The Key Choice in Picking an Advisorin Trusted Advice
When even Jack Brennan, chairman emeritus of low cost do it yourself king Vanguard Funds, has come out saying most people need an advisor, you know something has changed. When picking an advisor, there are many good sources for the standard questions to ask, including the SEC website. But after spending over twenty years in the investment industry, and learning a lot about the business, I thought I would discuss what I see as the key issue when picking an advisor: Should you go with a broker or a Registered Investment Advisor (RIA)?
First off, there are many different types of professionals calling themselves a financial advisor. These include traditional and discount brokers, insurance salesmen, bank investment officers, mutual fund company advisors and independent investment advisors. Some of the titles they use are: financial planner, financial advisor, financial consultant, and wealth manager. Whatever they call themselves, they can be broken down into two basic groups: brokers and RIA’s. When offering investment advice, the brokers, insurance agents, bank officers and mutual fund company advisors generally fall under the traditional category of salespeople and are acting as brokers. As a quick check, if they have a brokerage license, such as a Series 6 or 7, and most of the above do have one, they are a broker and thus a salesperson. If they are not licensed and instead are registered with and regulated by the Securities and Exchange Commission, they are an RIA. While the vast majority of professionals involved in the investment industry are good people, it is more of a question of the underlying structure of the system within which they operate; some have more conflicts than others.
There are two main distinctions between a broker and an RIA. The first big difference is in the level of responsibility. Traditionally, all those that fall under the broker category (including insurance agents, commission-based bank officers etc.) only need to determine that an investment is suitable for the client before recommending it. This is a much lower standard of care than an RIA (and some bank trust officers), who is held to the higher fiduciary standard of acting in the client’s best interest. As an example, a large cap mutual fund may be a suitable investment for a client. However, if it is the fifteenth one they would own, or a mediocre one from the wholesaler that just took the broker to lunch, it would not be in their best interest to own it. So while an RIA would not use that fund, a broker, or insurance salesman, etc. could.
The second big difference is in how they are paid. Brokers are traditionally paid for completing a transaction, while RIA’s are paid a percentage of the assets they manage for you. Whether it is through load fees in mutual funds, or commissions on insurance policies or stocks, brokers are paid when they make a sale. So they are constantly under pressure to sell. Imagine what could happen in the face of additional pressure to make a sales quota, or meet large expenses. It might not be in the client’s best interest, but the fund was suitable, the monthly production was short and little Joey’s college bill was due, so time to sell. On top of this, in the past, there were many instances of brokers being incented to sell their employer’s products with higher commissions, regardless of the quality of the product. While such overt incentives have generally gone away, there are still many less obvious pressures that a brokerage, or insurance company, or bank, can apply to push its own products out through its broker network.
In contrast, RIA’s are paid based on the amount of assets they manage. They are, therefore, incented to grow those assets. To do that, it is in their, as well as the client’s best interest, that they use the best and most appropriate investment vehicles regardless of the source. In addition, large commissions, needless trading, and taxes are all friction costs that reduce the investment portfolio and so are to be avoided. In this structure, the client’s interest and the RIA’s interest are aligned.
Therefore, brokers work in a system where they are paid for selling to clients, might be conflicted about what to sell to those clients and have a lower level of responsibility to their clients. Not the greatest alignment of interests. An independent RIA however, is paid to grow the client’s assets, is able to choose from a wide variety of securities and funds, and has a higher level of responsibility to their clients. This is a much better system structurally that aligns the RIA’s interests and that of their clients. It is your call, but seems like an easy choice to me. Full Disclosure: I am an RIA.