Some people use the terms "financial advisor" and "broker" interchangeably, although they mean starkly different things. As someone wanting to take charge of your personal finances, these differences are important to understand.
This is the follow-up to Financial advisors, the tell all series. Part 1: How do advisors get paid?.
In this post, the second in our 4 part blog series, I will outline the differences between a broker and an independent advisor.
What is a broker?
A broker, or registered representative, is someone that has passed a state test allowing them to sell financial products such as bonds, stock, annuities and mutual funds. Brokers are overseen by FINRA, which is a broker self-governing body. Brokers are usually employed by a large broker-dealer such as Merrill Lynch or Morgan Stanley, or an independent broker-dealer like LPL, Ameriprise, or Edward Jones.
Although most brokers say they have access to numerous products that are “suitable” for the client, regardless of what firm they come from, the incentives often still very much cause brokers to favor their own products. The most obvious reason for this is that the broker-dealer i.e. their employer, makes more money if they sell in-house products. Additionally, brokers spend numerous hours each week learning about their own products, so they often end up favoring them over external ones since those are the ones that they can pitch better. When it comes to products outside of the broker-dealer, the brokers can still have an incentive to favor these over other more suitable options. The reason is that mutual funds often pay millions of dollars to broker-dealers to get prime “shelf space” with their clients. They pay millions because it means that the brokers at the firm will sell them.
So although brokers have access to a plethora of suitable products, they often end up favoring products that their broker-dealer sells, or outside products that their broker-dealer gets paid to sell.
Brokers are not fiduciaries… yet.
Although brokers are technically required to sell suitable products to their clients, they are not required to be fiduciaries. Fiduciary sounds like consigliere, but no, the broker is not required to be your Tom Hagens.
A fiduciary is a person who holds a legal or ethical relationship of trust with you. As an example, a doctor’s hippocratic oath is a fiduciary duty to their patients i.e. they swear to act in the best interest of the patient no matter what. There is a new Department of Labor law set to be phased in called the Fiduciary Rule. This rule will force brokers to act as fiduciaries when it comes to your retirement accounts (RIAs, 401Ks, etc.). Which sounds great. But there is a loophole. If a broker wishes to continue selling you retirement products from which he collects commissions, he simply has to ask you to sign a disclosure agreement called a Best Interest Contract Exemption (BICE) that basically says “Hey, I am letting this advisor sell me products that might not be in my best interest.”, and of course it will be sugar coated accordingly. Another concern is that even if the law is fully enforced, all non-retirement accounts (like after-tax investment accounts) are fair game, and brokers can still sell products that are not necessarily in your best interest.
Don’t get me wrong, the fiduciary rule is a step in the right direction, but ultimately, rule or no rule, brokers are salespeople, focused on pushing the most profitable products for their companies. Because of this, the advice aspect of a full-broker’s service often comes secondary to selling products. I have attended many of their internal conferences and the emphasis is around selling - they even call themselves "producers" instead of advisors.
Is there any advantage to having a broker?
OK, it can’t ALL be negative for brokers or they would have been out of business by now. (Although broker share of the overall business is clearly shrinking.) Fair enough.
Their biggest advantage is their ability to lend directly to their ultra-rich clients. Let’s say that you own $10 million in stocks and you want to sell $2 million to buy a second home, but you don’t want to have to pay taxes on the capital gains. No problem. One of the big broker-dealers will lend you $2 million using your stock ownership as collateral, so that you don’t have to sell your stock and thus avoid the taxes.
What is a "Registered Investment Advisor" (RIA)?
Registered Investment Advisors (RIAs) are advisors that are regulated directly by the Securities and Exchange Commission (SEC.) Unlike brokers, RIAs are not employed by broker-dealers* and operate independently. Many RIAs are ex-brokers who wanted to focus on meeting clients’ needs rather than fulfilling sales quotas.
Their independence allows RIAs to have a truly “open architecture” when it comes to the products they recommend to their clients, as they don’t actually have any products of their own (like broker-dealers). However, it is important to remember that some RIAs may still favor some mutual funds over others based on the commissions they get paid from the mutual fund family, so it is still always best to ask upfront if the advisor is compensated in any other way besides of your fee. (We touch on this in How do advisors get paid?)
A bit of history
In prior decades, going independent reduced an advisor’s value proposition compared to brokers, as they would lack the infrastructure and support of a big firm. But over the last 20 years, technology advancements brought down the cost of portfolio analysis tools, client reporting systems, trading and rebalancing software, and CRM tools. In other words, the disadvantage has mostly disappeared.
The biggest advancement though is the growth of custodial services by firms like TD Ameritrade, Fidelity and Pershing, which has allowed RIAs to outsource the custody (or storage) of client’s money. What this means is that the RIA manages your money, but your money is held in a “custodial” account at a large bank like TD Ameritrade. This has removed operational headaches for RIAs and some of the client concerns around allowing a smaller independent advisor to manage their money.
What is best for the client?
After looking at the pros and cons of RIAs and brokers, RIA’s incentives are better aligned with their clients than a broker’s.
Please bear in mind that the above opinions are NOT recommendations on the advisors’ skills, abilities or qualifications. In my experience, the range from terrible to excellent is vast, regardless of whether the advisor is a broker or an RIA. To become a "financial advisor" you need to study for a few days to pass a state test, while to become a hairdresser you need to take a 9 month course and train for 1,500 hours before you are certified. Makes you think.
I often meet with RIAs that manage over $1billion who have trouble understanding the basics of investing or financial planning. Meanwhile, I have met with advisors that manage $150million and are truly exceptional. So there is a lot more to consider than just the title or amount of money they manage. In addition, different RIAs or brokers specialize (Or they should) on different stages of people’s financial life so an excellent advisor that focuses on retirees will not necessarily be best for a 35 year old which goals are to pay down student loans and buy a house.
In the next blog, What Makes For A Great Advisor? I will focus on what value best-in-class advisors offer.
If you missed the previous posts in this series, click here to start from the beginning.
About the author: Andres Garcia, CEO and Founder of Zoe Financial, Inc.
* Some RIAs have loose relationships with broker-dealers yet still call themselves independent. So it is important to ALWAYS ask the advisor if they have any relationships with broker-dealers.