Outsourcing, the SEC, and you

A proposed SEC rule could alter the way you manage client relationships

Outsourcing — using third parties to manage client investment accounts — has become increasingly popular among independent financial advisors. It provides a welcome means to devote more time with clients and/or focus on business development. However, a new rule — 206 (4)-11— proposed by the SEC may diminish that benefit by introducing a new level of time-consuming due diligence. 

The Flexible Advisor spoke with Paul Binnion, Chief Revenue Officer at Hanlon Investment Management, about the proposal (December of 2022 ended the comment period) and what it may mean for advisors and the future of outsourcing.

The proposal

In summary, the rule would require advisors to 1) conduct due diligence prior to engaging service providers to perform certain functions, and 2) periodically monitor the performance and reassess the retention of each service provider. The SEC is also proposing corresponding amendments to the investment advisor registration form to collect information about the service providers defined in the proposed rule, and amendments to the Advisors Act books and records rule including a new provision requiring advisors that rely upon third parties to conduct due diligence and monitoring of those third parties and obtain certain reasonable assurances that the third parties will meet certain standards.

The SEC frowns very heavily on advisors parking assets on a platform and doing nothing else. — Paul Binnion

The SEC‘s concern

“The SEC frowns very heavily on advisors parking assets on a platform and doing nothing else, but collecting a 1% advisory fee,” says Binnion. “I think they're saying, ‘If you are going to outsource, you have to be doing something for the fee you're charging. We'd like to see you do more fiduciary oversight.’ Remember, the whole move away from the commission-based model was to create a more involved relationship with the client. The apparent intention of this rule is to stop advisors from charging a 1% commission, calling it an advisory fee, and acting like they're doing something valuable when in essence they're not.”

The devil is in the details

Because the proposed rule is still being refined, Binnion notes that key details remain unclear. “There is talk about the advisor doing due diligence on the money managers on the platform, when in essence the broker/dealer already claims to be doing that. It’s unclear if the SEC is saying that on top of the broker/dealer oversight, they will now require an advisor to oversee more of a partnership relationship, and less a distribution relationship. It will be interesting to see what this proposed rule ends up looking like and how it will be enforced.” In any case, Binnion sees an opportunity for advisors to assess how they work with clients. “What does your workflow look like? What is your process? How many touches do you have, and how do you touch? All those things can be reviewed and enhanced.” 

The enduring value of outsourcing 

This brings us back to a primary reason advisors choose to outsource in the first place: to devote more time to clients. An outsourcing partner should put time back in the advisor’s day so they can actually spend that time with clients, according to Binnion. “The key here is rule #1: know your client. You can’t determine how to position a client's wealth from a risk profile. You do that through conversation. When an advisor spends more time with their clients, the relationships deepen. There's a higher level of trust and confidence. For example, in a period when the markets are down, advisors who have deep relationships with their clients are far less likely to run into problems regarding underperformance because they spent the time to explain and discuss it with them; those who haven't potentially open themselves up to a whole can of worms as far as compliance and oversight.”

The advisor’s next step

What can an advisor do right now to be compliant with these proposed new requirements? Begin by reading the current proposal. “Just read about it and see where perhaps you're falling short or perhaps where you're exceeding,” said Binnion. “The answer, I think, is outsourcing to credible platforms that help advisors do their job, rather than taking on the advisor’s job. Second, consider how you can deepen your client relationships. No matter how much you already do, what more can you do? Rather than spending a half hour with your clients two times a year, maybe you spend an hour with them four times a year.”

You can access the full discussion on The Flexible Advisor, wherever you get your podcasts.