Brokers trying to decide if they should go independent have a lot to consider. (Illustration: © C.J. Burton/Corbis)

There are a lot of issues to consider before making the move from a wirehouse or bank to an independent advisor. Although as an independent you get to make your own decisions, this autonomy comes at a price. Specifically, you are required to pay your own expenses. If you are unfamiliar with these expenses, and everything else included in the life of an independent advisor, it’s not unusual to be a little apprehensive. Therefore, my goal in writing this is not to talk you into or out of this decision, but to give you a clear picture of precisely what is involved.

In this article, we’ll cover the most important issues you’ll face, provide a process for your decision and, hopefully, arm you with the tools and information you’ll need to make the right choice. Obviously, independence is not for everyone, but for some, it can be a highly rewarding experience. As is the case with all decisions, there are two components. One is logical and the other emotional. First, do your analysis (logic) and then make the decision (emotional).

Why Advisors Opt for Independence

There are a number of reasons advisors consider independence. Perhaps the most common is frustration with the status quo and a desire to conduct business in a way that differs from their employer. In other words, they believe they can do things better on their own. However, a word of caution is in order. Michael Gerber, author of “E-Myth Mastery,” writes that there are three essential qualities required for a successful transition from employee to business owner (my interpretation): The individual must be a good entrepreneur, manager and technician. A good entrepreneur will see the big picture and set the company goals. A good manager will take the big picture and condense it into several smaller steps. A good technician will execute the smaller steps to achieve the larger goals. Many who begin a new business are good technicians. However, if they lack the entrepreneurial and managerial skills, their odds of success diminish. Personality also plays a role.

The Most Important Traits

Financial advisors come in a variety of personality types, from outgoing and gregarious to introspective and reserved. An advisor can be successful regardless of personality type. That said, there are three traits I’ve noticed in all successful advisors: confidence, passion and tenacity. In fact, 2002 Nobel laureate Daniel Kahneman found that financial advisors tend to be overconfident. Overconfidence can be problematic if it causes one to act before understanding the facts. Moreover, confidence comes from two sources: analysis and intuition. In addition, passion and tenacity emanate from an individual’s emotional DNA.

Making the Decision: First Steps

A good decision is a well-informed decision. Therefore, the first step is to conduct a thorough cost-benefit analysis (we’ll discuss this in detail later). Next, does the analysis indicate a greater likelihood of success or failure? If the analysis points to a successful outcome, then examine yourself to determine if you have the emotional persistence required to stay the course. Building your own firm will require a solid plan, hard work and perseverance. Finally, the analysis will be influenced by the type of independence you choose.

Independence: The Three Options

There are three distinct independent paths: an independent broker or registered rep; a registered investment advisor (RIA); or a hybrid advisor. There are a few key differences between each of these paths, including the legal requirement; the disclosure requirement; compensation; the level of freedom; and the applicable regulatory authority.

Legal requirements. This may be the most crucial issue. A broker is held to a suitability standard while an RIA must adhere to a fiduciary standard. Here is the definition of each.

Suitability Standard

A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance and any other information the customer may disclose to the member or associated person in connection with such recommendation.

Fiduciary Standard

A person operating as a fiduciary, when making decisions for a client, must place the interests of the client ahead of his own at all times.

To illustrate, a broker could make a recommendation based solely on which product pays the highest commission and still be within the legal standard, as long as the investment is suitable for the client. Conversely, an RIA must always place the client’s interests ahead of his own.

Disclosure requirements. Brokers are not obligated to disclose how they are compensated, any past disciplinary actions or conflicts of interest, although clients can find that information on FINRA’s BrokerCheck. An RIA, on the other hand, must disclose all of these. Here’s an example of a common conflict of interest. If a mutual fund wholesaler gave a gift to a broker as a way of saying “thanks for the business,” the broker would not have to divulge this. An RIA would be required to inform the client. Why? Because this is considered a conflict of interest, which could influence the advisor’s recommendations. Also, an RIA must provide clients with a copy of his ADV Part II, a document that contains all material aspects of the RIA’s business, including all fees.

Compensation. A broker is compensated by commissions. An RIA charges a fee for advice. Moreover, as an independent, a broker should expect to receive 75% to 95% of all commissions generated. An RIA will receive 100% of the fee paid by the client. There are some nuances that could slightly alter these percentages, but we’ll have to discuss that another time.

Level of freedom. All independent advisors have a greater level of freedom than a wirehouse or bank advisor. However, an independent broker will still have to contend with his broker-dealer’s compliance department. An RIA will handle all compliance matters internally (unless it is outsourced). In fact, an RIA who is a sole practitioner will often be required to wear multiple hats, including that of a compliance officer. Even though an RIA has the greatest level of freedom, he also has more responsibilities. For example, becoming an RIA is tantamount to opening a store and having to make all decisions pertaining to the business. This includes deciding what products to offer, what price to charge, maintaining proper records, etc. Obviously both must comply with all applicable laws and regulations.

Applicable regulatory authority and qualifications. Brokers are regulated by FINRA whereas RIAs are overseen by the SEC (if AUM is greater than $100 million) or their individual state. Brokers must obtain (or maintain) a Series 7 (general securities registered representative license) and a Series 63 (state exam). RIAs must pass a Series 65 exam, although in some states, certain designations are accepted in lieu of the exam, including CFP, CFA, CIC, ChFC and PFS.

The Hybrid Advisor

The number of hybrid advisors increased greatly as a result of a court case that pitted the Financial Planning Association (FPA) against the Securities and Exchange Commission (SEC). In it, the FPA was seeking an injunction on brokers charging a fee for investment advice. The FPA prevailed and the brokerage industry was forced to discontinue their fee-based brokerage accounts or adopt the RIA framework.

Today, a hybrid advisor can act as a broker or an RIA, charging a commission (as a broker) or a fee (as an RIA). In addition to the regular account paperwork, if the advisor is engaged as an RIA, the client must sign an advisory agreement that provides the details of the arrangement.

Expenses

Regardless of the type of path one chooses, all independent advisors have this in common: They are responsible for their own expenses.

Obviously, there’s a cost of doing business. Will you be a solo practitioner or share expenses with a partner? Will you join an existing firm? Will you hire an assistant immediately or wait until your revenue is sufficient to compensate that person? In short, will you increase your expenses incrementally as you build your business or will you invest a lump sum to establish your infrastructure up front? These are only a few of the questions you must address. Your answers will depend heavily on two factors. First, what is your projected income? Second, do you have an adequate cash reserve to establish your business up front? Your cost-benefit analysis will shed much light on these decisions. Let’s take a closer look at expenses.

Office space. There are several options. You could purchase a business duplex and rent out the other half. Perhaps you’ll rent an office and share a common secretary, copy machine, conference room, etc. Perhaps you know a CPA or other professional who will sublet office space to you. If you create a partnership, formal or informal, you would share expenses. You may decide to work from home and lease office space as needed for client meetings if your home office isn’t conducive to this.

Technology. This is an area of great importance. There are certain staples you will need. For example, you’ll need a good contact management system (CMS or CRM), performance reporting software, investment research tools, financial planning software (if applicable), a website and email. Then there’s a second-tier group that includes such items as account aggregation software, online document storage, portfolio rebalancing software, online meeting tools and more. Many of these second-tier tools are becoming commonplace today. Here’s a brief commentary on some of these items.

  • Contact management system. I’ve used ACT! from the beginning. I paid for the software once (plus any upgrades) and thus avoid a recurring expense. I’ve also used Goldmine, but ACT! is much easier to customize. In addition, I tried Redtail and salesforce.com briefly. Salesforce.com is probably the most robust of this group. It’s also easy to customize and integrates well with other software applications, but is the most expensive. At the time, Redtail didn’t allow as much customization as I required, but they have released a newer version since then. If you plan to be a solo practitioner with an assistant, ACT! will suffice. ACT! also has a cloud-based version, but I haven’t seen it. If you plan to grow and add multiple employees, budget permitting, salesforce.com is a great choice.

  • Investment research tools. Will you outsource your asset management or keep it in house? If you choose the latter, you’ll need a good research tool. I’ve used Morningstar tools for decades. This includes Morningstar Office, Advisor Workstation and Principia. (Note: In the original article, we wrote that Principia has been discontinued for new users, but a Morningstar spokesperson said that in addition to continuing to provide Principia support for existing users, it will also make Principia available to new Advisor Workstation subscribers as well.-Ed.)

    If you’re looking for research, Advisor Workstation may be sufficient. If you want something more robust, Office incorporates additional features such as performance reporting, limited financial planning, etc. Based on my need for research, I chose Advisor Workstation. I also use QuoteStream by QuoteMedia, which is a quality charting and research tool.

  • Financial planning tools. I’ll keep this brief, but there are a few points I’d like to make. First, I use Microsoft Excel with an add-in called Crystal Ball. CB provides Monte Carlo simulation, decision tree analysis, optimization, time series forecasting and a host of additional statistical tools. Having recently compared this to a couple of other applications, I decided not to make a change.

Employer benefits. You should compare your current benefits and estimate the cost you will bear as an independent. Benefits such as a company retirement plan, health insurance, deferred compensation, stock options, restricted stock and other monetary rewards have value. When creating your cost-benefit analysis, be sure to obtain a health insurance quote as you will bear the entire premium, which may be substantially more than you are currently paying.

Putting It All Together: The Cost-Benefit Analysis

The two components of this are income and expenses. In reality, you are preparing a budget, the results of which will guide many of your decisions. Here are some steps to consider when projecting your income. Some steps may not apply depending on your choice of broker or RIA.

  1. Go through your existing book of clients and make a list of those who will likely follow you.

  2. Rank your confidence level on each client in Step 1.

  3. Include the amount of assets you expect to manage (per account or per client).

  4. Create a fee schedule for fee-only clients.

  5. Project your fee income per client.

  6. Estimate the amount of commissions from your commission-based accounts (if applicable).

  7. Project revenue from additional services you plan to provide (e.g., financial planning, insurance).

  8. Total the expected income.

You will incur two types of expenses: start-up costs and recurring expenses.

Start-up costs include any expense you will incur prior to the day you open. Table A includes some of the most common expenses.

Table B contains a list of typical expenses you may incur on an ongoing basis. I would suggest using the format shown, which allows for expenses to be included as they occur each month. It would also be prudent to use this same format when projecting your income.

Many questions will be answered through this process. For example, can you meet your start-up costs? Is your projected monthly income sufficient to meet ongoing expenses? If you answered no to either question, add a column to your spreadsheet and prioritize all expenses.

There are many other issues to consider before deciding to become an independent advisor. Here are a few of them:

  1. Do you have a non-compete agreement with your current employer? If so, how long does it last?

  2. What business entity will you select?

  3. What will you name your new company?

  4. How will you obtain new clients?

  5. What services will you offer?

  6. How will you distinguish yourself from your competitors?

If you are a broker, do you want to maintain your licenses? As an RIA, you will not need this. Hence, if you choose to become an RIA only, your licenses will eventually lapse.

Is independence right for you? Only you can answer that. However, if you decide to take the plunge, make sure to formulate your budget, choose the path that best suits your desired business model, create your transition plan and don’t look back. Deciding to become an RIA is one of the best business decisions I’ve ever made. I love the freedom and the fact that I’m building equity in my business, and the reward I get from helping clients is still as fresh as it was the day I began. I can truly say I love independence.

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