Also available as podcast (Episode #16)
What is an advisory agreement and how do I create one?
An advisory agreement is the main document used to memorialize, in writing, the relationship between the Registered Investment Advisor (“RIA”) and client. Among other things it generally outlines the services to be offered, the fees to be charged, and the overall expectations of the RIA/client relationship. It is standard practice to utilize the services of an experienced RIA consulting firm to help you create an advisory agreement that is specific to the unique circumstances of your RIA.
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What is an advisory agreement and how do I create one? This is the Transition To RIA video series, it is question #16.
Welcome. I’m Brad Wales with Transition To RIA, and today’s question is what is an advisory agreement and how do I create one?
Before we can jump into exactly what an advisory agreement is, it’s important to understand this triangle of the three parties involved with having an account open for a client and you being able to provide that service to the client. I want to go through each of those three points of the triangle and how they all work together, and then you’ll see how that goes into the advisory agreement itself.
As an RIA, you will open your RIA. You will have your RIA established, but you need a custodian to custody your client’s assets, and also, as they say, custody and clear the trades, facilitate the trades. That’s the first two prongs. There you are as the RIA, and then you need a custodian to hold the client assets. Then the third prong of this is the client. The question is, how do these three components to the relationship all work together? That’s what I want to walk through here first.
As an RIA, if you have assets under management, you will need a custodian to hold those assets. The first relationship here is between the RIA and the custodian. That’s when the RIA goes to a custodian and says, “Okay, I would like to use your services, and here’s the amount of assets I have, and the clients I have, and the products and services I need available to me. Is this a good fit?”
By the way, that’s a large part what I help advisors with is there’s a lot of options out there, different kinds of custodians and platform providers, and they’re very different. So the question is, which one is best for you as an advisor that has their own RIA? Which custodian or custodians, plural – I’ll do a whole separate video on this, but it’s possible to have more than one custodian.
So you need to select one. Let’s just move forward and say you’ve selected one for the time being and that’s the custodian you’re going to use. That relationship is memorialized by what’s often called a “service agreement.” It might be an “RIA custodian agreement” or whatever the terminology that the custodian wants to use for that. But basically, it’s a legal document that is entered into between the custodian and the RIA that spells out….“as a custodian, here’s all of the services we are going to provide for you as an RIA and your clients, and here’s the expectations of the relationship, the understanding of the relationship, the costs associated with the relationship.” It is the legal document that establishes that (relationship) between the RIA and the custodian. Again, you’ll hear that referred to oftentimes as a service agreement or something along those lines.
So that’s how the RIA itself enters into a relationship with the custodian. And keep in mind, this has nothing to do with the client. This is just a one time, not a per account, or anything like that. This is a onetime macro relationship that’s entered into between the RIA and the custodian.
The next prong is, how and when does the client come in? If you want to open an account for the client with the custodian and then you’re going to provide the (RIA) services, that’s where the remaining two parts of this triangle come in.
Let’s first take the arrangement between the custodian and the client. Now make no mistake, the client is your “client” from an advisory perspective. It is not a matter of do I own the client? Do I own the book? Any of those things. I did a whole video on that. It is absolutely your client as the RIA. It is not, in essence, the custodian’s client in the terminology that we’re all used to using.
However, to a degree, it is the custodian’s client because they do open an account for that client. They are required to send statements to that client. They are required to send tax documents. So, to a degree, it’s their client. But certainly, make no mistake, no custodian thinks of these clients as theirs in the same sense that you might be used to of, a traditional wirehouse firm thinking that they own the book of clients, not you. That’s not at all the case in the custodial world.
But for that client to open an account with the custodian, because again, that account needs to be opened somewhere because someone has to custody those assets for the client. That is generally memorialized with a traditional new account form. And maybe if it’s a retirement account, there might be some other paperwork and things like that. But, generally, it’s a pretty simple new account form process that the client fills out. That’s essentially a two-party agreement between the client and the custodian that says….”Client, we’re going to open this account for you, and again, here’s the expectations. Here’s the cost,” or anything like that is baked into that new account form.
Now, of importance, a couple things that that new account form does do is it does say, “Hey, Mr. and Mrs. client, just so we’re all clear on this and in agreement, by you signing this new account form…” – two critical pieces of information that are important to the RIA – “Mr. and Mrs. client, you are giving us as custodian permission to take trading instructions from the RIA. When the RIA tells us to buy or sell something in your account, we will do that because the RIA has instructed us to do that. So, just to be clear, you are giving us permission to follow their instructions.”
The second thing is it also generally lays out that….”Mr. and Mrs. client, you give us permission to deduct from your account the advisory fees for the RIA. The RIA will tell us how much they are charging you for your advisory fee.” And perhaps that’s done on a quarterly basis, or monthly basis, or whatever the frequency is. “When they tell us to deduct that fee, we will deduct it and we will send it to them.”
The new account form generally lays out a couple of the components with that relationship with the RIA, but the RIA does not sign the new account form generally themselves. It’s a two-party agreement between the custodian and the client.
The final relationship then, and the topic of today’s video is…..the RIA and custodian have a relationship…..the custodian and client have a relationship……how do you then document and memorialize the relationship between the RIA and client? And that is what the advisory agreement is used for. That’s what we’re talking about here.
That advisory agreement is a two-party agreement. The custodian has no part to that. The custodian does not want to be named in that. The custodian, generally, does not even want to see that because again, they are not party to that. It is solely between the client and the RIA.
A couple things that advisory agreement will lay out….”Mr. and Mrs. client, here’s the services I will provide for you as part of our relationship. I might have verbalized all this to you and told you the sorts of things we’re going to do for you, but the advisory agreement lays it out exactly so we’re all on the same page. Here’s exactly the services I’m going to provide for you.” And then also lays out…”and here are the fees I’m going to charge you for those services.” Whether it is a 1% account fee, or something higher, or lower, or some other sort of arrangement, maybe a retainer fee or even an hourly fee. That is all documented there in the advisory agreement.
One of the last major things that’s pointed out there (in the advisory agreement) is whether you, as the RIA, will be acting with discretion on that account. I did a whole video on this. You can go check it out. I encourage you to do so because I go into a lot more detail on it. But as an RIA, you absolutely have the ability to use discretion with your clients’ accounts. Your decision to do that, your desire to do that has nothing to do with the custodian. Unlike perhaps at your current firm where you have to seek permission from your firm to be able to act with discretion. You do not ask your custodian for permission to have discretion. You have that ability as an RIA to make that determination on your own. Again, check out the whole video on it because there’s a lot of nuances with it that are important to understand.
In that advisory agreement, that’s where you would lay out….”I am or I am not going to act with discretion on your account.” And so, again, it’s really to make sure everyone is on the same page in written form. That’s generally referred to as the advisory agreement. That is between the RIA and the client. The custodian has nothing to do with that.
The next question is, how do you go about making an advisory agreement? That is a table stakes part of why you use a compliance consultant. I’ve done a couple videos talking about compliance consultants. I encourage you to go look at them. But the two main things you use a compliance consultant for are 1) the startup of your RIA and then 2) the ongoing compliance going forward.
In that startup package that they put together for you, part of which is actually literally making the RIA from a legal and regulatory standpoint, but another part of that is all the components of actually running the RIA from day one. Part of that is drafting that advisory agreement for you to use with your clients.
Now, make no mistake, a fair amount of the verbiage in an advisory agreement is pretty generic boilerplate language that is used in almost every advisory agreement that’s out there. However, a lot of it is very customized, as it should be, to your specific RIA.
I’d encourage you if you think you can Google and find some easy, cheap solution of an advisory agreement off the shelf that you can buy for $500 and call it a day, I highly encourage you not to do that because the regulators will notice that. They want to see that your advisory agreement is specifically tailored to your RIA and the services you’re going to provide. The fees you’re going to charge. Everything about your RIA. The advisory agreement is what documents all those details.
Yes, a compliance consultant generally starts with a template every time they go to make these. And so, again, there is some boilerplate language in there. But they will make it very specific to what you plan to do with your clients and what the client’s expectations are.
Part of the discovery process when you begin working with a compliance consultant is they don’t need these questions just so they know how to create your RIA and your ADV. It’s also so they know how to properly document your advisory agreement.
They will ask you a lot of questions. What type of services do you plan to intend on providing your clients? How much do you charge, or how much do you plan on charging? Will there be different circumstances of those fees? Will you act with discretion? A whole host of things they need to understand so they can properly write that for you.
I don’t want this process at all to sound intimidating. Again, this is table stakes for a good compliance consultant firm. Again, that’s another thing I do with advisors. I help them understand – there’s a lot of compliance consultant firms out there – why you might choose one over the other. They all have different price ranges and cost structures. I did a whole video on how much these compliance consultants cost. That’s a big thing I help advisors with is, again, is vendor selection of why you should use one option over another.
With any good compliance consultant, creating an advisory agreement is table stakes. So do not be intimidated by this process. They will absolutely walk you through it. Absolutely get you where you need to be to be compliant. That is a typical part of a startup package.
There will be a learning curve as you implement your new RIA and what paperwork you use with clients to open accounts. Don’t get intimidated by that. When you first joined your current firm, you had to figure out what form is it that I use to open a taxable account? And what form is it I use to open a retirement account? And if it’s a fee-based account, maybe there’s an additional form, an advisory form the client has to sign.
It’s going to be no different as your own RIA. You simply need to learn the new process. The compliance consultant will help you walk you through all of this. Your custodian will walk you through anything related to opening accounts with them. Then you work with your team there in your office to figure out your workflows and your process that…..”We have a new client and they want to open three accounts. One is a trust, one is a taxable account, and one is a retirement account. What all paperwork do we need?”
At first, this is going to be new for you because it’s going to be a new environment. But once you get it down, once you get your workflows down, this is not at all difficult to work through. It’s just part of the process of starting up an RIA. And again, that’s what I help advisors with is understanding all of these steps so as to not be intimidated by them.
With that, my name is Brad Wales. I’m with Transition To RIA, and my goal is to help advisors just like you understand everything there is to know about why and how you might want to transition your practice to the RIA model.
What I help advisors with is to really understand, what is your practice now? What affiliation model are you with now? What firm are you with now? What clients do you have? How would that all look if you were to move to the RIA model?
Everything from an economic standpoint, to a flexibility standpoint, to a control standpoint, to a responsibility standpoint. I help advisors go through all of that so they can really understand how the model works. And if it is something that does seem like a good fit for them, I then help them think through all these steps of how to go about transitioning to that RIA model. Today’s video talking about an advisory agreement and the need for one and how to get it created is a perfect example of the sort of thing that I help advisors think through and be aware of.
I hope you found value in today’s video, and I’ll see you on the next one.
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