Assessing Independence
“If you want
to go fast, go alone. If you want to go far, go together.”
This is
probably not the first time you have heard that oft-quoted proverb, but for
specialist financial advisers serving defined contribution (DC) plans and
defined benefit (DB) plans these days, that conventional wisdom may not be so
cut and dried.
Whether operating as an independent registered investment adviser (RIA) or an affiliate with a regional, national or wirehouse broker/dealer (B/D), advisers broadly believe that supplying the best possible service to clients takes considerable help and coordination. However, “going together” today may mean seeking help from outside professionals paid by way of fees, rather than from people on the firm’s own payroll. In either case, effectively advising clients is a team sport that requires sophisticated tools and capabilities unmanageable by the individual.
That is an important fact to keep in mind, as the face of the advisory market changes and individual advisers and their firms must determine where they will get back office support; whether they will make the challenging decision to pursue their own independent RIA designation from the Securities and Exchange Commission (SEC) vs. establish a relationship with an existing RIA; or whether they can do either—or want to do either—if that means leaving a lucrative role at a B/D. Whichever road they choose will significantly impact how advisers do their daily work and how they partner with others to get that done, pros and cons being associated with each model.
This discussion is not just happening in the retirement plan specialist space but across the financial adviser industry as a whole. Analysts at leading research firms such as Cerulli Associates and Morningstar believe independence will continue to triumph over broker affiliation, and surveys they have conducted support their views. The February issue of “The Cerulli Edge – U.S. Monthly Product Trends Edition” maintains that the current regulatory and market environments materially increase the “appeal of independence.”
Cerulli says about half of U.S.-based financial advisers “view the registered investment adviser business model as a sensible solution to increased regulatory pressure.” At a very broad level, this is because the RIA model is conceived to be less product- or commission-focused when it comes to structuring fees and compensation—possibly giving advisers greater leeway to make impartial recommendations that will be in their client’s best interest. Related to this, according to Cerulli, nearly two-thirds (64%) of B/D-affiliated advisers “plan to shift more of their business toward fee-based advisory models in an attempt to be better positioned to comply with conflict of interest rules.”
Cerulli maintains that, “as advisers become increasingly comfortable operating in a fee-based environment and embrace fiduciary duty,” they may be more likely to consider moving away from commissions-based business models associated with the B/D channel, in favor of the RIA approach.
The Appeal
of Independence
Advisers’
reasons for feeling this way are not mysterious and stem at least in part from
the Department of Labor (DOL)’s efforts, under the administration of former
President Barack Obama, to strengthen conflict of interest standards applied to
fiduciaries that serve investors
protected by the Employee Retirement Income Security Act (ERISA). Even though
the new definition of “fiduciary” may end up being significantly dialed back by
the Trump administration, many retirement industry experts still argue that the
appeal of independence is increasing and will continue to do so in light of the
lawsuits being brought against retirement plans, as well as sponsors’ keen
awareness of fees.
For both large national wirehouse B/D firms providing their own proprietary products and small independent RIA shops strictly selling independent advice, the increased attention paid to fees and conflicts of interest has acted as a catalyst—forcing a re-examination of business models, simplification of cost structures and minimization of practice risk exposure.
“All industry stakeholders are now operating with a heightened sense of regulatory risk and are, therefore, more likely to be aware of cost and liability,” Cerulli researchers argue.
It is clear that one of the main points of going independent is to gain greater control over compensation models and what specific product recommendations can be made—also that the current environment favors flat-fee-based compensation approaches. Again, even among B/D-affiliated advisers with no plans to adopt the RIA approach, approximately two-thirds still intend to shift more of their business toward fee-based structures.
Cerulli feels the writing is on the wall: “Wirehouses have been experiencing steady losses from the continued migration of advisers to the independent space. Caught in a game of trading high-producing teams between the four firms, national wirehouses struggle to replace headcount outflows through recruitment from other channels. Independent broker/dealers are also at risk of losing their largest, most valuable teams to the RIA channel because these practices often operate fairly autonomously.”
Client
Demand
Many
advisers and supporting providers predict that these trends and their important
implications will continue, come what may as to the increasingly unlikely final
implementation of the DOL fiduciary rule. Morningstar, for example, predicts,
“broker/dealers will not reverse the progress they’ve already made to comply
with the anticipated regulation, in the best interest of investors.”
According to Tricia Rothschild, Morningstar’s chief product officer, based in Chicago, “The genie is out of the bottle. The cat’s out of the bag. The train has left the station.” Rothschild says that commissions are on the way out, in favor of flat-fee work, which naturally favors the RIA approach and puts pressure on B/Ds to reconsider their strategies.
Speaking of B/Ds, she says, “Many firms in the industry clearly see the benefits that the regulatory-driven discussions have fostered—regardless of the details of the fiduciary rule—including facilitating operational efficiencies in the adviser’s workflow. They are adopting better tools to help advisers analyze investment products and portfolios in the context of a client’s unique needs; adding a more-curated menu of investment options available to advisers and their clients; and building an emphasis on holistic planning and the demonstration of value-added advice.”
Morningstar suggests that these changes have allowed B/Ds to reform themselves to better match shifting investor preferences, but it will be difficult to combat the perception that RIAs are inherently less conflicted than affiliated advisers.
Cerulli researchers agree, adding that boutique B/Ds “are one of the segments that will be most impacted” under the new fiduciary future. Sizing this portion of the market, Cerulli observes that B/Ds with less than $10 billion in assets account for more than 80% of overall B/D firm volume but less than 10% of adviser-managed assets.
“Small B/Ds without scale are at higher risk,” warns Kenton Shirk, associate director at Cerulli in Boston. “It is likely that some of these boutique firms will be unable to support new regulatory costs, resulting in an increase in firm consolidations.” Shirk adds that smaller B/Ds may be acquired by larger ones, may choose to combine operations, or may “affiliate as an Office of Supervisory Jurisdiction [OSJ] with an independent firm to realize cost synergies.”
Many approaches can work, moving forward, but, under increased regulatory pressure, any firm touching retirement accounts governed by ERISA must double down on transparency and fairness, experts stress.
“Cost reduction, decreasing business risk, and effectively leveraging time and resources remain the main focuses of the adviser industry[—for both RIAs and brokers],” Shirk observes. “Clients increasingly favor fee-based business, so the majority of advisers surveyed plan to increase its use in their practices.”
Fee
Compression
It should be
noted that RIAs are by no means getting an easy ride in the advisory
marketplace at the expense of affiliated brokers. Independent firms, too, are
feeling the fee pressure.
Relevant data in the “2016 Fidelity RIA Benchmarking Study” shows that many independent advisers also feel they are facing a period of unprecedented change, driven by numerous forces. Among the more than 400 RIA firms surveyed, there is a “persistent organic growth challenge,” Fidelity reports. Organic growth dropped to 6.7% in 2015, the lowest level in the last five years.
“In this context, firms prioritized marketing and business development, but lack a strategic focus on pricing, which may prove costly,” Fidelity points out. “Median revenue yield dropped 4 basis points [bps] to 69 bps in 2015 after years of stability.”
Part of the growth problem, according to Fidelity, is the “tremendous variation in offerings and fee models across firms.” This state of affairs “creates major challenges for investors interested in comparing RIAs,” Fidelity explains, noting that the top driver determining an RIA’s pricing approach should be “a deep understanding of value delivered.” The Fidelity study further suggests “there is a misalignment between offerings, pricing and delivery. Segmentation, unbundling and use of minimum fees are key opportunities.”
Among the factors driving a need for both RIA and B/D pricing evolution, Fidelity says, are the increasing commoditization of investment management; increasing value placed on all types of planning, beyond just stock/mutual fund picks; increasing influence of newer, younger clients; advancements in available investment management technology; changes in the regulatory environment; and many other factors. The impact of “robo” and digital advisers on both investors and firms is also significant and puts additional pressure on established firms to adapt and reform their businesses, the study says.
Key Takeaways:
- Whether advisers go independent or affiliate with a B/D, they should recognize that they need the support of a well-rounded team and examine what model works for them.
- The fiduciary rule is prompting many advisers to become independent RIAs, freeing them from ties to in-house investment products or commissions, as well as giving them greater control over compensation models and what products they recommend.
- In light of the regulatory and legal climate, some B/Ds are helping advisers analyze investment products more impartially, and research firms such as Cerulli and Morningstar expect more advisers will adopt flat fees over commissions.