Q144 – How Does An RIA Compare To An Independent Broker-Dealer?

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Also available as podcast (Episode #144)

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How Does An RIA Compare To An Independent Broker-Dealer?

TL;DR – There are meaningful differences between the independent broker-dealer and RIA models. Ranging from technology, compliance, operational approaches, legacy mindsets, etc. The independent broker-dealer model remains a good fit for advisors with a commission heavy focus to their practice. For advisors whose practice’s reflect the industry trend towards a more fee-based approach of working with clients, the RIA model is generally the better fit.

Host:

Brad Wales founded Transition To RIA in 2020 after nearly 20 years of prior industry experience, including direct RIA related roles in Compliance, Finance and Business Development. He has an MBA and has held the 4, 7, 24, 63 & 65 licenses. He has been quoted or featured in 100+ industry articles including in the Wall Street Journal, Barron’s, and most every other major industry publication. He is well known for his RIA video explanatory series, and Kitces named his podcast as a “Top Podcast for Financial Advisors.”

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Full Transcription Of Video:

How does an RIA compare to an independent broker-dealer? That is today’s question on the Transition To RIA question & answer series. It is episode #144.

Hi, I’m Brad Wales with Transition To RIA where we 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 we provide from this entire series in video format, podcast format. There are articles, there are whitepapers. There’s a Vendor Profile Series. All kinds of things to help you better understand the RIA model.

Again, TransitionToRIA.com.

On this episode we’re going to talk about if you’re looking for a change with your practice, whatever kind of model you’re in now, whatever kind of firm you’re in now, should you be considering the RIA model or should you be considering the independent broker-dealer model?

Some of you that are at a wirehouse now and you’re considering a more independent path, you might be defaulting to think, if I’m at a wirehouse now, my next progression is an independent broker-dealer.

Or perhaps if you’re at an independent broker-dealer now and that is no longer a good partner, they’re no longer a good solution for you, you might be thinking…. “I should just be looking at other independent broker-dealers.” Essentially a lateral move.

I would challenge you, depending on the circumstances of your practice, that while you might look at those options, you should also be considering the RIA model.

And that is for sure if you are predominantly fee-based with your practice. Which mind you, it’s a common misconception, you do not have to be 100% fee-only to go into the RIA model. There are ways to solve for your, often referred to as “legacy” commission assets. I’ve done episodes on how that works. So just at a high level, you do not have to be 100% fee-only to go into the model.

And for those of you that are either perhaps already 100% fee-only, or predominantly fee-only, which I would describe as 70% or more fee-only, I would challenge you, are you only considering perhaps the independent broker-dealer path as your independent route? You should be looking at the RIA model as well.

So on today’s episode, I want to give you some of the comparisons between an independent broker-dealer and the RIA model.

Let’s start with a backstory on the independent broker-dealer model.

For those that are not already familiar with it, this is the idea that you are joining a broker-dealer in an “independent” affiliation model, often referred to as a 1099 model, or an independent contractor model.

The idea being is that you’re going to join that broker-dealer, they’re going to give you a relatively high payout. And in return, you are going to manage your so-called local expenses yourself as your own business.

You are your own business, you are 1099, you are that independent contractor. They provide you certain services, you in turn essentially run your local arrangement.

We call them independent broker-dealers because historically and primarily they were simply broker-dealers. Many of them have been around for decades and decades and if not entirely, almost all their business was working in that broker-dealer capacity.

This is where the advisors are “brokers” of the broker-dealer, or “registered representatives” of the broker dealer.

And I’m old enough to remember there was even a magazine at one point that was called Registered Rep, because that was the primary way that “financial advisors” operated was as a broker, as a registered rep of a broker dealer.

That primarily was where you would generate as that broker, you would generate a commission on each transaction you did for clients. Whether that was to trade an equity, buy into a mutual fund. Eventually ETFs came along, so there might have been a commission charge.

That was historically how it worked for a long time, and hence why we call them independent broker-dealers.

But over time, we’ve seen the wave towards more and more advisory fee-based accounts, which began long ago. There was this increase in demand from clients and from advisors that they wanted to work with their clients on a fee basis instead.

So as opposed to being on a transactional basis where you as the advisor are compensated on a commission for each transaction that’s done, there was this growth in the fee-based advisory account approach where you are providing advisory services and maybe portfolio management for your clients and you are paid not by each transaction that occurs, you are paid a fee directly paid by the client.

Well, to be able to do that, these independent broker-dealers had to also have an RIA. Because keep in mind, under a broker-dealer is where you do things on a commission transactional basis. Typically a Series 7 registered representative.

If you want to work on a fee basis, that must be under an RIA.

So these independent broker-dealers over time introduced what’s often referred to as a “corporate RIA”, which is essentially their affiliated RIA. They could then say to their advisors…. “If you want to open an account for a client on a commission basis, great, you’re technically doing it under the broker-dealer side of the house. And if you want to open a fee account for the client, an advisory account, you’re doing it over here on the RIA side of the house. But it’s essentially all under one roof.”

But we’ve kept calling them independent broker-dealers because that’s what we’ve always called them.

The reality though is as time has gone by, if you look at the stats of any of the large “independent broker-dealers”, as well as many of the smaller ones, over time because of the demand for, and desire for, more fee-based approaches to working with clients, if you look at those big independent broker-dealers, more client assets are now on the fee side, the RIA side of the firm, than are on the broker-dealer side of the firm.

So if anything, we arguably shouldn’t even be calling them independent broker-dealers anymore because they are no longer predominantly broker-dealers like they once were.

There’s a time they once were only a broker-dealer, and then over time eventually happened to have an RIA, and then that RIA ended up growing. And now, they are predominantly very large RIAs that also happen to have a broker-dealer solution alongside it.

I don’t think we’ll ever change the terminology because it’s just forever been called an independent broker-dealer. But I wanted to give you that little backstory of how we got to where we are with these so-called independent broker-dealers and what their current state looks like now.

And why, with that progression, you arguably should be looking at the RIA model if you’re predominantly fee based as opposed to that historical independent broker-dealer model.

So I want to get into that. And again, as a comparison, if you were to start your own RIA, clearly there’s not a legacy broker-dealer backstory to you starting your own RIA. Or if you were to join an RIA, particularly one that has been built in the last five, ten years that was built initially, solely, or primarily as an RIA, not as a broker-dealer that’s trying to reinvent itself. It was built to support that fee-based model from the beginning.

So we’re going to look at what some of those comparisons are. Some of the challenges of that historical independent broker-dealer model.

First, even though these broker-dealers have grown to the point where they have more assets on the advisory side, there still is decades of a legacy broker-dealer compliance mindset that has been built into these firms.

Even though the assets have slowly moved more into fee-based, you can’t just turn that tanker around quickly, if at all. Clearly FINRA is still part of this. FINRA still oversees the broker-dealer side of things.

Yes, they still must follow FINRA broker-dealer rules. But even though more of the assets are over here, typically, it still seems to be that higher bar, that FINRA, the more narrow restrictive restraints of a FINRA broker-dealer approach gets applied to the entire firm. Regardless of technically whether you’re, as the advisor, wearing your broker-dealer hat for one client or whether you’re wearing the RIA hat. It’s oftentimes one set of rules.

And they go to essentially the lowest common denominator, or I guess this could be the highest common denominator in the sense of the more burdensome approach to compliance, of that FIMRA side.

Where I’ve seen this is some of these independent broker-dealers over time have introduced what is often referred to as an “IAR-only” channel at their firm. They recognized this shift to more and more fee based. They recognized they have advisors that individually have shifted their practice predominantly, if not entirely towards fee based, under the corporate RIA side.

So they’ve said (to their advisors)….. “we have this IAR-only channel.” Meaning, “advisor, you will only operate under the corporate RIA side as an IAR, an investment advisor representative, underneath the RIA and you will not be tied to the broker-dealer side. You will be not be tied to FINRA.”

That sounds great and everything but the reality is, and I’ve talked to people that have made that internal transition, and I asked what all changed? Was compliance approached different?

One of them said, no, maybe the payout changed a little because of how they structured it, but the reality is it’s still the same compliance department that’s managing or overseeing everyone, regardless of if you’re in the traditional “broker-dealer channel” or you’re in the “IAR-only” channel.

And so the experience I’ve had with folks that have made that move, there’s that legacy approach to compliance that’s been ingrained for decades. Firms essentially can’t shake it and it is a constraint. Versus if you were to go to the RIA model, particularly if you end up being 100% fee-only, there is no legacy approach to compliance from a broker-dealer or FINRA standpoint. It is solely SEC regulations, RIA regulations.

So number one is that legacy approach to compliance.

Next, related to that, a lot of these large firms have very long tenured employees at the firm. Which in some ways is a plus and they can bring a lot of value and history of the firm.

But that institutional knowledge is from folks that are often high up in the ranks. That have been at a broker-dealer historically. That’s how they maybe started their career. That’s how they grew in their career. That’s the world they know.

And so how they approach growing the firm, or how they work with advisors, or what services are needed for clients, you have that institutional knowledge that is still based on a broker-dealer mindset. It’s hard to shake that.

Now, over time as there’s turnover at these firms and they maybe bring in outsiders that have been predominantly in the RIA space and they say to them… “come in and help us re-envision and re-look at how we view things here.”

I think over time that will change, but you do have heavily entrenched institutional knowledge that comes from a broker-dealer background at these independent broker-dealers that is hard to shake. So that is something you need to consider.

Another challenge with independent broker-dealers is they typically are built off of technology they’ve built themselves.

In some instances it’s technology they’ve been building for decades. They have that legacy broker-dealer based technology where now they’re trying to update it, but it was built for the broker-dealer model, for the registered rep model, for the transactional model, for a commission model.

Now, as the industry has changed, the industry has shifted, it is too entrenched. They can’t just throw it all away and say, hey, let’s rebuild technology from scratch reflecting our current day status, which is primarily RIA advisory-based. However, it is still needs to accommodate the commission side, but we want the focus and the solutions of it to be based on the RIA space, which is now the bigger part of our business.

They can’t do that. It’s legacy technology. They will continue to tinker on it, adjust it, change it. It’s essentially almost impossible. These firms have grown so big they can’t just throw it all away, rip the band aid, and start from scratch.

They are working off of a legacy broker-dealer technology code base and approach. All the functions that are built into it are having to be evolved or changed, not just built from scratch to support the needs of an advisory fee-based practice.

So, technology can be another challenge.

And then the last example, this is not an exhaustive list, at most every independent broker-dealer, you only have one choice of where to hold your client assets.

That’s either because the independent broker dealer is large enough to be, as they say, self-clearing. Which means they are their own underlying clearing broker-dealer.

Or they use a third-party clearing broker-dealer, where in that case the independent broker-dealer is what’s referred to as an introducing broker-dealer. They rely on a third-party clearing broker-dealer.

But with the latter, typically it’s only one solution to where the assets are held. It’s not like they have two or three clearing broker-dealers that they use. And obviously if they are self-clearing it’s just one solution.

And so, even though you are predominantly more fee-based in your practice, you only have one choice of where to hold your client assets.

Now that’s not to say that particular firm or that particular clearing firm is not a good option. But there’s oftentimes reasons you might want the flexibility of having different custodians to choose from or having multiple custodians to be able to offer your clients.

In the RIA space, you often have multiple custodians to choose from. Most RIAs of size, typically do eventually have more than one custodian option that they work with. They can say to their clients… “we work with both these custodians, it doesn’t make any difference to us from a revenue perspective, which you would prefer, but we do want to provide you with choice. Here’s why you might choose one over the other. We’re happy to work with you either way.”

Again, you generally do not have the ability to say that as an independent broker-dealer because in almost all circumstances, there’s just one option with that.

Custodian selection of where your client assets are going to be held is limited in the independent broker-dealer space compared to how it works in the RIA model.

Those are just a couple of variables to show you some of the challenges that independent broker-dealers have. And yes, they’re working to overcome them. But as I noted, you can’t turn an oil tanker around easily, if at all. The best you can do is try to hopefully steer in a better direction with it in many instances.

I want to leave you with a couple takeaways on this, as I’ve kind of been dunking on independent broker-dealers in this regard, but this is all factually correct what I’m saying.

Now, I would say I should not and will not paint a broad brush and say all independent broker-dealers are challenged in the same way. That they’re all equally slow to react to the changing landscape, that’s not the case.

There are some, not many, but there are some independent broker-dealers that I have observed to be more progressive and accepting of the new reality of where the industry’s going and that they need to reinvent themselves as best as possible into what is viewed more as an RIA option, versus that traditional independent broker-dealer option.

So I don’t want to come across as painting a broad brush that every independent broker-dealer has been slow to react. There are some that I would give credit to that I think are better at trying to evolve than others. But clearly there are many that are struggling and the needle is not moving as fast as it needs to be moving, considering where the industry is going.

So that’s takeaway number one, just to give a fair disclaimer on that.

Related, if you are predominantly fee-based with your practice, you should simply be looking at RIA options before, or with more focus, than looking at broker-dealer options.

If 70, 80, 90% of your practice is fee-based advisory and only that small minority 10 or 20% is commission, why are you looking at what is driven by the 10 or 20% as your main solution provider? Why are you not looking at how it works in the RIA space?

Yes, you might have that remaining 10 or 20%, and you might need a way to solve for that. And as I talk about on many episodes, there’s generally ways to do that. So do not assume that cannot be solved.

But you should look at your practice and ask yourself…. “predominantly, what kind of practice am I? Am I more a fee-based practice or am I a commission-based practice? And if I’m more fee-based, I should be more focused on what the RIA model has to offer versus that legacy independent broker-dealer model has.”

Now, if you are 70%, 80%, 90% still broker transactional with your practice, that’s fine. For instance, there are some practices that are perhaps all fixed income related practices, and that is just the model that works best for them and their clients. Everything is done on a commission basis. That is always going to be better in the broker-dealer space.

Now, that fixed income advisor could go and convert and do it in a fee-based account and charge a fee, and perhaps a lower fee if they wanted. But I get it, there are some circumstances, like the fixed income example, where maybe a broker-dealer path is the better path.

Or again, just in general, for whatever the reason, if 70, 80, 90% of your practice is broker-dealer commission based assets, and the minority position perhaps in your case is on the fee-based side, in that case, yes, you should be looking at the independent broker-dealer model.

I’d even say if you’re 50-50, the independent broker-dealer path might be the better path for you.

But the minute you start getting in the 70, 80, 90, 100% range of being fee-based, that’s where you need to put more focus on your RIA options versus that legacy independent broker-dealer path.

And then the final thing, to tie a bow on this, I talk to a lot of advisors and teams, and I hear a lot of feedback. There are several misconceptions in the marketplace about the RIA model.

It is well beyond the scope of this episode to address them all, but sometimes it’s just this mentality, particularly advisors that have been in the industry for a long time, they feel they somehow need a broker-dealer. Because their entire career they’ve been at a broker-dealer.

Again, these broker-dealers are reinventing themselves more as essentially RIAs, but there’s just this thought that… “I must be at a broker-dealer. If I’m going to make a change, and even if it’s a change to independence, I need to be in the broker-dealer world.”

Again, in many instances, that just doesn’t make sense, as I was just alluding to with the percentages.

I’ll talk to some advisors that are at a wirehouse W2 model, or an independent broker-dealer model, and they are literally 100% fee only. And they will talk about if they’re going to make a change, they’re going to look at independent broker-dealer options.

And I say… “why are we even talking about broker-dealers? Why are we even talking about FINRA? Your practice doesn’t have anything to do with that anymore.”

But there’s this mentality, often with folks that have been in the industry for decades, that you must be affiliated with a broker-dealer.

For some of you, that will be the better path. But for many of you, if you follow the industry trends and your practice is more fee based, it’s likely going to steer you more towards the RIA model.

So, just from a mental aspect, do not think you must be with a broker-dealer.

And again, for those of you that do still have remaining legacy commission assets, in many instances there are ways to accommodate that, or solve for that in the RIA space.

I’m happy to dive into your particular practice, your profile, the percentage you have in fee-based, what your remaining commission asset looks like, and discuss the options you have. What would that look like? Is that workable for you?

Again, educate yourself on how it works before assuming you need to be with a broker-dealer, without fully understanding how the RIA model compares.

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. What are your circumstances now? What are the motivations you have for maybe making a change? What does that landscape look like?

And yes, there’s nothing wrong with understanding how independent broker-dealers work if you’re not at one currently. Or you’re at one now, and you might be wondering if there’s one that would be a better fit for you.

But at the same time, you owe it to yourself to say, what does the RIA model look like alongside that as well? I’m happy to have that conversation with you.

First things first, though, head to TransitionToRIA.com where you’ll find this entire series in video format, podcast format. There are articles, there are whitepapers. There’s a Vendor Profile Series.

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, I’m happy to have that conversation with you.

Again, TransitionToRIA.com.

And with that, I hope you found value in today’s episode and I’ll see you on the next one.

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