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August 25, 2014 at 08:00 PM
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.
