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What conflicts of interest do I have to disclose as an RIA?
While the implementation of Regulation Best Interest (Reg BI) has narrowed the gap to a degree, the requirements to disclosure conflicts of interest can vary significantly between a broker/dealer and Registered Investment Advisor (“RIA”) environment. Generally speaking, as an RIA you should endeavor to reduce conflicts wherever possible, and to properly disclose any conflicts that still remain. This disclosure is generally included in Part 2 of your firm’s ADV.
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Full Transcript:
What conflicts of interest do I have to disclose as my own RIA? That is today’s question on the Transition To RIA video series. It is question #26.
Hi, I’m Brad Wales with Transition To RIA where I help advisors like you understand everything there is to know about why and how to transition to the RIA model.
In today’s question, we’re talking about….“if I make that transition, if I become an RIA, what conflicts of interest do I have to disclose as my own RIA?”
The short answer is, you do have to disclose conflicts. Ideally, you minimize them, but you do have to disclose potential conflicts to your clients. That’s part of the fiduciary standard. That is the RIA standard. That’s different than the broker-dealer standard, which I’m going to go into here in a moment.
Your goal as an RIA should be to…number one, try to reduce conflicts of interest as much as possible. This is good for you and your clients. The idea is any that are still left – and I’m going to give you some examples of how it’s hard to essentially reduce them to nothing – you do need to disclose those if they’re relevant to your clients. That is usually done in your ADV Part 2. It’s technically where most of that will occur. So again, the idea is you do have to disclose conflicts. You want to try to reduce them. Then usually in your ADV Part 2, is where you disclose it from there.
I wanted to start with a reminder of the differences between the broker-dealer model and the RIA model. Reg BI, Regulation Best Interest has brought these a little closer together so that the example is not as clean as it perhaps once was. But pre-Reg BI, I want to give you an example because it makes it very black and white. The difference in the broker-dealer world, versus the RIA world with respect to conflicts of interest.
Pre-Reg BI, if an advisor was with a broker-dealer, and while they’re wearing their Series 7 hat, their registered rep hat, they have a client who’s in a commission account. Even if that advisor happens to also be an investment advisor rep of the corporate RIA, of the firm they’re at, if that client solely has a commission account, in that capacity, that advisor is working as a registered rep for that account.
The standard of care in the broker-dealer world at that time was a suitability standard. A quick example….imagine two clients come into that advisor. Let’s say they’re exactly the same. They’re both the same age. They both have the same net worth, the same income, the same goals, or whatever the case may be.
That advisor, under the suitability standard – let’s say that advisor wanted to help them and put them in a mutual fund. A very simple example, we are going to use one fund, and for whatever reason, that’s the case. It’s in a commission account, so it’s going to be a loaded mutual fund. There’s going to be a front-end load (commission) back to the advisor.
From the universe of options that advisor has to pull from….let’s say he (she) narrows it down to two options. One of those has a 5% load and one of them has a 3% load. Again, these clients are the exact same. The advisor could choose to put one client in the fund that has a 5% load and one client in the fund that has a 3% load.
Let’s say, all other things equal, these mutual funds are arguably on par with each other. And let’s say they’re both, as a result, “suitable” for our profile client. They have the exact same profile. Which of those mutual funds do you think the advisor would use?
Maybe with both clients, they decide….“I’m going to use the 5% load mutual fund.” They don’t have to go and tell the client….”Oh, by the way, there was a less expensive option.” Again, this is all pre-Reg BI. “There was a less expensive option I could have chosen for you, but because both options were technically suitable for your profile as a client, I went with this option. I didn’t even have to disclose that to you, that there was this potential conflict of interest I had, where maybe I could use the one that would cost you less on a load but as a result, it paid me less as the registered rep.” In that broker-dealer world, all that was required was the suitability standard. As long as both mutual funds were suitable for that profile of that client, that was perfectly allowed.
Now, mirror that to the RIA world. In the RIA world, you couldn’t do that sort of thing at all. You wouldn’t be getting loaded mutual fund commissions in the RIA world, but the idea is in the RIA world, you have to be entirely transparent with the client. You can’t have a couple of options, and one clearly might benefit you more than another, but not disclose that to the client. You absolutely need to try to eliminate those kinds of conflicts of interest. And if they do exist, you have to disclose it.
The main way this (disclosure) is accomplished in the RIA world – it’s very clean between the RIA and client. As the RIA, you go to the client and you say….”Mr. or Mrs. Client, the only way I am going to get paid is by the advisory fee you pay me. (Let’s say it’s 1% on the account.) You are going to pay me a 1% fee. It doesn’t matter which mutual funds I recommend to you. It doesn’t matter which other investment products I might recommend to you. It doesn’t matter how frequent or often we trade in the account, whether it was a change in mutual funds or a change in equity positions, or whatever the case is. I, as the RIA, get paid on none of that. None of that impacts me. The only fee I get is from you, the client. As a result, I can do what’s solely in your best interest. I have no conflicts as far as whether I should pick one mutual fund over the other. It’s not going to make any difference to me from a compensation standpoint, whether I use this fund or this fund. I only get the 1% from you.”
This is part of what makes the RIA model so clean and so beneficial, for both the RIA and the client.
Now you might think….“in the RIA world, I’ll simply eliminate all conflicts of interest. I won’t have this loaded mutual fund conflict for sure because that’s not part of the RIA world. But I’ll go ahead and get rid of all conflicts.” I would caution you to not believe that’s necessarily even possible.
I see from time to time, and I’m not a fan of it, you’ll look at an RIA’s website, and they will declare….”We are 100% conflict-free.” I don’t think that’s accurate. I’m going to give you some examples. I think you’re only setting yourself up for failure by that. The reality is, there are some inherent conflicts out there that are not necessarily bad conflicts, but they are conflicts. Some of which are almost impossible to eliminate. To the degree you properly disclose them, there’s nothing wrong with that. But to declare up on the mountain top….”I am 100% conflict-free,” I don’t think is being accurate.
Let me give you a couple of examples. I’m not suggesting that anything that could be deemed a conflict of interest is necessarily a bad thing. It is simply if there’s the potential for this conflict of interest, you need to make sure the client understands the whole spectrum of what goes into maybe making a decision, what are both sides of the coin. As long as you’re transparent about that, there’s nothing wrong with that.
The first example is let’s say a new prospective client comes to you. All of their investable assets right now are in a company 401(k) plan. They recently left that company, so now have the opportunity to roll that 401(k) potentially into an IRA, which then you could manage under your RIA.
There’s an inherent conflict there because if they say….”Mr. or Mrs. Advisor, what should I do with my 401(k)?” One option is (in most instances) to solely leave it there on that 401(k) platform. If it’s left there, the RIA itself might not have a way to generate any revenue from that relationship.
There actually are ways you can still help people like that as an RIA. I did a whole video on different ways you can charge for your services. But generally speaking, you wouldn’t be managing it if it was over there in that 401(k).
Oftentimes, an advisor (in this situation) will explain the value they provide for clients, the services they provide for clients, and so on. “Mr. or Mrs. Client, if you roll over your 401(k) into an IRA, here’s everything I will do for you, here’s what it will cost, we’re fully transparent.”
This could be perceived as a conflict of interest though because if they don’t roll it over to you, you perhaps won’t generate any revenue from it, or potentially a lot less than had they rolled it over. So again, it’s an acknowledgment that there is a conflict of interest. There’s nothing wrong with suggesting maybe the best path for a client is to go ahead and roll that over as long as you explain why that’s perhaps in their best interest, what value you will provide, what the costs are, etc. This all is a perfect example of why you shouldn’t say….”I don’t have any conflicts of interest.” Has that advisor that’s declaring that never had a rollover conversation with a client?
The second example I’ll give – I’ve mentioned this on the video I did about as an RIA, can you sell insurance products? The short answer to that is you absolutely can. I encourage you to watch that video, to learn more about that if that’s something you’re interested in.
That (selling insurance) could drive some conflicts of interest. Not necessarily a bad thing, but a conflict of interest nonetheless. An easy example is, let’s say you want to be able to offer term life insurance to your clients. When you’re wearing your advisory hat, you’re getting paid your 1% advisory fee and you’re helping them understand all of the steps they need to be taking in their life to achieve their goals and all those sorts of things.
One of those might be….“you (client) need life insurance to protect your family.” That’s a common piece of advice. All day long, that sort of thing comes up. It’s quite conceivable you might give that advice.
But then if you also say….”Oh, and by the way, here, within my firm, I also can offer that insurance, I can sell you that term life insurance directly.” That might be a tremendous value-add for the client and make it significantly easier for the client. They’ll have one single point of contact, for everything about managing their wealth. To have it all under one roof could very well be appealing to the client.
You can understand where there’s a potential conflict of interest there. Because you are giving that advice – which arguably you probably would have given the advice exactly the same even if you didn’t sell the insurance, if you had to refer them to someone else. But the reality is, you do sell insurance and you do get paid for selling that insurance. So that is a conflict of interest.
That’s the sort of thing you want to disclose. In your ADV, you’ll disclose….”I also offer insurance services. I am paid separately for those insurance services.” So again, a perfect example of where a conflict of interest is not necessarily a bad thing, but it is something that exists, and is something you need to essentially acknowledge and be transparent about and make sure it’s disclosed. Part 2 of the ADV is usually where that occurs.
Bottom line on this, I’m of the belief – there may be other opinions out there – you will never be 100% conflict-free by definition of conflicts of interest. I would suggest you not raise that banner and say….”I am 100% conflict-free.”
The goal is to reduce those conflicts where you can. If it’s not critical to your business, maybe reduce it. Regarding insurance – I gave this extended example on the separate insurance video I did as well – if you do want to offer insurance products, great. But if you’re only going to rarely do it, and it’s only going to be a tiny, little part of your business, maybe don’t offer it. Maybe refer that business out because it’s not worth your while. If it won’t benefit enough clients, maybe it’s better to reduce that conflict and not do that in-house.
That’s a personal decision for each advisor to make, but that’s an example where you can reduce it. Maybe it is such a big part of your value-add, that it absolutely makes sense to keep it and you can disclose it. That’s fine. I’m not suggesting you can’t do it. But to the degree you can reduce it, or it might make strategic sense to reduce it, I encourage you to do so. And then where they still exist, you need to disclose them so the client has a full understanding of that.
The last point on that, and I’ve mentioned it a couple of times….”You need to disclose it in ADV Part 2,” and those sorts of things, this is exactly what the compliance consultant you’ll be working with will help you with all of this.
In a number of videos I’ve done, I keep mentioning that a standard part of having your own RIA is working with a compliance consultant. Part of what I do is help advisors understand the different array of consultants out there, the different services they provide, the different cost structures they have, etc. I’m more than happy to have that conversation with you. I can certainly help guide you through that.
The idea though is you will be using one. That is standard practice in the RIA world. Disclosing conflicts of interest is a standard part of the service they provide. Everything I’ve said in this video about disclosures, I don’t want you worried about….”where was it again I was supposed to disclose this, or how am I supposed to do this?” The compliance consultants will absolutely help you figure all that out and make sure you’re staying compliant. Do not have any anxiety over that. Just be aware that is part of the process.
With that, like I said, I’m Brad Wales with Transition To RIA where I help advisors understand everything there is to know about why and how to transition to the RIA model.
Today’s conversation is a perfect example. A part of that understanding process is to know how conflicts of interest must be addressed in the RIA world. It could be quite a bit different perhaps than what you’re currently used to in your current affiliation setup or the current firm you’re with.
I’m more than happy to talk to you about your current situation and what that might look like in the RIA model with respect to this topic, conflicts of interest, or any of the other many variables that you’re going to want to be aware of, what those differences are. I’m more than happy to have that conversation with you.
I hope you found value in today’s video, and I’ll see you on the next one.
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