The Financial Industry Regulatory Authority Inc.'s targeted reviews of 529 college savings plans date back to the mid-2000's, when the regulator began a fact-finding sweep which resulted in a number of large fines for broker-dealers. With continued growth of these plans — currently in excess of $260 billion — and as an extension of the agency's ongoing reviews of mutual fund sales practices, Finra has stepped up scrutiny of 529 plans, both through cycle exams and targeted inquiries. In fact, 529 plans were included in Finra's 2016 Priority Letter.
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Finra's concerns center primarily on the broker-dealer's recommendations of mutual fund share classes within the 529 Plans as they relate to their clients' time horizons. The agency is seeking to ensure that appropriate due diligence and suitability of share class along with supporting documentation have been maintained.
Here are some steps broker-dealers should take, both to prepare for, and to validate a supervisory structure that's likely to withstand a Finra review of its 529 plan practices:
• Firms should review current procedures and processes as they pertain to the point of sale determination for choosing the appropriate mutual fund share class. For 529 Plans, this analysis should incorporate the beneficiary's time horizon, which is generally longer in nature from the funding phase. Finra has questioned firms for C-share purchases made by clients where the beneficiary's age is younger than 10 years. Finra examinations put the burden of proof on broker-dealers to provide adequate reasoning and documentation to support the recommended share class. Proof may include a Finra share class analyzer, and/or notes documenting an analysis, discussion and feedback from the financial advisers. Books and records requirements of broker-dealers, including beneficiary information, may not be as readily available for assets held away.
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• Finra examiners are also identifying A-share purchases in which the beneficiary's age is greater than 10 years old and the purchases are being made within just a few years of the beneficiary reaching the age of 18. The analysis of A vs. C-share suitability can certainly be a gray area, mostly in the 10- to 13-year age bracket. The comparison results can lead to suitable A-share investments for larger dollar purchases where breakpoints are achieved. Keep in mind that the age of 18 is not the end of the withdrawal period, but generally, the beginning. Firms should disclose to Finra an appropriate time horizon that may extend many years past the age of 18. It is important for firms to have adequate documentation supporting the respective A or C-share purchase, which may include withdrawals occurring over an extended education period or the flexibility to change the beneficiary.
• Be aware of periodic investment programs (PIPs) which may have been created in prior years. PIPs should be reviewed when the account is moving from the accumulation phase to the withdrawal phase. If there are no sales charge reduction opportunities and withdrawals are estimated to occur within the next few years, the C-share could be the appropriate share class.
• Re-examine procedures and processes to include recommendations for in-state versus out-of-state plans. Many in-state plans provide for state tax deductions in addition to federal tax benefits. While those tax deductions make opening an in-state plan seem relatively more attractive, those benefits should not be the only consideration. In some cases, better investment choices and performance of an out-of-state plan can outweigh the in-state tax benefits. Again, the firm must be prepared to identify the thought process and reasoning behind any recommendation.
• Review and modify automated exception reports to identify 529 plan transactions which may lead to higher expenses for the account, given the beneficiaries' time horizons. This can reduce the manual review burden on principals and compliance staff while increasing the quality of the firm's books and records.
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In light of what is expected to be Finra's continued scrutiny of 529 plans, broker-dealers need to be proactive in reviewing and enhancing their existing practices to ensure compliance with regulatory requirements. Furthermore, a comprehensive review of holdings within their clients' accounts will minimize regulatory scrutiny.
Kamran Fotouhi, a former Finra surveillance director, serves as a managing director at Capital Forensics Inc.
