Investors who use independent financial advisors to manage their money assume they're getting guidance that's genuinely in their best interest. After all, truly independent planners are held to the wealth management industry's highest standard of financial care.
That top-notch measure, known as the fiduciary standard, requires that registered investment advisory firms put a client's interests above their own — even if it earns them less money — and disclose and avoid incentives that could line their pockets. It's the gold standard for building a long-term nest egg, and it contrasts with a lesser rule known as Regulation Best Interest that governs brokerages, which are required only to recommend investments that are in a client's "best interest" and to disclose conflicts of interest, not actually avoid them.
The seemingly bright line breaks down with independent advisors who are also brokers. The result is that retail investors from mass market to affluent can pay the price in lower after-tax gains in their retirement portfolios, according to recent academic research.
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But they don't always.
The problem arises thanks to the emergence over the past decade of firms and advisors that ride two horses. They're both a fiduciary that charges only fees, and a broker that charges both fees and commissions. Such "hybrid" firms are the most likely of all types of wealth planners to sock clients with higher fees and steer them into underperforming mutual funds that generate commissions, the study found.
Citing prior research that "brokers will limit their offerings and sell low-quality, high-commission products to unsophisticated clients," the 2019 study, which was posted on SSRN earlier this year, concluded that "fiduciary divisions of dual registrants have similar conflicts, leading to limited product choice, revenue sharing, higher fees and inferior mutual fund product offerings relative to independent RIAs."
RIA on a broker-dealer 'chassis'
It's a tension that's likely to grow amid a Securities and Exchange Commission
Boyson's 2019 study, which claims to be the first of its kind, highlights the degree to which once-distinct business models in the wealth management landscape — commission-based brokerages vs. fee-based advisors — are collapsing. The fall out has left many investors none the wiser.
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Fee-based planning used to mean that a retirement nest egg was built and nurtured in the best possible way for a saver. But what Cerulli Associates called "business model convergence" had spawned a "lack of consistency and clarity regarding 'comprehensive wealth management,' causing investor confusion and advisor misrepresentation."
Last year, Cerulli wrote that "advisors have more opportunities than ever before to not only become an RIA, but to operate like an RIA inside the B/D (broker-dealer) chassis." Whereas fee-based revenues were once the province of independent advisors, Cerulli predicted that by 2023, 93% of all advisors, from fully independent ones to dual-registered brokers, will earn at least half of their revenue from fees.
The melding has
Purely independent firms stake their reputation on holistic planning and the most lucrative recommendations for customers. But Boyson found that clients of the RIA portion of hybrid firms "rarely receive personal financial planning services beyond investment allocation and selection advice, indicating that dual RIAs do not treat RIA clients much differently than brokerage clients."
Pure brokers aren't the worst
The upshot is that a fee-based model can vary widely. Investors most likely to be harmed by doing business with hybrid advisors range from smaller ones locked out of traditional RIAs, which tend to have steep account minimums, to affluent ones. Boyson found that high net worth clients of dual registrants with more than $1 million in investable assets pay an average fee of 1.42% of their assets, compared to 1.03% paid by independent RIA clients of the same firm. The gap is even larger for mass market retail clients with less than $100,000 in investable assets: dual registrants serving these clients charge 2.19% of assets, compared to 1.13% of assets charged by independent RIAs.
The higher fees come from advisors who sell to clients mutual funds that are managed by a corporate affiliate such as a bank, investment advisor or insurance company. The RIA portion of a dual registered firm faces a potential conflict because that parent firm earns both management and advisory fees.
Conflicts also arise when a hybrid advisor and his firm have revenue-sharing agreements with third-party mutual fund families. Under the arrangements, fund families pay to have their investment products listed on a brokerage's sales platform. Still another conflict arises when a dual RIA-brokerage collects both commissions on mutual funds and asset-based fees on the same mutual fund held in a fiduciary account.
Brokers have historically gotten a bad rap for overcharging clients. But Boyson's study said that RIA clients of dual registered firms may get a worse deal than retail brokerage clients of the same firm. She wrote that while hybrid firms invest their retail RIA clients in the same underperforming revenue-sharing mutual funds as brokerage clients, they charge their retail RIA clients higher management fees for a mutual fund with an upfront commission — 2.2% a year vs. the typical 1%.
The more fees an investor pays, the less money remains, once the tax hit is figured, in a nest egg. A 1% annual fee on a $100,000 portfolio that earns 4% over 20 years will reduce that nest egg by nearly $30,000,
Historical hangover
The blurred lines stem from the early 1990s, when Merrill Lynch and other Wall Street brokerages began charging some clients annual fees based on assets under management — the traditional purview of independent advisors — instead of commissions for transactions. By 1999, the SEC proposed a rule that exempted fee-based brokerage accounts from adhering to the fiduciary standard that independent advisors must follow. After 15 years of use, that so-called "Merrill Lynch rule" became law in 2005, but it was overturned two years later after a successful lawsuit from the Financial Planning Association, a trade group for independent advisors.
The victory meant that brokers who wished to charge asset-based fees had to register as fiduciary RIAs with the SEC. The shift prompted many brokerages to transfer their fee-based accounts to the RIA units of their firms.
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Boyson's paper, "The worst of both worlds? Dual-registered investment advisers," cited SEC data showing dual registrants, also known as hybrids, as moving over $300 billion of assets from brokerage fee-based accounts to RIA fee-based accounts. The shift opened the door to brokerages engaging in "reverse churning" by putting clients in fixed-fee accounts while doing little, if anything, to justify the fee.
In September,
Ryan Walter, a co-founder and partner at RIA Lawyers, a New Jersey-based law firm that caters to wealth management practices, said that when hitching their wagon to a hybrid firm, investors "are exposing themselves to conflicts of interest." It's not just with commissions and products. A dual-registered advisor, he said, can put a client in an account that costs more, such as a managed account for select stocks and bonds, even though the client already has her portfolio and doesn't need those services.
An independent advisor at a hybrid firm may "recommend the account type or relationship type that pays the most to the advisor," Walter said. But "for sure, you have to disclose those conflicts and act in the client's best interest."
