Chapter 5: Your Financial Advisor’s Business Model Matters

Despite the many job titles and professional designations that exist in the financial advisory profession today, there are three basic business models for financial advisors: a retail broker employed by a brokerage firm, an independent broker, or an independent investment advisor. Although you will find exceptional financial advisors working under each of these business models, the following discussion identifies the strengths and weaknesses of each business model from the client’s perspective. Let’s compare them.

The Retail Broker

The retail broker is employed by a brokerage firm and is otherwise known as a stockbroker or registered representative. Retail brokers offer brokerage accounts. As noted in Chapter 4, brokerage accounts provide no fiduciary legal obligation to act in your best interest.

Retail brokers generate income by selling securities such as stocks, bonds, mutual funds, and annuities. The more they sell, the more they earn through commissions. Their employer restricts the securities that they are allowed to offer, and the firm might have “revenue-sharing arrangements” with issuers of various financial products, such as mutual funds and annuities. This means that the firm might have extra incentives to recommend that clients purchase specific financial products. Under this model, the employee’s primary allegiance is to their employer, whose interests may often be at odds with yours.

It should be noted that retail brokers also may be licensed as investment advisors. In fact, it’s a regulatory requirement if the broker offers advisory accounts. So the same person may be dually-licensed as both a broker and an investment advisor. When the broker is acting as an investment advisor and making a recommendation on an advisory account, he has the legal obligation to act in the client’s best interest—but only under those circumstances.

If your advisor is dually-licensed as both a broker and as an investment advisor and you have both a brokerage account and an advisory account, he can change hats at-will. One minute, he may be a fiduciary, legally obligated to always act in your best interests, and the next minute, he can sell you a financial product for which he receives a large hidden commission, such as a variable annuity. Your only warning that this transformation occurred might be a short disclosure in your account paperwork to the effect that “Your interests and our interests may not always be the same.”

Any advice provided by the retail broker is considered to be “incidental to the sale” of a security or other investment. Yet in reality, people rely on those recommendations quite significantly. And, again, those recommendations may be influenced by commissions or sales contests.

Why should you care how much commission your financial advisor receives? Ultimately, you pay this commission through higher operating expenses, which are charged to finance the commission. There is no free lunch.

In addition to hidden financial incentives, retail brokers might be pressured by management to sell their house brand of mutual funds and other products, including banking services such as checking accounts, credit cards, and mortgage loans. The less revenue the broker generates, the more vulnerable he may be to cave to management’s pressure to fatten the bottom line by selling certain products.

Then there’s the sales manager who supervises a group of retail brokers. The brokers who “play ball” are the ones more likely to receive the most lucrative accounts. There tends to be a distrust of management among retail brokers. This is one reason why so many of them have become independent brokers or independent investment advisors. They can join a firm with an independent broker platform, join a registered investment advisor firm (RIA), or open their own RIA. Even a very small RIA can offer just about everything that a large brokerage firm can. The RIA can affiliate with a large firm to handle clearing and custodial needs, such as carrying client accounts. One exception would be the availability of initial public offerings (IPOs). Question: How much money have you made on IPOs from your brokerage firm? You get large allocations of the bad deals, and little to none of the good deals, right? Brokers pursuing these independent channels can control their expenses and keep more of the revenue they generate. This is why so many brokers have become independent.

The pressure to produce commission revenue may intensify if the broker has received a bonus for switching brokerage firms. If the value of the broker’s assets-under-management has fallen, he will have to generate extra revenue from the assets and clients that remain, or possibly be forced to return part of a signing bonus. There is no requirement that these (and other) rather obvious potential conflicts of interests be disclosed.

If you maintain both a brokerage account and an advisory account with the same firm, you should insist that your financial advisor declare in writing the capacity in which he is acting—advisor or broker—whenever he makes a recommendation that you purchase any financial product or service.

The Independent Broker

The independent broker is somewhat similar to the retail broker. Independent brokers can offer advisory accounts as well as brokerage accounts, provided they are dually-licensed. Unless you maintain an advisory account, the independent broker does not have a fiduciary legal obligation to you.

The term “independent” merely refers to the fact that these individuals are typically self-employed contractors. They do not work directly for the brokerage firm whose name is on their office suite. They pay their own expenses, but they are registered with the brokerage firm and subject to the same product restrictions and some of the same potential conflicts of interest as retail brokers.

Independent brokers do not have sales managers pressuring them to meet sales quotas. Independent brokers are typically former corporate employees of a brokerage firm who may have become frustrated that their employer was taking a large share of the commission revenue that they generated. They may want to be free of office politics and sales managers who may know less than they do, telling them what products to sell and how to serve their clients. They decide to associate with a new brokerage firm, one that caters to independent brokers.

What they gain is the right to keep much more of the gross revenue. A retail broker (a corporate employee who receives a paycheck from the brokerage firm) might receive 40 percent of the revenue he generates. An independent retail broker (a self-employed individual with identical revenue production and who is registered with the same brokerage firm) might keep 80 percent of gross revenue production. In return, the independent broker covers all the expenses that the large firm formerly covered—keeping a great deal more of his gross revenue if he maintains low overhead.
Independents may have more latitude than retail brokers about the amount of commission or markups for some transactions, such as stock or bond transactions.

The Independent Investment Advisor
The independent investment advisor is truly independent in every sense of the word. These advisors maintain their own offices and are either self-employed as a Registered Investment Advisor (RIA) owning their own firms, or employed by an RIA firm. The advisors offer fee-based advisory accounts, not brokerage accounts.

Independent investment advisors are typically not dually-licensed as brokers. Independent investment advisors are full-time fiduciaries. Some strictly offer financial advice and financial planning, but others offer investment management as well. Do not confuse an independent investment advisor with a broker, retail or independent, who is dually-licensed.

There are two types of independent investment advisors: fee-based
investment advisors and Fee-Only investment advisors.

Fee-Based Independent Investment Advisors

Independent fee-based investment advisors do not charge commissions for so-called “secondary market” securities transactions, such as buying or selling a share of stock on an exchange as opposed to buying a share of a “new issue” of a particular security. Fee-based advisors are typically compensated by “hard-dollar” fees—fees that are either remitted by the client, or charged to the client’s account by the custodian holding the account. Fee-based advisors can accept commissions for selling certain products, such as insurance policies, or can accept placement fees for selling or placing new issues of certain securities. Under this arrangement, certain potential conflicts of interest exist that you need to be aware of. For example: assume that you have an advisory account with your fee-based independent investment advisor, for which you pay an annual advisory fee of 1.0 percent. Now assume that he sells you $100,000 of a new product his company is offering—a structured note, for instance. The product has an embedded commission or placement fee built in amounting to 3.0 percent. If he only offsets one year of advisory fees, a common practice, he stands to receive a windfall of 2.0 percent, or $2,000. He should offset the full amount of the placement fee dollar-for-dollar so that there is no potential conflict, and he should fully disclose the amount of the placement fee or commission.

Fee-based independent investment advisors are required to make full disclosure of all sources of compensation, as set forth in the Investment Advisers Act of 1940. Again, these advisors should offset any commissions or placement fees against the advisory fees they charge on a dollar-for-dollar basis. This will help remove the potential conflicts of interest presented by placement fees for new issues or commissions for the sale of insurance policies.

Independent Fee-Only Investment Advisors

Independent Fee-Only investment advisors are full-time fiduciaries. They are not selling anything, and are not dually-licensed as brokers.

The Fee-Only investment advisor, as the name implies, is compensated strictly by the fees paid by their clients. They may be paid by the hour, the project, or as a percentage of assets-under-management (AUM).

Independent Fee-Only investment advisors receive no commissions, placement fees or any other form of third-party compensation. The most common arrangement is that advisors receive one fee, paid quarterly, as a percentage of AUM. They have the legal obligation to always act in the client’s best interest.

My RIA firm—ClientFirst Wealth Management—is Fee-Only. A large part of my practice involves the design and management of fixed-income portfolios. I am always free to pursue the most attractive offerings and to negotiate prices. My independence also provides access to high-quality research from many sources.

It is important to note that Fee-Only investment advisors are not totally free of potential conflicts of interest—nobody is. For example, what if a client’s needs are best served by paying off a mortgage? This will mean fewer dollars under management and less revenue for the advisor.

If you wish to work with an independent Fee-Only investment advisor with a local presence, there are thousands of qualified individuals located across the U.S. Go to www.napfa.org (the website of the National Association of Personal Financial Advisors) to find advisors in your area. Membership in NAPFA is comprised solely of Fee-Only investment advisors. For independent Fee-Only investment advisors who are paid by the hour, check out the Garrett Planning Network at www.garrettplanningnetwork.com.
Another source of Fee-Only investment advisors is Vanguard (www.vanguard.com). Vanguard, famous for its low-cost index funds and exchange-traded funds, also offers financial planning and investment management from licensed specialists who are typically compensated by salary.

If you are unsure about your financial advisor’s legal obligation to you and want to make sure that he has an uninterrupted, full-time fiduciary legal obligation to act in your best interests, have him sign the following commitment (obtained from NAPFA):

I am a fiduciary regulated by the Investment Advisers Act of 1940. I am legally obligated to act in good faith and in the best interests of my client. I will provide written disclosure of any conflicts of interests that I or my employer may have, which may compromise my impartiality. Neither I, nor any party in which I have a financial interest, receive any compensation or remuneration contingent upon a client’s purchase or sale of a security or other financial product. I do not receive fees or other compensation from another party based upon referring a client or a client’s business.

If your advisor can’t (or won’t) sign it, consider an advisor who will.

The NAPFA website offers the following:

“Start with a general practitioner…a Financial Planner (whose) compensation should be from fees alone.”—Money magazine
“Members of the National Association of Personal Financial Advisors (NAPFA) are ethically bound to operate on a fiduciary standard, meaning they have promised to do what’s in your best interest.”—SmartMoney magazine

“If you don’t have a planner, ask your friends for recommendations. You want a ‘Fee-Only’ planner, meaning one who earns a living solely by charging fees for advice. Steer away from planners who sell financial products of any sort.”
—CBS MarketWatch

“It’s worth your while to check out Fee-Only advisors so you don’t have to worry about anyone selling you a product for their personal gain.”—Gerri Willis, Fox Business News (formerly of CNN)
You can learn a great deal about a registered investment advisor firm (RIA) through the firm’s required filings with regulators. Form ADV is available online at www.sec.gov. RIAs are also required to maintain a narrative brochure. Go to www.adviserinfo.sec.gov and look for the investment advisor search page.

In the next section, we begin to look at investing. We will start by exploring the impact of fees (investment fees and advisory fees) on the long-term growth of investments.

NAPFA Fiduciary Oath

The advisor shall exercise his/her best efforts to act in good faith and in the best interests of the client. The advisor shall provide written disclosure to the client prior to the engagement of the advisor, and thereafter throughout the term of the engagement, of any conflicts of interest, which will or reasonably may compromise the impartiality or independence of the advisor.
The advisor, or any party in which the advisor has a financial
interest, does not receive any compensation or other remuneration
that is contingent on any client’s purchase or sale of a financial product. The advisor does not receive a fee or other compensation
from another party based on the referral of a client or the client’s business.

Following the NAPFA Fiduciary Oath means I shall:
• Always act in good faith and with candor
• Be proactive in disclosing any conflicts of interest that may
impact a client
• Not accept any referral fees or compensation contingent upon the purchase or sale of a financial product

(How To Select A Financial Advisor Series – Ed Mahaffy)

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