Q82 – Won’t Large RIAs Have The Same Challenging Compliance Departments As Broker-Dealers?

Also available as podcast (Episode #82)

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Won’t Large RIAs Have The Same Challenging Compliance Departments As Broker-Dealers?

A common frustration by financial advisors in the broker/dealer model is an overbearing compliance department. This is often the result of the firm managing compliance to the lowest common denominator amongst thousands of advisors at the firm. An understandable, though inaccurate, assumption about the Registered Investment Advisor (“RIA”) model is that joining an RIA with similar growth aspirations will lead to a compliance burden that is no better than what the advisor is trying to get away from at their broker/dealer.  There are significant differences between the broker/dealer and RIA models which alleviate this concern.

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Full Transcript:

Won’t large RIAs have the same challenging compliance departments as broker-dealers? That is today’s question on the Transition To RIA question & answer series. It is episode #82.

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 to the RIA model.

If you’re not already there, head to TransitionToRIA.com, you’ll find all of the resources I make available to help you better understand the RIA model. This entire series is available in video format, podcast format. I also have articles, I have whitepapers. All kinds of resources to help you understand the RIA model.

Again, TransitionToRIA.com.

I want to start by explaining what I mean by today’s question, “Won’t large RIAs have the same challenging compliance departments as broker-dealers?”

I struggled with how to word that to try to keep it concise, but still make the point I’m trying to make with this episode. But let me extrapolate what I mean by it.

Fair or not, there is the perception, the reality, that at the very large broker-dealers, compliance is often thought of as a hindrance to financial advisors. There are jokes about compliance being the anti-business department.

While some of that is overblown at times, some of it is valid criticism. It can be very hard for a financial advisor to work with their clients and do their job if there’s an overbearing compliance department pushing new procedures on them or onerous tasks they must do.

What we’re going to be talking about today is, if that’s such an issue for large broker-dealers, if you were to go and join an RIA, and that RIA itself grows to be very large, won’t that RIA have the same problem? That’s what we’re going to dive into on today’s episode.

I’ll start by saying my intent here is not to dunk on the compliance department, or dunk on compliance people. Compliance is a very important part of our industry. A very necessary part of our industry.

The reality is, even though 99.9% – or whatever the math is – of financial advisors are highly ethical professionals, there are bad apples. Anytime you get a large enough group of people in any profession, there are going to be some bad apples. The compliance apparatus is meant to try to identify those bad apples or keep those bad apples from being able to do bad things for clients. It is a necessary part of the industry.

I’ve done several episodes discussing how compliance works in the RIA model. I encourage you to check those out if you want to dive further into the topic.

But again, this episode is not a knock on compliance. In fact, 20+ years ago when I started in this industry. I worked for several years in compliance. So, this is not a knock on any compliance folks that might be listening along, but it is an acknowledgment of what’s happening at times in the marketplace.

What typically occurs at the large broker-dealer firms is the often-noted phenomenon of having to manage compliance to the lowest common denominator.

If you have 5,000, 10,000, 15,000 plus advisors – while the overwhelming majority are wonderful, ethical professionals – you inevitably have some bad apples in the bunch. Such a large group is also comprised of advisors of all different experience levels. There are industry veterans with 20+ years’ experience, and there are folks that are new to the industry.

The issue is that all 10,000+ plus advisors, or whatever the case is at your firm, are generally managed by one set of compliance policies and procedures.

It is not logistically feasible to have multiple compliance levels for different subsets of advisors. Advisors with 20+ years’ experience, play by the same rules as advisors with 10 years of experience, or barely any years of experience.

There is one set of guardrails for all advisors at the broker-dealer. And because they are looking for the bad apples, these guardrails must be managed to the lowest common denominator. They must implement policies and procedures accordingly.

While they might be able to identify which advisors have different years of experience, they don’t know who the bad apples are.  The latter don’t go around raising their hands identifying themselves.

As a result, compliance departments are forced to put in tighter guardrails. The problem is that everyone else is squeezed by the same policies and procedures, they’re squeezed down to the lowest common denominator.

That’s ultimately what creates a lot of frustration for advisors. “Why can I not do something that I’m trying to do? Why do you make me do onerous documentation for the 100th time?”

Again, it’s not the ethical and professional advisors that are forcing this hand. It’s the bad apples that cause it.  Compliance is tasked with protecting the firm from them.

With that, we’ll pivot to the question of this episode.

I speak often regarding the different ways into the RIA model that you might consider if you were to transition into it. That is something I help advisors think through. It’s unique and specific to each advisor.

Some of you might open your own RIA, and there are pros and cons to doing that. Some of you might join an existing RIA, with pros and cons to that. There are also flavors in the middle I’ve talked about.

If you were to join an existing RIA platform, there are some wonderful solutions to choose from with different value propositions, price points, all sorts of variables. I help advisors understand what those are and who those players are.

If you were to utilize such a solution though, there might be a concern that as they continue to grow, won’t they just grow themselves into the same challenging compliance apparatus you’re trying to get away from in the broker/dealer world?  Being managed to the lowest common denominator?

It’s a fair question to ask. I’m going to go through some examples of why that won’t be the same issue that it is in the broker-dealer space.

These are examples of what makes managing compliance in the broker-dealer environment significantly harder for the compliance teams than in the RIA space. And when it’s harder to manage the risk, broker-dealers in turn must put more and tighter guardrails in place that simply aren’t applicable in the RIA space.

These are some of the issues that create the most compliance problems for broker/dealers, create the most risk, result in the most client complaints, result in the most regulatory issues. They don’t apply in the RIA space.

First example is the concept of churning.

Churning is the idea in the commission broker-dealer world where a broker transacts more trades in an account than is arguably beyond what is necessary. The more trades that are done, the more income to the advisor.

There are bad apple brokers that have done this in the past, and it continues to happen at times in part because it’s hard to monitor at what point is the level of trading go beyond what’s prudent for the client – which of course the bad apple advisor always claims is the case – to a point where it is being done to generate unnecessary commissions?

Guardrails must be put in place to monitor for this, and document that it is not occurring.

There is no such thing as churning in the RIA model because the only way the advisor is paid is by the client. If the advisor charges a fee of, for example 1% of AUM, it doesn’t matter whether the advisor does one trade in the account per year or 200 trades. The number of trades has no impact on the advisor’s compensation.

Because churning is non-existent in the RIA space, RIA compliance teams do not have to put such heavy handed guardrails in place regarding trading activity.  So that’s the first example.

Next, is the challenge of commission products that generate a large commission for the broker.

An argument often made in broker/dealer client complaints is that a particular investment solution was recommended to a client because the advisor would receive a large, oftentimes upfront commission.

Variable annuities are an example of where this could be applicable.  This is not a knock-on variable annuities, as they are a good investment solution when used appropriately. But it is what it is, when you have a product that pays a large commission – often the largest of the available solutions that a broker could utilize – it attracts the bad apples.

Broker/dealers in turn must implement guardrails to try to limit the risk of such products being used inappropriately.

Related is when you see a variable annuity being exchanged. This is where a client has an existing annuity and the broker explains – and again, it could be appropriate to do this – that because of changes in interest rates, VA features, etc. that the client would now be better off exchanging the annuity for a new one. Buying the new annuity in turn generates the advisor a commission, often a large commission.  So again, broker/dealers must put in guardrails to make sure exchanges are occurring appropriately.

In the RIA space, this doesn’t apply at all.

While there are a growing preponderance of fee-based variable annuity solutions available in the RIA model, by nature of their fee-based approach, the same conflicts of interest do not exist.

There is no economic incentive for an advisor in the RIA space to recommend a variable annuity over a different investment solution, as their compensation does not change.  In turn, an RIA compliance team does not have to implement the same heavy-handed guardrails that broker/dealers do.

Also often related with commission-based variable annuities are investment solutions that require a long lock-up period for the client. If the client needs/wants to liquidate the position prior to the end of the lock-up period, there are usual financial penalties to the client for doing so.

Lock-ups often exist with investment products that pay a broker a large upfront commission, as the product manufacturer needs the lock-up period to generate enough revenue from the product to pay for the large upfront commission that was paid.

Many client complaints have alleged that a broker never explained the lock-up period to the client.  That risk raises costs for a broker/dealer, and hence they must implement guardrails to try and limit it.

As commissions don’t apply in the RIA world, once again this issue is not applicable.

The next example in the broker/dealer model I want to discuss is an account’s ROA, Return On Assets.

In a commission account, if you add up the commissions generated over a period (typically one year), and divide it by the account value, you get the ROA.

The comparable in the RIA model is the often used 1% AUM fee. In that example, 1% is the ROA on the account.

In the broker/dealer model, at what point is an account’s ROA no longer appropriate?  1.25%?  1.5%?  2%? At what point are we nearing a possible churning situation?

Even if a prudent argument can be made as to why the number of trades occurred, that doesn’t mean a client (or their attorney) might not make an accusation that it is excessive, done of course to generate commissions for the advisor.

Broker/dealer compliance teams in turn must implement even more policies and procedures to try to limit ROA risks from occurring.

Over in the RIA space, it’s a moot point.

If an advisor is charging, for example, a 1% AUM fee, the client knows ahead of time exactly what they’re going to pay. The advisor is not motivated to invest in any particular way to try and increase their compensation.

The 1%, or whatever the advisor/client agree to, is not going to change. There’s nothing to monitor from the compliance teams in the RIA space. Once that fee is set, it remains constant. Broker/dealers do not have this luxury. They must implement guardrails to monitor for potential ROA issues.

Ok, I have two examples left.

While this can also be applicable (in some instances) in the RIA space, the broker/dealer model typically always involves advisors wearing two hats.

They are wearing their Series 7, Registered Representative hat in some capacities, while other times wearing their Investment Advisor Representative hat. This is so they can offer, where it makes sense, commission accounts for some clients and fee-based accounts for other clients. And sometimes it’s a mix of the two for the same client.

I’ve done episodes on how this can occur the RIA space as well. You do not have to be 100% fee-only to transition to the RIA model. There are ways to accommodate – oftentimes legacy – commission business in the RIA space which requires a broker-dealer. So, that dual hat scenario is possible in the RIA model, but a large portion of RIA advisors have moved to solely 100% fee-only.

At the large broker/dealers where almost all advisors are wearing dual hats, the broker/dealer compliance team must implement policies and procedures around how the advisor decides to put a client into a commission account or a fee-based account. Not to mention, how that decision is monitored for possible adjustment over time.

That issue is eliminated in the 100% fee-only model.  There is only one hat being worm. It is very transparent. Conflicts of interest are disclosed, the fee is disclosed. You’re not paid any different as the advisor. It is always the same.

Some broker/dealers – utilizing their affiliated “corporate RIA” – are starting to build out so-called IAR-only channels where the 100% fee-only scenario would be applicable.

The dual-hat scenario nonetheless requires broker/dealer compliance teams to implement guardrails to make sure each hat is being utilized appropriately.

The final example I’ll give, which thankfully due to some new regulations over the past few years is less present, are the days of sales contests, or high-pressure sales tactics to push certain commission investment products.

A lot of that has gone away, but there’s likely still informal practices occurring. Broker/dealer compliance teams thus must monitor for is there any undue influence occurring? Is there any unnecessary pressure? Are there hard sales pitches being used by advisors with the high-commission products? They must put in guardrails to try to identify those folks and prevent that from happening.

In the RIA space, it’s a moot point. You are receiving your 1%. There is no pressure to use mutual funds or ETFs or annuities or whatever because it doesn’t make any difference for you as the advisor. You are paid the exact same no matter how you invest the client’s assets.

The main takeaway here is while there are some RIAs that will grow quite large by advisor count – some predicting we’ll reach a point of having a handful of so-called “national RIAs” – the way such firms approach compliance is fundamentally different than how broker/dealers must.

There will always be a need for compliance. There will always be policies and procedures. Even if you have your own RIA.

But many of the issues in the broker/dealer space that lead to client complaints, regulatory issues, etc. are simply not applicable in the RIA space.

As a result, the compliance apparatus in the RIA model, even a firm with thousands of advisors perhaps, does not have to be as heavy-handed because it’s not possible for the bad actors to do as many of the types of things they can do in the broker-dealer space.

So, if you fear that joining an RIA will result in the same compliance challenges as you have at a broker/dealer, I’m here to tell you it’s entirely two different worlds. It will always have to be a heavier hand in the broker-dealer space because of the challenges and risks they have which are not applicable in the RIA space. Don’t let that limit you from looking at the RIA model, or the idea of joining an RIA.

There are different approaches, different pathways into the RIA model. It’s important for you to understand how each of them work to figure out which one is best for you. For some that is starting your own RIA, for others, joining an RIA makes more sense. Again, that is what I help advisors think through. I’m happy to have that conversation with you as well.

As I said at the top, if you’re not already there, head to TransitionToRIA.com.

You’ll find all the resources that I’ve talked about. This entire series is in video format, podcast format. I have articles, I have whitepapers.

At the top of every page is a Contact link. Click on that, 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, and what your experience with compliance or anything else is in the broker/dealer world, and you want to understand how that would look for you in the RIA space, I’m happy to have that conversation with you.

Again, TransitionToRIA.com. You’ll find the Contact link at the top of every page.

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

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