Considering Using an Investment Adviser? Why Titles Matter

RIAs vs. broker-dealers

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Scott Holsopple

Financial adviser has become a common job title, but the term covers a broad array of roles, duties, company configurations, and pay structures.

In fact, there are so many nuances and caveats that I could write ten articles about financial advisers. But I want to focus on a few particulars that should help you understand your relationship(s) with your own financial adviser(s).

There’s a distinction that affects the level of legal and regulatory responsibility a financial adviser has: A registered investment adviser, also called an RIA, is an individual or organization registered as such with the Securities and Exchange Commission and the state(s) in which he or it practices.

An RIA assumes fiduciary responsibility for the financial planning and investing advice he provides. The SEC requires that fiduciaries make recommendations that are solely in best interests of their clients. Further, fiduciaries must disclose to clients any potential conflicts of interest.

Fiduciaries know they could be sued, fined, or banned from practice if they don’t act solely in the best interests of their clients. Consequently, an industry culture has developed wherein most RIAs take significant steps to ensure they uphold their fiduciary duty.

Look for RIA compensation to be fee-only, which means RIAs either charge a percentage of assets under management or a flat-rate fee. Fee-only planning doesn’t favor one mutual fund or financial product versus another because fee-based advisers make the same amount of money regardless of recommendations.

It is important to note that fee-only is different from fee-based compensation models. Fee-based compensation can sometimes include commission payments, therefore possibly diminishing an adviser’s ability to act solely in the best interest of his clients. 

Financial advisers who aren’t obligated to meet fiduciary standards generally come under the broker-dealer umbrella. Broker-dealers are regulated and licensed, but they’re held to a suitability standard rather than a fiduciary standard. Broker-dealer compensation is generally commission-based.

Broker-dealers must prove that investing advice and financial products are suitable for clients. Proving suitability is no small task, but broker-dealers need not act solely in a client’s best interests. So, for example, if several suitable investment options exist, a broker-dealer can recommend the option that would pay him the highest commission. It need not be the most appropriate option; it only needs to be suitable.

Of course, many broker-dealers make recommendations solely in the best interests of their clients. The distinction is that they don’t have a legal or regulatory obligation to do so. Broker-dealers are allowed to operate when conflicts of interest would prevent RIAs from doing business.

Clouding the waters is the fact that many financial advisers are registered as both IAs and broker-dealers. These individuals and organizations are supposed to disclose to clients when they’re acting as an IA and when they’re acting as a broker-dealer.

Full disclosure from me: My company is an RIA. That aside, I’m biased in favor of RIAs because of the legal framework that supports RIA clients. However, you can have a very trusting and beneficial relationship with a broker-dealer. It’s important to ask the right questions to establish that fruitful relationship with any financial adviser, whatever his registration status.

Here are important questions to ask your financial adviser:

Are you an RIA or a broker-dealer? If the answer is both, tell your adviser you want to know, each time he makes a recommendation, whether he is held to a fiduciary standard or merely a suitability standard for the recommendation.

How are you compensated for the piece of advice you’re giving me right now? If the answer is a commission, that doesn’t mean it’s bad advice. It does mean you should delve further into a discussion about all your options. Ask how much this commission will be. If the answer is a fee, clarify whether the fee is a flat rate or a percentage of your assets under management.

Can you provide a complete disclosure of all the fees I’ll pay for this advice? In this instance, you can uncover trading fees and fund expenses, as well as adviser compensation.

Can you provide an itemized list of all the services you’re providing and the credentials you hold? This is particularly helpful if you’re comparing different financial advisers to determine where you’ll receive the best value for your money.

Armed with this information about compensation and liability, you’re in a good position to guard your interests as you seek financial advice.

Scott Holsopple is the president and CEO of Smart401k, offering easy-to-use, cost-effective 401(k) advice and solutions for the everyday investor. His advice has been featured on various news outlets, including FOX Business, USA Today and The Wall Street Journal.