The potential class-action litigation cost of using the best interest contract to receive commissions may take toll on operating margins of the largest firms.
Executives', policymakers', and stock analysts' assessments of the Department of Labor's fiduciary rule are missing a key input: the potential class-action litigation cost of using the best interest contract, or BIC, to receive commissions. We estimate a long-term annual range for the industry from class-action settlements of $70 million–$150 million. That said, we wouldn't be surprised if near-term class-action lawsuit settlements exceed this by a multiple, as firms figure out how to determine, demonstrate, and document best interest. In a bearish scenario, the cost of class-action settlements alone could decrease the operating margin on the advised, commission-based IRA assets of affected firms by 24%–36%.
Michael Wong, CFA, CPA, is director of equity research, financial services, North America, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.
We previously estimated that the fiduciary rule affects over $3 trillion of wealth management assets and $19 billion of annual revenue. So, the question of "to BIC or not to BIC?" and potentially suffering the slings and arrows of class-action lawsuits or steer away from the status quo and adopt a primarily fee-based model is a major strategic decision for wealth management firms. We assess that firms with economic moats--sustainable competitive advantages--are the most likely to make a successful transition, as the quality and diversity of their platforms will retain or attract assets during this tumultuous period.
We believe that the Department of Labor's regulatory impact analysis is well founded, thoughtful, and responsive to private industry input. Its overall cost estimate of $5 billion of startup costs and $1.5 billion of ongoing costs for the financial sector is also likely in the right range. That said, we believe its cost estimate for individual large financial firms is likely off by a multiple or, at a minimum, not representative of the largest wealth management firms.
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