The Bigger Picture on FINRA’s 529 Plan Share Class Initiative

In early 2019, FINRA implemented the 529 Plan Share Class Initiative in response to exam findings that some financial services firms have failed to supervise rep’s share class recommendations of products that have multiple share and class types, such as mutual funds and in particular 529 savings plans. Although this has been a big deal for many firms this year, it is the tip of the iceberg as far as regulatory concerns surrounding share class selection. The concerns encompass any type of product that involves the selection of a share class, and the accompanying conflict of interest disclosure.

The Nature of the Problem

Representatives were recommending share classes that provided a larger financial incentive for themselves, but may not have been the best choice for the customer.

For instance, if a customer wanted to invest in a 529 plan for a four-year old child (starting college in roughly 14 years), Class A shares with an up-front sales charge would be a better choice for the customer over a long period of time because of the lower ongoing fees. However, if the representative recommends Class C shares instead, with no up-front fee (much easier to sell) but with higher ongoing fees, he receives a higher commission. The customer, however, pays higher fees in the long term since she would be holding the investment longer than five to seven years.

On the other hand, if the child were using the 529 plan savings for elementary school or high school and needed the money in a shorter time frame, the Class C shares could be the best option.

This example clearly illustrates why the time horizon is such an important factor to consider in the selection of share classes — and why the MSRB has stated that information about the 529 plan’s designated beneficiary, such as age and the number of years until the funds will be needed to pay for the qualified education expenses, is relevant in determining the customer’s investment objectives.

A Brief History of Share Class Initiatives

Proper share class selection and the application of quantity discounts have a deeper history than the recent share class initiative. In 2003, 200 broker/dealers were required to perform a breakpoint analysis to determine if clients were receiving the appropriate breakpoint discounts. This analysis process concluded that broker/dealers overcharged $364 per customer on average.

In 2018, the SEC launched a Share Class Initiative that focused on mutual fund share class selections by investment advisers with the concern that advisers were not appropriately disclosing the conflict of interest with fees they receive.

FINRA has stated that firms must supervise recommendations to purchase higher expense share classes, particularly when an investor is seeking a long-term investment. With regard to Class C shares, FINRA has cautioned that customers should be told of the long-term effects of higher ongoing sales charges and that firms should keep written records of such discussions.

The 529 Plan Share Class Initiative

Because of recent rule changes that allow the use of tax-free withdrawals from 529 plans for K–12 tuition and expenses, reps and firms should be even more vigilant about recommending the share class that best serves the circumstances of each individual investor. FINRA has expressed concern that because of the unique features of 529 plans, some firms may not supervise these transactions adequately. For example, 529 plan transactional data, including account asset levels, may not be available in the systems that firms use to monitor other types of transactions.

Responding to these concerns, in 2019 FINRA launched a “529 Plan Share Class Initiative” to:

  • Promote firms’ compliance with the rules governing 529 plan recommendations
  • Remedy any supervisory and suitability violations related to recommendations that 529 plan customers buy share classes inconsistent with their investment objectives.
  • Encourage firms to assess their supervisory systems and procedures governing 529 plan share-class recommendations
  • Identify and remedy any problems
  • Compensate any investors harmed by supervisory failures

April 1, 2019 was the deadline for the grace period provided to firms for self-reporting violations to FINRA, which would recommend a favorable settlement if the firm presented a detailed plan to return the money to the harmed investors “quickly and efficiently.”

Although firms have been given grace for self-reporting, there is no guarantee that such grace will be offered to representatives who recommended unsuitable share classes.

Nervous About Not Self-Reporting?

Some firms choose not to self-report because they had no significant findings and they felt their supervisory systems and controls were in good order. In spite of this confidence, some firms are choosing to double down on this assurance by taking the following actions:

  • Maintain a file of accounts reviewed, the findings, and any remedies
  • Prepare a memo describing why the firm did not self-report, and why the overall supervisory review process is in good order
  • Strengthen policies and procedures focusing on the share class determination process and disclosure of conflicts of interest
  • Distribute policy updates to all employees
  • Conduct 529 plan training and/or include it in this year’s Firm Element training

Help Is Here!

NRS FIRE Solutions has updated its emphasis on share class suitability in all its courses related to products that provide share class fee structures including 529 plans and mutual funds.

Find out more here.