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Also available as podcast (Episode #127)
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What Is The Difference Between An RIA And A Broker-Dealer?
TL;DR – While there are multiple additional nuances between them, at a high level: 1) a Broker/Dealer is an entity, which enables the individuals registered with it (Registered Representatives) to offer investment product solutions to their clients, and in turn earn a commission for the product sale; 2) an RIA (Registered Investment Advisor) is an entity, which enables the individuals registered with it (Investment Advisor Representatives) to offer investment related advice and services to clients, and in turn be paid a fee for doing so.
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Full Transcript:
What is the difference between an RIA and a broker-dealer? That is today’s question on the Transition To RIA question & answer series. It is episode #127.
Hi, I’m Brad Wales with Transition To RIA where I help you understand everything there is to know about why and how to transition your practice to the RIA model.
If you’re not already there, head to TransitionToRIA.com where you’ll find all the resources I make available from this entire series in video format, podcast format. I have articles, I have whitepapers. All kinds of things to help you better understand the RIA model.
Again, TransitionToRIA.com.
On today’s episode we’re bringing it back to the basics of what is the difference with fundamentals and logistics and verbiage between an RIA and a broker-dealer.
There are several reasons I want to make this episode. One, for educational purposes for folks that do not know what the differences are. And then also, as I’ll explain, the terms are sometimes used in more ways than one. So I thought it’d be good to make a clarification episode of the differences between them and discuss some of the verbiage used.
This topic is then compounded further by the fact that in our industry, unfortunately there is no official, regulatorily defined definition of a “financial advisor.” It is essentially a generic term that is used by many different solution providers within the space that are providing at times many different solutions to their end clients.
So much so that’s why it’s sometimes hard when you see stats or surveys that try to identify how many financial advisors there are in the United States, and they struggle with defining it. Because who do you include by that definition? But usually it’s understood to mean somewhere in the range of about three hundred thousand or more “financial advisors” in the United States. But again, generally in different capacities.
So I wanted to dive into what some of those definitions and logistics are. We’re going to talk broker-dealer, then also then also RIA. And then I’ll wrap up discussing where this is some overlap.
First up, what is a broker-dealer?
A broker-dealer is an entity. You, an individual, are not a broker-dealer. You might work underneath a broker-dealer either as a W2 financial advisor, or maybe 1099.
It is that capacity under a broker-dealer that enables you to provide solutions for your clients on a commission basis. You are selling them an investment product, an investment solution, and you are compensated for that in the form of a commission.
Historically, go back decades, this was done even just to buy or sell an equity. You had to turn to a “broker” at a broker-dealer to transact that for you. Now, with the advent of the E-Trade’s of the world, you can go online and do it yourself if you want. But prior, you had to go to a broker to buy or sell equities and they were compensated on a commission basis for that. A broker can also get a commission for selling a mutual fund, variable annuity, etc.
So again, it’s an investment product that is being sold. The individual selling it is under a broker-dealer and they’re earning a commission for it. That individual is formally referred to as a “Registered Representative.” Others refer to them as a “broker” or a “stock broker.” But Registered Representative is the official term of what that individual is when they’re working under the capacity of a broker-dealer.
To become a Registered Representative, you first must pass a qualifying exam. For most individuals that is the Series 7. Some folks have taken the Series 6, and maybe that’s still what they hold.
For those that aren’t aware, the 6 is a limited purpose version of the 7. But the 7 is the typical exam used to obtain the Registered Representative designation. And then due to state laws, you might need the 63 exam as well.
But again, traditionally when we think of, “did you pass the exam to become a Registered Representative,” we’re talking about the Series 7.
In more recent years, there’s another layer to that exam process called the SIE, the Securities Industry Essentials exam.
The challenge with the 7, 6, or 63 for that matter, to this day you cannot “sit” – as they call it – for a series 7 exam unless you are “sponsored” by a broker-dealer.
A broker-dealer says, “this individual works for us, is affiliated with us. They are attempting to become a Registered Representative. We as a broker-dealer are going to sponsor them to enable them to sit for the 7.”
And so the challenge for people new to the industry was, there are a lot of broker-dealers that don’t want to hire you until you have the 7. But you can’t get the 7 until you’re with a broker-dealer. It’s a catch-22 issue.
Several years back, FINRA rolled out the SIE exam – again, the Securities Industry Essentials exam – which anyone can sit for. It’s self-study, just like the 7. Anyone that wants to sit for the SIE can do so. You are not required to be sponsored by a broker-dealer.
And so now, oftentimes, if you’re trying to get into the industry, you would sit for the SIE and demonstrate your ability to learn the material and pass the exam. And then at that point, you’re more attractive to a broker-dealer to sponsor you to take the 7.
The SIE by itself is not good enough to become a Registered Representative. It’s essentially a prerequisite now for the 7 that you need to pass.
However, just because you’ve passed the 7, that alone does not make you a Registered Representative. At the moment you pass it, that’s all you’ve done, is pass an exam. Your broker-dealer then must register you as a Registered Representative of their broker-dealer.
So there’s multiple steps involved. Pass an exam, then the broker-dealer registers you as a Registered Representative of their firm.
At that point, you are now acting in the commission capacity. Historically, your duty of care to clients was a “suitability” standard. Meaning if a client came to you and there were five different mutual funds that you could potentially sell them – again, for commission – it didn’t matter if one would generate a higher commission for you than another. If whichever one you recommend was suitable based on the profile of that client, you are allowed to sell it to them. That was the standard for many decades.
More recently with Reg BI, Reg Best Interest, there’s now a higher level of care. But it’s not fully the fiduciary level, as-is the case in the RIA model.
In addition, in a Registered Representative capacity, because you’re acting in a commission capacity you cannot act with discretion as a Registered Representative.
If part of your value proposition to clients is to manage their assets, as a Registered Representative you cannot place trades on a discretionary basis. It is not allowed. Doing so requires a fee-based solution, which we’re going to contrast this to shortly.
So keep in mind, as a Registered Representative, it is a non-discretionary relationship with the client.
And just to tie a bow on the broker-dealer, the Registered Representative….for decades, that was the predominant way that a “financial advisor” operated. You, as a client, would go to your stockbroker to make a transaction, whether an equity trade, bond trade, etc. There are many advisors that still do that in a large capacity, but it’s generally no longer their sole capacity as it once was.
So that’s broker-dealer at a high level.
Now let’s compare it to an RIA.
An RIA stands for Registered Investment Advisor. An RIA is an entity. An individual is not an RIA, yet you sometimes hear that term misused where some advisors say, “I’m an RIA.” That’s like saying, “I’m a McDonald’s.” No, you might own a McDonald’s, you might run a McDonald’s, but you are not a McDonald’s.
But it’s common verbiage of someone saying, “I’m an RIA.” They in theory should say, “I own an RIA” or “I run an RIA.” As the RIA is the entity.
Working underneath an RIA is what enables a “financial advisor” to operate on a fee basis with clients. They are not being paid a commission for every transaction that occurs. They’re being paid on a fee basis.
I did a recent episode on the different kinds of fees you can charge in the RIA model. By far though, the number one fee approach is the AUM fee. The proverbial 1% of assets. The client brings you assets, you charge them give or take 1%, you provide certain value in return, which often, not always though, involves managing the assets that are in the account. And no matter how much you trade, you’re not, as the advisor, being paid a commission on any of that. You are solely getting the fee, in this example, a 1% AUM fee.
When you’re operating in that capacity, you are operating as the individual, as an IAR, Investment Advisor Representative. So again, the RIA is the entity, the IAR is the individual that’s acting in the capacity I just described underneath it. The IAR is comparable to a Registered Representative under a broker-dealer.
To become an IAR of an RIA, generally requires passing an exam just like it does under the broker-dealer process. The common exam required to become an IAR is the Series 65 exam. Though some folks use the 66, which is a combination of the 65 and 63.
And then many states, it varies by state, allow you to potentially exempt out of taking those exams if you have certain designations. A common example would be a CFP or a CPA. It varies by state, but most instances, if you were to have one of those, you might not have to take the 65.
Like the 7, simply passing the 65 solely means you’ve passed an exam. You then go to an RIA, whether your own RIA or someone else’s, and they formally register you as, again, an Investment Advisor Representative underneath the RIA.
In the capacity of an IAR, you operate under a fiduciary standard with your client. You must, among other things, put their interests first above your own. The disclosure requirements are much more significant in the fee-based world than the commission-based world.
There’s a different standard of care. Even though the suitability standard has pushed closer to a fiduciary standard, unfortunately, for better or worse, there is still a different approach. There are a lot of voices in the industry advocating to make a single standard of care, but for now there remains a difference.
When operating on a fee basis as an IAR, you can operate both on discretion or non-discretion.
Most advisors that are operating as an IAR typically operate with discretion with their client because that’s part of their value add for their clients. “Come to me. You don’t want to worry about having to invest your assets. You’re not experienced at investing your assets. We’re going to do that for you. We’re going to sit down with you two, three times a year and go over how the portfolio is doing. But rest assured, we will make the trades and here’s our investment philosophy. We’re not compensated on any of those trades. There’s no commission involved. You just pay us the (for example) 1% and we will act on discretion to do those trades on your behalf.”
But it is possible, if it makes sense for the IAR and the client, to also, if you’d like to, have that relationship be a non-discretionary relationship like the broker-dealer world.
When I talked about the registered rep broker-dealer in a historical context, going back decades, that was kind of the primary way the stock broker operated. The world however is increasingly moving more and more to the fee based side. That is where the industry is going. Obviously I’m biased, I’m a believer in the RIA space, but it is what it is. You look at the stats, increasingly more and more advisors are working under a fee-based capacity. I fully expect that trend to continue forward years, if not decades to come.
To then tie a bow on where those worlds combine a little is most “financial advisors” – again, we don’t have a defined definition of that – but at many of the big wirehouse firms or regional firms or even independent broker-dealer firms, many of their advisors are wearing both of those hats. They are a Registered Representative of that firm’s broker-dealer and an Investment Advisor Representative of the same firm’s, often referred to as, “corporate RIA.” They are wearing both of those hats.
If a new client comes in and wants to hire the advisor for all the services they’re going to provide, that advisor could potentially work with them on a commission broker-dealer basis or potentially on a fee only RIA basis, or maybe even a combination where one account is commission and another account fee.
As the industry continues to shift more towards the fee-based side, it is interesting how that impacts commonly used verbiage. For example, we commonly refer to “independent broker-dealers.” That term has been around decades. There’s some very large players in that space.
In most instances, at least with the major players, they are both a broker-dealer and an RIA, as I’ve been describing. And if you were to look at the underlying client assets of that “independent broker-dealer”, more of the client assets are now on the fee side of the relationship than the commission side. So arguably, we shouldn’t even be calling these firms independent “broker-dealers” any longer because they are now more predominantly RIAs than they are broker-dealers. But because we’ve used that vernacular so long, it probably will stick around for quite some time.
You see this also with references to how an advisor should maybe change broker-dealers. Maybe to another wirehouse firm. Well, typically when someone uses that kind of language, they’re not suggesting the advisor go join a firm that is solely a broker-dealer. Because again, most “financial advisors” nowadays are wearing both hats, and usually more heavy on the fee side.
Yet, we commonly refer to (for example) wirehouse firms as “broker-dealers” because historically they were only broker-dealers. And we’ll probably keep referring to them as such.
The main point being, if you hear someone use the term “broker-dealer” that’s typically in many instances referring to a solution that is both a broker-dealer and an RIA. But because of historical verbiage, we refer to them as broker-dealers.
And then the final thing I’ll say, and I’ve done other episodes on this as it is beyond the scope of this episode, is if you were to transition your practice on the RIA path, you do not have to be solely fee only, solely under an RIA, whether your own RIA or someone else’s RIA.
There is a way to be under an RIA and act in a fee capacity with your clients. And also, if you have legacy commission assets that need to be accommodated, there is a way to work in a so-called “hybrid” arrangement where you are under an RIA, and also an “RIA friendly broker-dealer.”
How that all works is beyond the scope of this episode, but the takeaway is don’t go away from this episode thinking, “If I want to go RIA I have to be 100% fee-only.”
Many advisors choose to transition and go down a path where they are 100% fee-only, but that is not a requirement. Many advisors operate under a hybrid capacity where they can still accommodate commission assets. I’m happy to chat with you about that, as it’s beyond the scope of this particular episode.
With that, like I said at the top my name is Brad Wales with Transition To RIA. This is the sort of thing I help advisors with all day long. Oftentimes there is a lot of education that goes into it. Using the correct vernacular. Fully understanding it.
You must make sure you understand these semantics because, as I noted, the verbiage can get blurred, where terms (like broker-dealer) are used in ways that mean more than just what it means at its core.
First things first though, head to TransitionToRIA.com where you’ll find all the resources I make available to help you better understand the model. This entire series is available in video format, podcast format. I have articles, I have whitepapers.
And at the top of every page is a Contact link. Click on that and you can instantly and easily schedule time to have a one-on-one conversation with me, whether you want to talk about today’s topic or anything else RIA related.
Again, head to TransitionToRIA.com.
And with that, I hope you found value on today’s episode, and I’ll see you on the next one.
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