What are the differences between a Broker-Dealer vs RIA?
That may seem like a mundane question, but it’s an important one. We encourage people to understand what capacity their financial advisor works in because it can have important implications for your investments and the costs you incur.
RIAs (Registered Investment Advisors) are independent fiduciaries legally and ethically bound to act in their client’s best interests. RIAs are almost always compensated on a fee basis, often charged as a percentage of assets under management (AUM). This can help align interests between the advisor and the client since both benefit when account values increase.
Broker-Dealers, often previously known as “stockbrokers,” are typically affiliated with full-service brokerage firms (like Merrill Lynch or JPMorgan) or discount brokerage firms (such as eTrade or Fidelity). Brokers are held to a lower legal standard and are not fiduciaries required to always act in their clients’ best interest. Brokers may also be compensated via commissions or other structures that can create conflicts of interest with their clients.
To choose the best advisor for you, you need to know your goals and understand the different rules and obligations that govern each.
KEY TAKEAWAYS
- SEC (Securities and Exchange Commission) Registered RIAs have a legal obligation – known as fiduciary duty – to act in your best interest and avoid or disclose potential conflicts of interest. They generally use a transparent fee-only compensation structure.
- Broker-Dealers have a greater potential for conflicts of interest because their “suitability” standard allows them to make investment decisions that benefit their employer over their clients. They may also work for commissions that incentivize them to use certain investments or strategies that may not be in their client’s best interests and they aren’t required to disclose any conflicts of interest.
- Hybrid Advisors are broker-dealers who are also registered as RIAs. Rather than being the best of both worlds, this can create confusion among clients since it is often unclear how they manage the dual nature of their opposing roles.
Understanding the differences between a Broker-Dealer vs RIA
We can make the distinction between RIAs and broker-dealers a bit easier to understand by studying practical examples.
Assuming it makes sense to have large-cap stock exposure in your portfolio, an RIA is likely to consider funds or other investments based on your risk tolerance, the cost of the investment, its tax efficiency, and other items. Their success (in the fees they collect) is a direct result of your success (in terms of returns). This means they are likely to select investments with favorable characteristics.
A broker-dealer has an obligation to their employer first, so they may be most concerned with how much money they can make by recommending a certain investment. Because of this, they’re more likely to choose the fund with the highest commission or other revenue as long as it’s deemed “suitable.” The highest cost investment is unlikely to be the most favorable for the client, according to studies by Morningstar and others.
It’s important to know your investment preferences and financial goals to choose the right financial professional.
For example, if your focus is more long-term and you’re looking for someone to be a voice of reason for money-related challenges and questions that come up over the years, you’re most likely looking for an RIA.
However, it’s important to note that RIAs tend to have higher minimum investment amounts – it’s not uncommon for the minimum requirement to start at $500,000-$1,000,000. If you’ve got substantially less than that to invest, you may be better off using a different approach. Though, there are some RIAs called “robo advisors” which can be an excellent starting point.
On the other hand, RIAs are not always the best option. If you have a lot of stocks that you purchased many years ago that are now trading well above their initial purchase price, it may not make sense to sell them and pay a lot of capital gains taxes, particularly if you’re older. That’s because, under current tax law, you can get stepped up cost basis when you pass away.
For example, if you buy a stock at $100 per share and it rises to $125, and then you sell it, you will have to pay tax on that $25 capital gain. However, if the stock goes up in value and you pass away before you sell it, your initial purchase price, the cost basis, gets stepped up to the date of death value, and your heirs won’t have to pay capital gains if they sell right away.
So, if it doesn’t make sense to sell your stocks, and you decide to continue holding them, there is no reason to pay fees to an RIA that isn’t really managing the portfolio.
In this example, it may make more sense to open a brokerage account that doesn’t incur annual fees to hold these stocks. If there is little to no trading, then there won’t be a lot of commissions paid.
Investment Advice
We can make the distinction between RIAs and broker-dealers a bit easier to understand by studying practical examples.
Assuming it makes sense to have large-cap stock exposure in your portfolio, an RIA is likely to consider funds or other investments based on your risk tolerance, the cost of the investment, its tax efficiency, and other items. Their success (in the fees they collect) is a direct result of your success (in terms of returns). This means they are likely to select investments with favorable characteristics.
A broker-dealer has an obligation to their employer first, so they may be most concerned with how much money they can make by recommending a certain investment. Because of this, they’re more likely to choose the fund with the highest commission or other revenue as long as it’s deemed “suitable.” The highest cost investment is unlikely to be the most favorable for the client, according to studies by Morningstar and others.
It’s important to know your investment preferences and financial goals to choose the right financial professional.
For example, if your focus is more long-term and you’re looking for someone to be a voice of reason for money-related challenges and questions that come up over the years, you’re most likely looking for an RIA.
However, it’s important to note that RIAs tend to have higher minimum investment amounts – it’s not uncommon for the minimum requirement to start at $500,000-$1,000,000. If you’ve got substantially less than that to invest, you may be better off using a different approach. Though, there are some RIAs called “robo advisors” which can be an excellent starting point.
On the other hand, RIAs are not always the best option. If you have a lot of stocks that you purchased many years ago that are now trading well above their initial purchase price, it may not make sense to sell them and pay a lot of capital gains taxes, particularly if you’re older. That’s because, under current tax law, you can get stepped up cost basis when you pass away.
For example, if you buy a stock at $100 per share and it rises to $125, and then you sell it, you will have to pay tax on that $25 capital gain. However, if the stock goes up in value and you pass away before you sell it, your initial purchase price, the cost basis, gets stepped up to the date of death value, and your heirs won’t have to pay capital gains if they sell right away.
So, if it doesn’t make sense to sell your stocks, and you decide to continue holding them, there is no reason to pay fees to an RIA that isn’t really managing the portfolio.
In this example, it may make more sense to open a brokerage account that doesn’t incur annual fees to hold these stocks. If there is little to no trading, then there won’t be a lot of commissions paid.
Hybrid Advisors
Hybrid advisors (also known as dually registered advisors) are new on the financial scene and the idea is that they fill two roles: that of RIA and broker-dealer.
They technically fulfill a fiduciary role while maintaining the flexibility to sell commission-based products, but if you feel like this is confusing, you wouldn’t be the only person to question the transparency of such an advisor model.
For example, when does your hybrid advisor work as a fiduciary acting in your best interests, and when are they a broker-dealer recommending an annuity at 7% commission?
We strongly recommend you ask these kinds of questions before agreeing to work with a hybrid advisor so you have an idea of how they differentiate between their fiduciary duty and the potential pressure of meeting a sales quota from certain products or providers.
Even with disclosure, be aware that you’ll probably never have a complete understanding of the implications of a hybrid advisor’s compensation structure.
Broker-Dealer vs RIA: Deciding which is best for you
The transparency of a fee-only compensation structure – and an RIA’s fiduciary duty – help you understand which services are included, what you’re paying for them, and that any advice you receive is in your best interests.
Access to services beyond portfolio management, like financial planning, tax code navigation, and coaching helps with smarter money management and can lead to the long-term outcomes you want.
You might choose a broker-dealer advisor if you indefinitely want to hold onto stocks you purchased long ago or if you’re interested in self-directing your investments.
To decide which financial model is best for you, take time to understand your goals and the type of advice and compensation structure you’re most comfortable with.
In any case, be sure you’ve checked for potential costs associated with commissions, sales loads, and product sales before you sign on the dotted line.
Do you have financial questions? Talk to a fee-only SEC Registered Investment Advisor
**Notice:
Armbruster Capital Management’s views, as portrayed in this post, are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Investing involves risks, and the value of your investment will fluctuate over time, and you may gain or lose money.
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