, "It's mind-bottling". The shift in the financial powerbase from Wall Street to Main Street has only just begun. Over the past 6 months, most financial firms have been simply positioning for survival and living off TARP money. The damage caused by the subprime mortgages and all the various ways it was packaged is already legendary. But as commodity, equity, debt and residential real estate values have plummeted, it is widely thought that there is one more shoe to drop. That is commercial real estate. As commercial real estate becomes the last bubble to pop, a new wave of firms, many insurance companies, will need access to capital or risk government intervention, which as we know, is not a good thing. The key driver here is leverage which works great going up and is devastating going down. Investment Banks were the worst employing up to 30X in debt to equity. Next have been the commercial banks who were hovering around 20X. Life insurance companies have been relatively safe at 10X, but those with large commercial real estate exposure will have trouble. The least leveraged of the bunch appears to be Property and Casualty companies who have had roughly 5X leverage. Once we get over this period of downsizing and fighting for survival, and I think we're about at that point now, then I think we'll see the consolidation games begin. Once they have cut all that can be cut, the Financial Firms will have no choice but to begin to move from being reactive to more strategic. "Strategic Reviews" such as what ING used to decide to sell their Broker-Dealer business, will be the new phase. What you will see is firms shedding all that is "non-core" as companies retreat to their respective silo's where insurance manufactures insurance products, banks provide banking products and investment companies provide, surprise!...investment products. Then within each respective financial services silo, the consolidation games will begin as the balance sheets and equity values rebound. Mid-sized or regional firms, heretofore under the radar, may emerge as players in the consolidation of the businesses as the giants are still staggering from the blows they have taken and continue to deal with their legacy costs not to mention the requisite in paying back the government first.
As the Smoke ClearsSo the smoke is beginning to clear and we can see the rough shapes taking form. New Regulation will force transparency, full disclosure and a fiduciary standard across all financial disciplines. This forces a move towards fee based lines of business. Consumers will demand simplicity and actually make attempts to get their financial houses in order. This forces a move towards financial planning. Financial institutions will be forced to "stick to their knitting" and do what they do best which is to manufacture products and services in their area of expertise. So I think you can probably guess what my conclusion will be. Financial firms will manufacture products and distribute them through fee based and/or fee only financial planners driven by new regulation, changes in consumer attitudes and the new economic reality caused by the great recession of 2008. Does this mean that stockbrokers and insurance agents and other financial services specialists will become extinct?...of course not! As I mentioned at the start of this piece, I'm suspect of any extreme position and tend towards moderation. But the stage is set for financial planning to play a much larger role in the financial services business as the evolution takes hold. Who, how and when will this happen...I'll save that for another chapter...and as the smoke clears.