Eliot Spitzer, New York's attorney general, is at it again. This time he is suing H&R Block for what he says are excessive fees it charges for its Express IRA product, a vehicle designed for low-income folks to save for retirement. Spitzer seeks $250 million from Block. H&R Block denies the allegations and intends to fight the suit, claiming that most of the Express IRA clients who lost money did so because they faced penalties for closing their accounts prematurely.
No matter what you think of this latest Block case (it settled earlier suits over excessive fees in 2003 and 2005), and no matter if you love or hate Spitzer, who is running for governor of New York, this latest suit will force financial advisors and financial-services executives to sit up and take notice. And you can even set aside political ideology. (Some wonder: Even if fees for financial services should be set by the government, why Spitzer's office? Why not the SEC or the Department of the Treasury's Office of Thrift Supervision or even the FDIC?)
On a practical level, you, the financial advisor or RIA, had better be able to justify your fees. That's because regulators have been busy examining fees charged to retail clients. Says an SEC spokesman: “In exams we've been looking at fee-based versus commission accounts, and NYSE and NASD have new rules that require broker/dealers to evaluate which type of account would be best for customers.” By best, he means cheapest. And, he also says, “We have had an informal staff position for many, many years that an advisor that charges a very high advisory fee — 2 percent or more — must provide clients with additional disclosure that the fee is higher than most advisors charge and to explain why.”
Now, more than ever, fees are under the microscope. “I think there is a lot more scrutiny on fees right now,” says Chip Roame, managing principal at Tiburon Strategic Advisors in Tiburon, Calif. “It's led by Spitzer, but there are plenty of other participants in this critique,” he says. “Fees are fine. Even high fees are fine, as long as you can justify what you're doing for them.”
Churning in Reverse
The tax-preparer giant is certainly not the first to be scrutinized for the fees it charges clients. Last year, Raymond James and Morgan Stanley were fined by NASD for “reverse churning,” or putting buy-and-hold investors in fee-in-lieu-of-commission accounts when commission accounts would have been the cheaper option. And then there was the investigation into the use of back-loaded B shares, which have since become virtually radioactive. And, of course, Spitzer famously required many of the fund companies charged with marketing timing and late trading (such as Federated Investors, Strong, Alliance Capital, Janus and Putnam, among others) to lower the expense ratios on their mutual funds as part of their settlements. In fact, mutual fund investors are paying about 6 percent less in annual management fees since Spitzer began his legal actions in September 2003, according to Morningstar.
In the meantime, the SEC is conducting an ongoing investigation into fees charged on index funds in general, and S&P 500 index funds in particular. Morgan Stanley, which charges an expense ratio of 1.4 percent and a 12b-1 fee of 1 percent on its S&P 500 index-tracker fund, has been the target of one such investigation. (The typical S&P 500 Index fund levies little more than a 0.40 percent annual fee, according to Morningstar.)
There are more investigations to come, says Roame, particularly in cases where there are multiple layers of fees. He predicts that pricing on funds of hedge funds will come under scrutiny, as will fees on separately managed accounts. Of the latter, regulators will ask, “Do they do the things they claim? Do they customize accounts, tax loss harvest?” he says. Insurance and annuity products with mortality expenses could also come under fire, especially when these are sold to consumers who don't need the additional coverage. And, finally, regulators may question advisors who use third-party managers who then select mutual funds or ETFs as opposed to stocks, something he says is gaining popularity in wirehouse wrap programs. “At some point, some guy named Spitzer is going to come and say, ‘You're paying a manager to pick investments whose actually paying someone else to pick investments. That's a lot of fees here and you've got to justify it,’ ” says Roame.
One b/d executive claims that if regulators put too much pressure on pricing, some products will just go away. “If it was up to Eliot Spitzer and elected officials, we might end up pushing fees down to a level where no one wants to sell anything,” he says.
There are measures that advisors can take to protect themselves. One advisor, who preferred to speak off the record, says you must document the services you are providing — daily. The advisor, based in the Midwest, says he records and files any conversations he has with fee-based clients, and not just because he is afraid of regulators. “If clients call to complain, ‘I paid you this and you didn't do anything,’ I can say, ‘Actually, yes, on such-and-such a date, we talked about refinancing your mortgage, and we also talked about how to raise the money to pay for your kids' education next fall.’ ”
It's ironic, he adds, “Regulators are still focusing on the trade instead of the services. And it's not about the trade anymore.”
Whatever the outcome of the H&R Block case, fees are increasingly in regulators' sights. John Freeman, a law professor at the University of South Carolina, puts it this way: “In the immortal words of [Saturday Night Live's] Roseanne Rosanna-Dana, ‘It's always something.’”