B/D or RIA? How to Decide for Yourself

Commissions

Simply put, if an advisor does not have a strategically important reason for using commissions in his business he will have little reason to affiliate with a broker/dealer. That is not to say that there is no place for an organization that can add scale and resources to a practice–a variety of organizations, including some created by broker/dealers, can do that–but those will be a very different form of contracts from the B/Ds as we know them today. Such fee-only broker/dealer models already exist or are being created by several of the broker/dealers and other third parties. For the B/D model as we know it, however, the strategic use of commissions is important. The key word is strategic. If the use of commissions is temporary or accidental then the decision becomes fairly straightforward. Similarly, if the use is long-term and important for the practice, the choice is easy. (For a further treatment of when commissions may be appropriate, see "The Case for Commissions" Web extra at www.investmentadvisor.com.)

The Economics

The economic models are surprisingly straightforward but they are also a common source of confusion and misunderstanding. The first task is to compare the differences in expenses between contractual models. Some of the expenses are very scalable and therefore their magnitude as a percent of the revenue of the practice will vary widely between the wirehouses and the independent practice.

The difference between expense responsibilities defines the budgets necessary to become independent as either an RIA or IBD practice (see table, above). Essentially, we are suggesting that in order to move from a wirehouse or boutique firm to an IBD, advisors need to be able to pay for their own branding, office staff, junior advisors, most of the technology, some of the product development, and some of the investment selection. The total budget will vary depending on the size of the practice and its unique needs, but generally it is difficult to create a functioning office with less than $80,000 in budget. If you assume that expenses should not exceed 40% of the total revenue, this implies that you should not have less than $200,000 in revenues as an IBD advisor. Some advisors are able to function with a lower budget in a shared office where they "rent" staff and services.

The incremental difference between IBDs and RIAs will be replacing the technology provided by the broker/dealer, the product development, the investment selection, and, most of all the reporting, billing, and compliance. These incremental costs typically amount to $20,000 to $30,000 for compliance, $30,000 to $40,000 for billing and reporting, and $5,000 or so for technology. This $75,000 incremental budget raises the bar to practice as an RIA to about $387,500 in minimum revenue ($75,000 in expenses plus the $80,000 divided by 40%). Routinely, I round that up to $500,000 since RIAs need to go through a learning curve of operating on their own and that typically involves some additional time and expenses.

The hidden cost of independence is time. Based on some surveys, the time the advisor spends on operations and compliance and other non-client issues is estimated to be as high as 40% of the total. This "cost" is perhaps more significant than any other expense. Finally, the investment process can have a significant impact on the cost of time. If the firm uses third-party managers from a short and stable list, this will drop the cost of investment selection and will likely substantially reduce the cost of portfolio service and reporting.

Hybrid Models

Many practices have an integral need for using commissions in their business but also have a relatively independent business philosophy that drives them to an RIA model. It is important to keep a sense of perspective in this decision. The choice of custodian is a very important decision, perhaps more important than the choice of broker/dealer (depending on the practice). If 90% of your business is RIA and if you can't choose a custodian because one is mandated by your broker/dealer, you may want to consider which relationship is more important.

Unfortunately, some practices will find that they gravitate toward the RIA channel because they are fiercely independent even though they don't have the budget to be an independent RIA. In such cases, advisors should look to join forces with other advisors or perhaps join an existing RIA in order to find the infrastructure they need.

Finally, most hybrid firms today have to expect that they will share their RIA revenue with their broker/dealer although this may change as the model is supported by an ever increasing number of broker/dealers. For example, a $1 million firm that does 50% of its business in an RIA is subject to a 95% payout on the RIA side and 90% to 92% on the brokerage side resulting in about 93% overall payout. In some models the payout on the RIA side is 100% but only if the broker/dealer is the custodian of the assets.

So Where Do You Belong?

It should be a straightforward process for an advisor to find the best combination of resources to achieve his professional and personal goals. However, the five decision-tree questions can combine to produce many different outcomes. The factor that often gets overlooked but is one of the most important influencers is the cultural decision. The strongest social drive we have as human beings is the desire to belong. That sense of belonging can trump all the rational reasons but it can also be a powerful booster for the rational choices. What is often misunderstood is that the sense of belonging is present in all the models–from independence to full-time employment. It is not about the people you greet in the office in the morning but rather about the people with whom you feel you share the same values, ideals, and goals. That defines where you belong much better than payouts and printouts.

Philip Palaveev is president of Fusion Advisor Network. He can be reached e-mail at [email protected].