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Kitces to broker-dealers: It's time for an attitude adjustment

A major news event occurred last year that I think went underappreciated. According to Financial Planning’s FP50 2018 report, the top 50 independent broker-dealers surveyed said they generated more revenue from fees than from commissions in 2017.

That’s right, independent broker-dealers — whose fundamental reason to exist was to be an intermediary for the distribution of products for which they received commissions — are now doing more fee-based revenue than commission-based revenue, when just 10 years ago fees from broker-dealers were barely one-third of their commission revenue. Aite Group predicts that across the entire industry of broker-dealers, fee-based assets are now up to about 40% of the total, and wirehouses in the largest independent broker-dealers have been leading the charge.

Yet even as broker-dealers transition from their commission roots to fees, too many still treat the growing volume of advice dispensed by their advisors as a liability to minimize, rather than a value-add to enhance. I think this mindset will make it difficult for broker-dealers to compete, even as they seek to recast themselves as sources of sound advice.

THE SHIFT IS ON
The move from commissions to fees is nothing short of incredible, and one I think will only accelerate. Firms are discovering that fee-based revenue is more stable and sustainable, such that firms are valued at more than double the revenue multiple of commission-based firms.

Furthermore, the Department of Labor’s fiduciary proposal — and what now seems to be a global trend of fiduciary rulemaking that often includes a curtailment or outright ban on commissions — is driving top broker-dealers to reinvent themselves as fee-based advisory firms before the regulators do it for them.

This I think is why there’s been such an explosive shift toward dual-registered advisors over the past decade. If you want to get paid for advice as a broker-dealer, you have to be registered as an investment advisor. Consequently, more and more broker-dealers are running hybrid platforms and dual-registering their advisors in both the broker-dealer legacy business and the RIA platform, where they’re building out fee-based revenue.

But a fundamental problem is starting to crop up both in some of the enterprises I consult with directly and the advisors I hear from at broker-dealers who are trying to implement tools like AdvicePay to get paid for planning. And I can only characterize it as a mindset problem in the broker-dealer community: Broker-dealers aren’t actually treating advice as a value-add. Rather they’re treating it as a liability.

Independent broker-dealers' revenue

THE LIABILITY FALLACY
Perhaps the clearest illustration of this is the infamous disclaimer associated with virtually all advice-related communication under a broker-dealer, where the advisor makes a recommendation that has some tax consequences or tax benefits and then includes this verbiage: “This is not tax advice. Please consult your tax advisor.”

This of course prompts the client to think, “Wait, you literally just gave me advice about a strategy that has tax benefits — and provided a recommendation about what to do for tax purposes — and now you’re saying it’s not tax advice?”

The client’s confusion is justified. You can’t give a recommendation to open an employer retirement plan, save in an annuity or buy a tax-advantaged master limited partnership and discuss the tax benefits of the recommendation, and then say you’re not giving a tax-related recommendation. You just gave one.

And if the client trusts you, they’re not going out for a second opinion on the tax outcome because you already told them what it would be. You can’t give what’s clearly advice, and then just try to disclaim it away.

Historically, broker-dealers tried to avoid fiduciary liability by claiming advice was solely incidental to the sale of brokerage products. And technically, most broker-dealers still rely on that exemption for at least some of their advice — never mind that they have “Financial Advisor” printed on their business cards.

But beyond broker-dealers’ efforts to avoid registering as RIAs, the other reason they have avoided advice is that not all their registered reps necessarily have the training and expertise to provide it. After all, you can become an advisor with a relatively simple three-hour regulatory exam that you can prepare for in a few weeks. CFP certification takes most people nine to 18 months, but that’s optional.

This means that if any of a broker-dealer’s advisors is giving tax or other advice, it’s crucial to oversee their practice, which is difficult and cost-prohibitive.

The end result is a form of what I call lowest common denominator, or LCD, compliance. This manifests in the firm writing the compliance rules to protect itself against whatever the most incompetent person in the entire organization might do. Since the bar to get hired at most broker-dealers is pretty low, the lowest-quality rep at most firms is pretty low-quality. How do you limit your liability from that rep who has no training or experience in giving advice? You ban that person from doing so.

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Never mind that it ties the hands of dozens, hundreds or even thousands of good advisors with the requisite training and experience to give good advice. The firm’s liability and the compliance processes are built based on the lowest common denominator.

The end result is that broker-dealers tend to ban and limit advice. Stated plainly, broker-dealers are treating the delivery of advice as a liability exposure that has to be controlled.

PLANNING THE PLANNING
A broad example of this is the recent shift to create centralized planning departments that produce and deliver plans for their reps.

As we learned in our recent Kitces Research study on the planning process, being able to delegate plan prep tasks — either to a staff member or a centralized resource — can be a real boost to advisor productivity. I am all for delegation of delegable tasks. But a number of broker-dealers use the centralized department not just for plan preparation, but for standardizing plans-in-a-box that the advisor just delivers to the client like a product. Even worse, the centralized planning department itself may deliver the plan to the client.

I’m not against more consumers getting plans, and I don’t mean to suggest centralized planning departments don’t do a good job, they often do, but the approach epitomizes the view of so many broker-dealers that you can’t possibly let the advisor who sits across from the client produce and deliver a plan you don’t directly control and oversee.

For many large firms centralized planning resources aren’t just a means to improve the efficiency in the delivery of planning advice, but actually a system to take advice delivery out of the hands of the end advisor and put it into the home office instead, where the compliance department can better manage liability exposure.

I think that’s why there was such a huge boost in technology spending when the DoL’s fiduciary rule was rolled out two years ago. Firms suddenly realized that they were going to be more liable for the advice and recommendations their advisors gave beyond just product sales.

In fact, I predicted that if the DoL fiduciary rule stayed, the biggest risk of a class action lawsuit against large firms would not come from whether they met the duty of loyalty to clients and navigated all those conflicts of interest, but whether they violated the duty of care by sending masses of advisors out to give advice without any actual education, training or experience. Imagine the courtroom when the attorney asked, “So, how would your advisors have known what advice to give based solely on a three-hour Series 65 exam?”

Consequently, firms limit this massive liability exposure by using technology that takes advice-giving out of the hands of their advisors. This explains the rise of robo tools that take client-directed risk tolerance questionnaires and link them to home office–designed portfolios.

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In this way, broker-dealers are assured that the advisors themselves don’t actually give the advice.

I don’t want to suggest all broker-dealers engage in this kind of approach because not all do. But I suspect many who work under a broker-dealer have experienced some form of this, where the home office tried to limit the scope of their advice or force them to provide disclaimers that they’re not giving advice even though they are, or take steps that are basically designed to limit the broker-dealer’s liability exposure.

The advisor is effectively reduced to being a human mouthpiece that outputs the software or planning department’s recommendations. From the advisor’s perspective that’s obviously not ideal.

THE VALUE-ADD
With the ongoing commoditization of basic asset allocation advice, it’s increasingly necessary for advisors to justify our 1% AUM fee. We need to be providing real value-add beyond the portfolio.

Here’s the disconnect: In our minds advice is the key differentiator, whereas in the minds of large-firm compliance departments advice is a liability. That’s a problematic mismatch. Compliance departments simply don’t recognize the business opportunity for what it is. The ramifications play out along these lines:

  • Picture an advisor who wants to do more work with younger clients. The advisor studies up on student loans, only to be told by compliance they can’t write any articles or get paid for any advice pertaining to student loans.
  • Picture an advisor who implements increasingly sophisticated tax strategies and client portfolios, and then has to give every client a disclaimer saying that’s not their value-add because the compliance department has declared they’re not competent enough to give that advice.
  • Picture an advisor who wants to customize their plans to give more specific advice to their clients, and is told by compliance that they’re not allowed to add anything or modify the standard planning software output for MoneyGuidePro or eMoney Advisor in any way that might possibly deviate from the cookie-cutter printout of the software itself.

It’s time for large broker-dealer leadership to undergo an attitude adjustment. Simply put, leadership’s goal should be figuring out how to train, develop and support their advisors, so they don’t have to worry about getting sued.

WHERE TO BEGIN?
Getting advisors enrolled in CFP certification is obviously a sound, proactive step for leadership to take. But it’s just the first of many. They also need to teach and train staff in how to create plans on their technology platforms. They need to encourage employees to deepen their expertise post-CFP education. If the future is advice, a liability-mitigation strategy shouldn’t be based on taking advice out of the hands of advisors. Rather it should be designed around investing in advisors themselves — making them so good at their jobs that their knowledge and expertise become the firm’s best defense.

And rather than trying to force all advisors to be generalists, large broker-dealers should be driving staff toward owning niches and specializations — where their expertise is so deep and their value-add is so high that clients actively seek them out.

Think about how this can unfold. If one advisor specializes in student loan advice and another in retirement distribution strategies, the firm doesn’t need to scrutinize their advice as much because they’re literally already the recognized experts at those subjects. The firm merely needs to ensure that the student loan expert doesn’t give retirement advice and vice-versa. I.e., You might be the world’s leading orthopedist, but if you operate on my brain and not my knee I’ll sue you. If I wanted a brain surgeon I’d get one.

The bottom line is just to recognize that as long as large firms fail to view advice as the essential value-add — and fail to adopt strategies that maximize the ability of their advisors to give advice and elevate their expertise — the breakaway RIA trend will continue. Advisors want better control of their own compliance to give the advice value-adds they want to provide — not because it’s impossible in a broker-dealer environment, but because it’s impossible the way broker-dealers think of advice.

Disclosure: Michael Kitces is a co-founder of AdvicePay, which was mentioned in this article.

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