For years, investors' uninvested cash has been a lucrative revenue source for the wealth management industry. Companies have been paying customers minimal interest on that cash even as rates soared over the past two years, allowing firms to earn much higher yields than they paid out to their clients. Now, that’s beginning to change.
Morgan Stanley will raise rates on some customers’ uninvested cash in advisory accounts. Effective Aug. 1, clients with $250,000 or more in deposits will receive a yield of 2%. The company currently pays 0.01% on balances between $250,000 and $500,000.
Morgan Stanley indicated last week that these changes were coming. It isn’t the only wealth manager making adjustments. Wells Fargo said Friday, July 12, that it had increased the interest it pays on clients’ uninvested cash.
That some of the nation’s largest wealth managers are now raising rates on cash has shareholders concerned about the ripple effects on net interest income, an important profit center for wealth managers. Last week saw a selloff in wealth management stocks—11% on average—as Wells Fargo and Morgan Stanley announced changes that raised alarms among analysts about potential hits to future profits and competitive, regulatory, and legal pressures related to how firms have treated uninvested client cash.
“Right now, it is too early to make definitive predictions, but if this reverberates through the different business models of the industry, the impact could be fairly profound,” UBS analysts led by Brendan Hawken wrote on July 18.
Legal questions are emerging. The fact that some firms have been sweeping customers’ uninvested cash into low-yielding bank accounts and then making a profit by lending out that cash at much higher interest rates is becoming a thorny legal issue. Across the industry, wealth managers generally pay clients about 1% or less on sweep deposits, Goldman Sachs analysts led by Alexander Blostein wrote on July 22. Rates of 5% are readily available in money-market funds, and some firms, including Vanguard, provide such funds as a default option.
There are two different legal standards of care wealth managers must abide by. In general, brokerage firms are held to the Securities and Exchange Commission’s Regulation Best Interest, which requires them to act in clients’ best interest, while registered investment advisors are required to meet a fiduciary standard, which is considered more stringent. In practice, however, the distinction isn’t so clear because some accounts at brokerage firms are governed by the fiduciary rule.
Newly filed lawsuits are taking aim at brokerage and wealth management companies’ cash practices, which they say fall short of the fiduciary standard. Such suits are less likely to come from self-directed investors who have the opportunity to seek out higher yields for their uninvested cash if they want.
Last week, a customer of LPL Financial sued the company for alleged breach of fiduciary duty and “unjust enrichment” related to LPL’s cash sweep programs. “The programs are so indifferent to the needs of defendant’s customer cash holdings that in most managed customer accounts, defendant’s customers lose money on their cash positions while LPL reaps substantial profits from that cash,” the complaint states.
The lawsuit is seeking class-action status and was filed on July 17 in a federal court in San Diego. LPL Financial is the nation’s largest independent broker-dealer with $1.44 trillion in assets as of the first quarter. A spokeswoman for LPL Financial declined to comment, and the company has yet to file a legal response.
LPL isn’t alone in fighting courtroom battles over sweep account practices. The estate of a deceased Morgan Stanley customer filed a lawsuit against the company last month accusing Morgan Stanley of breach of fiduciary duty because of its 0.01% rate on customers’ uninvested cash. That lawsuit, which is also seeking class-action status, was filed on June 16 in a federal court in Manhattan. Morgan Stanley has yet to file a legal response.
Hawken, the UBS analyst, suggests that pricing pressures on client cash could disrupt some wealth management firms’ operations, particularly where they may have a fiduciary duty to the client with regard to cash management solutions. “In those cases, the wealth management firm is a fiduciary and also derives economic benefit from deposit spreads,” he says. “Therefore, sweeping into a money-market fund or high-yield deposit would address that conflict.”
He posits that companies such as Morgan Stanley and LPL Financial could be most at risk. Charles Schwab, at least in its capacity as a custodian of assets for registered investment advisory firms, would be the least at risk. Hawken cautions that the situation is highly fluid and uncertain.
The common denominator among the national brokerage firms, also known as wirehouses, appears to be that they are increasing rates on cash held in advisory accounts, not brokerage accounts, says Goldman Sachs’ Blostein.
Wirehouse executives’ public comments indicate that these companies are increasing interest rates only on a relatively small portion of advisory deposits, he says. But the impacts across the industry could add up as more firms feel compelled to move client cash to higher-yielding products. That would be a boon to customers but detrimental to companies’ bottom lines.
“With large firms across the industry making similar changes, we believe the probability of this pricing change becoming industry standard is increasing, which is likely to put material pressure on the more pure-play wealth firms, driving potential changes in competitive dynamics, market share, and pricing models,” he says.
Regulatory issues? Investor concerns about net interest income began rising on Friday, July 12, when Wells Fargo disclosed that its wealth management unit would raise rates it pays on clients’ uninvested cash in advisory sweep accounts. The change is expected to reduce net interest income by about $350 million this year.
The company had previously disclosed that the SEC was investigating the company’s practices related to cash sweep options that its wealth management unit provides to investment advisory clients, putting equity analysts on alert for potential SEC interest in cash practices at brokerage firms. A representative for the SEC says it doesn’t comment “on the existence or nonexistence of a possible investigation.”
Days after Wells Fargo made its disclosure, Morgan Stanley indicated that it would also increase rates paid on some client cash. Citing “competitive dynamics,” Morgan Stanley CFO Sharon Yeshaya said during the company’s earnings call on Tuesday, July 16, that third-quarter net interest income could decline modestly in the third quarter, but that the impact would be “largely” offset with expected gains from the company’s investment portfolio. She also said the sweep accounts represented “a small portion” of overall bank deposits and were within the company’s advisor-led channel.
An analyst asked whether the company was raising the rates in response to regulatory pressures. She said Morgan doesn’t comment on regulatory matters.
During other wealth managers’ earnings calls, analysts peppered executives with questions about whether their companies had exposure to regulatory pressures like those at Wells Fargo. For example, Charles Schwab executives said on July 16 that they did not have the same exposure.
“With respect to the Wells Fargo issue, we have provided money-market funds, sweep cash, and—or money-market yields on bank cash for all of our fiduciary-driven investment advisory solutions already,” CEO Walt Bettinger said. “So I don’t really see the Wells Fargo report having any kind of meaningful implications for us.”
Shares of Schwab plunged last week because it missed on other key metrics with regard to its bank and results suggested that customers continue to shift billions of dollars from low-paying sweep accounts to higher-paying options such as money-market funds. That process, known as cash-sorting, has also buffeted other wealth managers and may be adding pressure to raise interest rates to stem deposit outflows, analysts say.
When other large wealth management companies report earnings this week, such as Raymond James and Ameriprise on Wednesday and LPL Financial on Thursday, analysts are sure to question executives about cash sweep accounts. You can bank on it.
