Many of our clients were led to LCR Wealth by exploring the differences and benefits of choosing an advisor versus a broker for financial guidance. In our previous piece on RIAs vs. brokers, we highlighted the general differences between a Registered Investment Advisor (RIA) and a broker-dealer, and the advantages of the RIA model became clear. This paper takes a deeper dive into the benefits that the RIA model offers advisors and their clients, benefits that are driving business away from the traditional broker-dealer model. There are a multitude of reasons for both advisors and clients to prefer the RIA model, including fiduciary duty, flexibility in investments, strength of client/advisor relations, and alignment of incentives.
Fiduciary Duty
Paramount to the RIA model is the legal obligation, known as fiduciary duty, that RIAs have to their clients. Under their fiduciary duty, RIAs are legally obligated to put the interests of the client above their own in every instance relevant to the client’s investments, assets, and general relationship with the advisor. In contrast, brokers do not operate under a fiduciary duty. As a result, brokers have no obligation to act in the best interests of their clients, even when acting in an advisory capacity. They “are simply obligated to treat their customers fairly.” This lack of legal obligation to act in the client’s best interests has led to the many complaints brought against broker-dealers for unethical conduct through the regulatory oversight of FINRA (the Financial Industry Regulatory Authority). Citing Eversheds Sutherland’s annual report of FINRA disciplinary actions, the financial data firm Terrapin Technologies notes that “the overall total of fines and restitution sharply increased in 2021. [Eversheds Sutherland] found that fines assessed by FINRA rose 60% from 2020, from $57 million to $91 million. This is the highest amount of total fines since 2016, despite a decrease in cases.”
Alignment of Incentives
Beyond the legal obligation of fiduciary duty, the compensation structure used by RIAs further aligns the incentives of advisors and their clients. RIAs charge advisory fees as a percentage of clients’ assets under management (AUM). Usually this fee is anywhere from 0.5% to 2.0% annually, based on a tiered structure with a lower percentage charged for clients with more assets under management. This structure creates a dynamic in which the advisor is incentivized to grow client assets as effectively and as safely as possible, such that the advisory fee in actual dollars grows along with the client’s assets even as the advisory fee as a percentage of AUM drops.
In contrast, a broker gets paid a commission on the investment products they sell, giving them no fundamental incentive to put the interests of their clients above their own. A 2020 white paper by Charles Schwab found that “78% of high-net-worth investors said it is critical that their financial advisor make investment decisions in their best interest at all times.” But the compensation structure for brokers incentivizes them to sell more products, not to make good investment decisions.
The superiority of the RIA model can be seen in the current trends in the wealth management space. As reported in Financial Advisor magazine, “[t]he investment advisor industry experienced record-breaking growth in 2020, growing to 14,000 Securities and Exchange Commission (SEC) registered investment advisors (RIAs) who manage $110 trillion in assets for nearly 61 million clients, according to a new report.”
In contrast to the fast-growing RIA industry, “the number of broker-dealers continued to decline—down 2.3% in 2020.” A McKinsey study found that over 1,600 advisors join the RIA industry annually, bringing $180 billion in AUM. This trend has emerged due to a shift in consumer demand. RIAs have grown in popularity across the country due to their fee-based structure and fiduciary obligation. Investors are more trusting of advisors who generate wealth for themselves only if they first generate wealth for their clients.
Flexibility in Investments
The Series 7 license authorizes the holder to act as an agent of a broker-dealer firm in both giving investment advice and selling securities. Advisors or brokers with Series 7 licenses who work at major wirehouses are seeing the benefits to clients that come with switching to a Series 65 license and the RIA model. The Series 65 license authorizes the holder to act as an agent of an RIA in giving investment advice, but does not authorize the holder to sell securities. One major benefit of the Series 65 license and RIA structure over the Series 7 license and broker-dealer structure is the flexibility they can offer clients in terms of investments. In contrast, brokers have limitations on what they can offer because they are often heavily incentivized, or even simply forced, to stick to selling and recommending their own companies’ products. This need to hit quotas and push internal products restrains good advisors from tailoring portfolios as effectively as possible to clients’ profiles.
As RIAs, advisors have more autonomy to offer clients nearly any investment from the whole range of product providers. For example, in 2021 a team of five advisors at Merrill Lynch left to form an independent RIA, bringing with them $1.75 billion in AUM. One of the advisors, Scott Bills, spent his entire 15-year brokerage career with Merrill Lynch and was ranked #3 among Forbes’ Next-Gen Advisors in 2019. He said about the transition, “We now have the ability to be solutions based, not product driven.” This autonomy also gives advisors the ability to select the best and most advanced technology to help serve their clients, such as financial planning software and portfolio analysis tools.
Strength of Client/Advisor Relations
Financial planning, estate planning, and portfolio analysis fall into the category known as “soft services.” These services have become an important way for RIAs to differentiate themselves from brokers and competitors by offering the highest level of service. Clients tend to develop deep and trusting relationships with their advisors, so RIAs’ ability to offer these soft services greatly benefits clients, who are able to rely on financial professionals that they know and trust for all of their financial advisory needs.
There is a growing trend in the wealth management industry toward a stronger relationship between advisors and their clients. This shift shows itself in the growth of RIAs across the country. The autonomy that RIAs offer, and these advisors’ obligation to put their clients’ needs first, is the future of wealth management—a trend that is evidenced by the push by both advisors and clients toward the RIA model.
Investors should continue to educate themselves about these differences, so they can make an informed decision regarding the type of financial services that best fit their lifestyle.