Financial Planning

Know the Difference Between a Broker and a Registered Investment Adviser

Their roles and responsibilities to you as a client are as different as night and day.

When families are looking for guidance on how they should manage their wealth, common questions include: Do we need a broker or a registered investment adviser? What is the difference? And why does it matter how he or she is paid?

You would think that the roles and responsibilities would be clear and that there would be a strong line between individuals who call themselves advisers and those who call themselves brokers. Unfortunately, this is not the case, creating lots of confusion between the two.

There are some important differences you need to be aware of when selecting who you will trust with some of the most intimate details of your life. Following is a brief summary of the differences to help you make the distinction between an adviser and a broker:

Transactions vs. Advice

Broker (Transactions): The definition says it well: A broker can be defined as “a person who purchases financial products on behalf of another for a commission.” Brokers sell products for a fee, which are sold by the brokerage firm they are affiliated with. Each investment decision is a distinct transaction for which the broker gets paid. Consultation and advice between the broker and client is common, but essentially it is mostly a transaction-based relationship.

Inherently, this leaves room for conflicting interest, because the commission-generating products they sell aren’t always the most prudent for the client. Brokers are driven to maximize profits for the firm and themselves, which often conflicts with acting in clients’ best interest.

Generally speaking, brokers get paid a commission from the products they sell. Wrap accounts are becoming more popular and are a way for brokers to select investments and make trades for clients, while charging them a flat quarterly or annual fee instead of collecting a commission for each purchase or sale of a security. Although this has, to some extent, reduced the art of “churning” (frequently buying and selling securities within client accounts to generate commission dollars), it doesn’t always mean that brokers are always making the best decisions for their clients.

Advisers (Advice): Registered Investment Advisers (RIAs) offer a more comprehensive set of services, including investment and planning guidance instead of selling financial products. RIAs examine a client's entire financial picture, assess the client’s goals and determine the time horizon for each set of assets to be invested: retirement, college savings, general investment, etc. After completing this asset allocation function, the adviser then selects appropriate investment vehicles to achieve specific objectives.

Another differentiator is that independent advisers often work in coordination with other professionals (i.e., CPAs, Trust and Estate Attorneys, Philanthropic Planners, etc.) on behalf of the client to ensure comprehensive planning. Comprehensive wealth advisers can be thought of as your personal CFO (Chief Financial Officer).

Some RIAs charge an hourly fee, but most charge a percentage of the assets under their care. There are two different compensation models: fee-only and fee-based. The difference is important because fee-based advisers do sell products. Fee-based compensation is popular because advisers can earn compensation from fees paid directly by clients plus fees they receive in the form of commissions from products they’re licensed to sell (e.g., insurance). They are not required to inform their clients in detail how their compensation is accrued. As you might imagine, the fee-based model opens up the conflict-of-interest door.

By contrast, fee-only advisers do not sell any financial products. They are incented, as a fiduciary, to search for the best options for you. They look for low fees, tax efficiency and are not required to use investment vehicles that are favorable to any particular brokerage house.

If their clients need products, they work with trusted professionals to find the right products based on the client’s objectives. There is no fee splitting or other incentive in the sale of products, so conflicts of interest are kept to a minimum.

Suitability vs. Fiduciary

Brokers (Suitability): A broker, or “Registered Representative” as they are sometimes called, is required only to recommend investments that are “suitable” for their clients. This means that a broker can legally put his or her own interest above yours when recommending financial products for your specific situation.

Advisers (Fiduciary): RIAs are ethically and legally responsible for acting in your best interests at all times, thanks to the Investment Advisers Act of 1940. They serve as fiduciaries, and one definition of a fiduciary is “a person who occupies a special trust and confidence when working with clients because he/she is legally required to act ethically and with undivided loyalty to the client.”

The fiduciary standard is the single largest difference between an adviser and a broker, because advisers are legally obligated to do what’s right for you. The Act of 1940 precludes brokers from being considered investment advisers. While advisers must act in your best interest at all times, brokers are not legally bound by this same requirement.

Disclosure vs Transparency

Brokers (Disclosure): The standard for “disclosure” in the brokerage industry is large voluminous prospectus booklets, lengthy legal documents printed in small type and highly formal and hard-to-read language. Understanding the makeup of various investment vehicles, the associated risk, why they are being recommended to clients, and their respective costs (often hidden deep within disclosure documents) is the brokerage industry’s “art of confusion” tactic. What I mean by this is that with lots of hard-to-understand disclosures, you might feel overwhelmed and intimidated and simply assuming that your broker has your best interests at heart.

Advisers (Transparency): Advisers adhere to a higher standard of transparency designed to give you meaningful, relevant and straightforward information. Advisers share details about all aspects of their services, and how they earn their fees, so that you understand how your wealth is being cared for and the associated cost for that care. Every RIA is legally obligated to send to their clients a copy of their Form ADV, which is a filing explaining the makeup of their firm, what services they offer and what they charge.

Professional Licenses

Brokers: A broker typically holds a Series 63 license, in addition to either a Series 7 or 6 license, in order to sell securities. Many brokers have begun to use the title of “Wealth Manager,” “Investment Advisor” or “Financial Advisor” without accepting the fiduciary duty of a RIA as described in the Securities Act of 1940. Some brokers have no real background or training in giving financial advice other than the sales training they have received. Most merely adhere to the “suitability” doctrine. In fact, some very large, household-name brokerages have lobbied Congress to avoid fiduciary level of accountability being imposed on their brokers.

Advisers: RIAs are required to receive a Series 65, which qualifies an investment professional to function as an Investment Adviser Representative. The license covers topics such as industry laws, regulations, ethics and topics such as retirement planning, portfolio management strategies and fiduciary responsibilities. It is not a product sales license. Other poplar adviser designations include the CFP (Certified Financial Planner) and CFA (Chartered Financial Analyst).

When working with an investment professional, it’s important to have a third-party custodian for your assets. This allows you the ability to reconcile your custodian statements and the statements you receive from your adviser. Avoid, at all costs, holding your assets in-house with your adviser.

RIAs believe the best way to earn your trust is through sound advice and an open relationship. No matter what regulatory standards are decided by our government institutions, the majority of quality RIAs gladly accept the fiduciary responsibility to their clients. The ethics and values they have for how they serve clients are higher than any legal standard. At the core of their values is the concept of fiduciary duty and their pledge that they will never compromise those values.

Woodring is founding partner of San Francisco Bay area Cypress Partners, a fee-only wealth consulting practice that provides personalized, comprehensive services that help retirees and busy professionals to enjoy life free of financial concern.

About the Author

Pete Woodring, RIA

Founding Partner, Cypress Partners

Woodring is founding partner of San Francisco Bay area Cypress Partners, a fee-only wealth consulting practice that provides personalized, comprehensive services that help retirees and busy professionals to enjoy life free of financial concern.

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