November 2003

On the CPA’s Role in Guarding Clients’ Investments

By Philip J. Harmelink and William M. VanDenburgh

The current stock market environment (Exhibit 1) has investors reassessing their investment strategies. Cost minimization is often overlooked as a component of successful long-term investing. The typical broker relationship is in direct conflict with the objective of achieving higher financial returns. That in April 2003 the securities industry paid fines totaling $1.4 billion only highlights this inherent underlying conflict. A commission-based broker derives little or no revenue from nontraded accounts. While fixed-fee brokerage accounts are available, they typically entail high annual fees.

CPAs usually become part of this process only after an investment decision has transpired. Integrating CPAs as part of the process allows for a thorough analysis of the available investment and tax options, as well as a level of independence that might not occur otherwise. When markets were producing double-digit returns, the fees incurred seemed immaterial. Recently, however, the fee factor is more relevant.

The recent SEC settlement with the brokerage industry reflects the conflict of interest between the brokerage industry and retail investors. The following points are excerpted from the SEC press release on this agreement (www.sec.gov/news/press/2003-54.htm):

• The historic settlement required payments of penalties of $487.5 million, disgorgement of $387.5 million, payments of $432.5 million to fund independent research, and payments of $80 million to fund investor education and mandates sweeping structural reforms (Exhibit 2).
• The settlement followed joint investigations of allegations of undue influence by investment banking interests on securities research at brokerage firms.
• The firms will not seek reimbursement or indemnification for any penalties that they pay. In addition, the firms will not seek a tax deduction or tax credit with regard to any federal, state, or local tax for any penalty amounts that they pay under the settlement.
• The firms are required to dramatically reform their future practices by separating the research and investment banking departments, changing how research is reviewed and supervised, and making independent research available to investors.
• CSFB, Merrill Lynch, and SSB admitted to issuing fraudulent research reports.
• Bear Stearns, CSFB, Goldman, Lehman, Merrill Lynch, Piper Jaffray, SSB, and UBS Warburg admitted to issuing research reports that were not based on principles of fair dealing and good faith and did not provide a sound basis for evaluating facts, contained exaggerated or unwarranted claims about the covered companies, or contained opinions without reasonable basis.
• UBS Warburg and Piper Jaffray received payments for research without disclosing such payment.
• CSFB and SSB engaged in inappropriate spinning of initial public offering (IPO) allocations in violation of SRO rules requiring adherence to high business standards and just and equitable principles of trade. The firms’ books and records relating to certain transactions violated the broker-dealer recordkeeping provisions.

In announcing the settlement, SEC Chairman William Donaldson said, “These cases reflect a sad chapter in the history of American business—a chapter in which those who reaped enormous benefits from the trust of investors profoundly betrayed that trust.”

While the agreement reflects a stated movement away from the conflicts of interest in the securities industry, the true commitment to this movement has already been questioned. After the agreement was made public, the chairman of Morgan Stanley made comments in the New York Times downplaying the issues raised in the agreement and provoking a sharp response by SEC Chair William Donaldson. Donaldson’s letter to Morgan Stanley, as published in the Wall Street Journal, stated:

I am deeply troubled that you would suggest that Morgan Stanley’s conduct, as described in the Commission’s complaint, was not a matter of concern to retail investors. … Your statements reflect a disturbing and misguided perspective on Morgan Stanley’s alleged misconduct. The allegations in the Commission Complaint against Morgan Stanley are extremely serious. They include charges that Morgan Stanley paid other firms to provide research coverage, compensated its research analysts, in part, based on the degree to which they helped generate investment banking business, offered research coverage by its analysts as a marketing tool to gain investment banking business, and failed to establish adequate procedures to protect research analysts from conflicts of interests. … Your reported comments evidence a troubling lack of contrition and lead me to wonder about Morgan Stanley’s commitment to compliance with the letter and spirit of the law.

Even if the securities industry follows both the letter and spirit of the law, the underlying conflict of interest remains. The securities industries’ reliance on actively trading securities inevitably increases the fees that are paid by investors and diminishes returns. In fact, the typical no-load, low-cost index fund’s return advantage over a managed fund is due, in large part, to a smaller fee structure.

Commission-Based Trading

Brokers derive approximately 74% of their income from commission-based products. To generate fees, therefore, a broker must have actively trading accounts. More frequent trading means that investors are incurring fees that reduce returns. Brokers are highly trained salespeople whose primary job responsibility is to generate fees for their firms or themselves. This is borne out in the following numbers from a 2002 Securities Industry Association (SIA) report on registered representatives-brokers:

• In 2001, the average broker earned $164,000, down from $199,000 in 2000.
• In 2001, the average total commission fell to $400,000, from $485,000 in 2000.
• Prior to 2001, these numbers had increased for six consecutive years.
• Most brokers handle more than 500 accounts, with an average value of $127,000.
• Brokers’ average value of total accounts exceeded $66 million.
• In 2001, the average payout to brokers was 37%.
• A broker had average industry experience of over 11.2 years (8.4 years with the same firm).
• The 2001 brokerage turnover was nearly 20% (36.3% for a broker with less than two years of experience).

With over 500 accounts, a broker cannot maintain constant vigilance over every client’s account. Investors that think a broker personally watches over their accounts and best interests are either deluded or misinformed. While a knowledgeable broker can justify his fees, the basic commission-based brokerage relationship is highly suspect at best.

The industry is currently expanding the revenue generated from fixed-fee accounts. In 1996, less than 10% of revenue was derived from these accounts, but today it is 26%. Although fixed-fee accounts overcome the basic conflict of interest of commissioned-based accounts, they come at high costs (mainly high annual account fees). In fact, depending upon the size of the account, fixed-fee accounts can generate greater overall brokerage fees than commission-based accounts.

Fixed fees typically range from 1% to 2% depending on the account size and the client’s negotiating ability. This would equate to roughly 50 to 100 billable hours of a CPA’s advice for an account worth $1 million. Given the volume of accounts they handle, brokers could not spend this amount of time on each client.

Deceptive Fees

While a typical full-service brokerage firm charges several hundred dollars for an investor to buy or sell 100 shares, this fee is clearly shown. In contrast, the fees charged for mutual funds, bond investing, and annuities are essentially hidden. Mutual funds have an array of fee structures that are no doubt designed in part to confuse an investor as to their impact. While one fee may not apply, others will.

Before investing, determining the overall fee structure, as opposed to a particular fee, is of critical importance. Many investors inquire about only part of the fee structure, not the overall fee reality. Brokers generally volunteer no more information than necessary, most likely to make it appear that the client is getting a good deal.

Funds with an upfront charge (load) of 4% or 5% are not uncommon. On a $100,000 investment this means that only $96,000 to $95,000 of the original investment is actually invested (see Exhibit 3). This initial cost disadvantage is difficult, if not impossible, to overcome through returns. Annual operating fees, which can be substantial, further erode investment returns.

Another area of fee abuse is annuities, the cost of which makes the above fund fees look good in comparison. On a $50,000 annuity purchase, fees of $3,000 to $4,000 can be incurred, which effectively negates any possible tax advantage. Tragically, some brokers consider elderly clients as prime targets for these products.

Brokers are fond of saying that they are making no commission on certain products, a statement which, while technically true, deviously hides the fact that other fees are being charged. On an outstanding municipal bond purchase, no commission is typically charged, but the brokerage firm and broker are compensated based on the purchase price. In essence, they sell the bond for more than its fair value. Due to difficulty in deciphering bond pricing, the spread is essentially hidden. It is common knowledge on Wall Street that the largest fees are usually hidden, and not in the clients’ interest.

Lowering Investment Costs

Investment costs have a fundamental impact on returns. Fortunately, there are highly viable alternatives to full-service brokerage firms.

• Investors can use discount brokers to dramatically cut the costs of purchasing shares (see Exhibit 4).
• No-load and low-fee mutual funds can be used.
• Bonds can be priced out by several brokerage firms.
• Treasury securities can be purchased directly.

Investors face a staggering array of choices. CPAs can assist them in selecting the best alternatives, whereas brokers have a basic conflict of interest.

Often full-service brokers attempt to justify their fees through better trade execution. This, however, overlooks the fact that equity markets are highly liquid. Consequently, any trade advantage would be difficult if not impossible to obtain.

Tax-Efficient Investing

A critical component of investing that often receives little or no attention is the tax implications of an investment choice. Here a CPA with tax knowledge can have a material effect on investor returns. Stock-loss selling is a time-tested strategy to reduce the tax costs of investing, but unless the sale is carefully planned, following detailed IRS rules, the loss may not be recognized.

Another strategy is to sell mutual funds with losses and invest the proceeds in a similar fund. The loss is fully deductible, but the proceeds are immediately reinvested, thereby minimizing the risk that upward market movement is not captured. Successful implementation of this strategy is not automatic. The following questions are relevant:

• Are the correct share blocks sold?
• Does adequate share identification occur?
• What is the impact of close-out fees and transaction fees?
• Is the substitute fund a close match?
• What are the fees of the new fund?
• Are year-end taxable fund distributions a factor?

Successful bond investing requires analysis of costs and tax implications (regular, alternative minimum, and state tax). Because the bond interest component is generally fixed, transaction costs and taxes are usually the defining attributes.

The CPA’s Role

A CPA is an investor’s first and last line of defense in this environment, with the benefits outweighing the costs. A CPA’s basic professional tenets of objectivity, neutrality, and independence are essential. Granted, the current accounting environment raises questions as to the profession’s adherence to these values, but that does not mean that it cannot reinvigorate these virtues.

A starting point can be the tax return and related documents, where essentially all financial decisions are disclosed. Instead of rushing through the return process, during off-peak season a CPA could initiate a review of the underlying accounts.

If the investments are inappropriate and not in the taxpayer’s best interest, then the CPA should fully advise her of the consequences (costs, tax effects, and various alternatives). Too often CPAs neglect this duty in order to maintain a friendly association with members of the investment community.

The securities industry is fraught with problems, as the recent $1.4 billion settlement indicates. Commission-based relationships have an inherent conflict of interest. The SEC and the New York Attorney General are investigating an array of deceptive practices in the mutual fund industry.

Fixed-fee accounts are generally cost-prohibitive. Annual fees of 1% to 2% of account asset value are typical, and hidden fees are common. Brokers, in the final analysis, work primarily for themselves and their investment house, not for their clients.

A well-executed strategy is needed for tax-efficient investing to occur in a low-cost environment. CPAs can be the last line of defense in advising individuals on investment options. CPAs can become designated as a Personal Financial Specialist (PFS) by the AICPA (www.aicpa.org) to demonstrate their knowledge, skill,
and experience.

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