By Julie Jason
Originally published in The American Association of Individual Investors (AAII) Journal, January 2020.
For those who are soon to retire or have recently retired, there is an inflection point between receiving a paycheck from an employer and a paycheck from your portfolio. For retirees who rely on their investments for retirement income, it is also one of the riskiest, if not the riskiest, time in an investor’s life. After all, you won’t go back to work for 45 years to recover from mistakes.
What type of financial service is best for the retiree who needs to “live off of” their investments?
By the Numbers
According to the U.S. Securities and Exchange Commission (SEC), registered investment advisers are growing in number, while the number of broker-dealers is declining. The SEC has stated that this “likely is a reflection of the market for investment advice, and potentially of the choices available to retail investors [that’s you] regarding how to receive or pay for such advice, the nature of the advice, and the attendant conflicts of interest.”
Over the last 14 years, the number of broker-dealers fell from over 6,000 in 2005 to less than 4,000 in 2018. At the same time, the number of investment advisers registered with the SEC rose from about 9,000 in 2005 to 13,300 in 2018. The 563 dually registered firms (both broker-dealers and investment advisers) hold over 90 million (63%) customer accounts, according to the SEC’s “Regulation Best Interest: The Broker-Dealer Standard of Conduct.”
The 770-page length of the release will tell you that this is a complicated topic that took careful consideration by regulators; however, if you want context, the introduction and background are only a few pages long and worth your time. You may also want to read comment letters from the public and the industry; there are thousands to choose from, including mine.
Do Retirees and Pre-Retirees Need Different Advice?
If you think about the nature of services pre-retirees and retirees need, do they differ? Before retirement, investors are getting recommendations from their financial professionals to buy stocks, bonds, mutual funds and the like; the primary goal is to grow capital. These are transaction-based recommendations that are the province of broker-dealers (brokers).
After retirement, investors with wealth switch to a different objective—protect capital, create income that can support living expenses and at the same time grow capital for a retirement that may last decades and for beyond, if there are legacy and charitable interests. The management of that enterprise is the province of registered investment advisers. While there may also be the need for transaction-based recommendations, such as the purchase of an annuity, there is a need for a more global and strategic approach, namely the structuring, monitoring and management of the retiree’s portfolio for a lifetime.
Broker-Dealers Versus Registered Investment Advisers
So, let’s tackle this question: What are the differences between registered investment advisers and broker-dealers and what could that mean to someone approaching or already in retirement? Most people don’t know.
A RAND study concluded that investors did not understand the differences between broker-dealers and investment advisers and that common job titles contributed to investor confusion. Focus group participants did not understand the term fiduciary, or how the fiduciary standard differed from suitability. Confusion about titles, services, legal obligations and compensation persisted even after a fact sheet on broker-dealers and investment advisers was provided to participants. (For more information on studies, you’ll want to read the SEC’s April 18, 2018, Form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles.)
The SEC wants to improve investor understanding of the financial industry through a series of recent regulatory changes, such as new disclosures called the CRS (Customer Relationship Summary) that applies to both brokers and investment advisers.
The good thing about the CRS is that any confusion that someone has about whether they are currently working with a broker or adviser will be addressed by it. The firm you currently work with will provide you with a CRS in the summer of 2020; it will explicitly state the firm’s role (broker-dealer, investment adviser or dual registrant).
The CRS also points out key information that defines the financial firm’s relationship with its clients, including conflicts of interest embedded in the relationship.
There are differences in services and obligations and that should matter to every investor, especially to someone who is investing for retirement security, which calls for the ongoing management of a personal portfolio. The differences have to do with transactions versus ongoing advice.
The SEC’s Best Interest release states, “Broker-dealers typically provide transaction-specific recommendations and receive compensation on a transaction-by-transaction basis (such as commissions) (‘transaction-based’ compensation or model). A broker-dealer’s recommendations may include recommending transactions where the broker-dealer is buying securities from or selling securities to retail customers on a principal basis or recommending proprietary products.”
Again, from the Best Interest release, “Investment advisers, on the other hand, typically provide ongoing, regular advice and services in the context of broad investment portfolio management, and are compensated based on the value of assets under management (AUM), a fixed fee or another arrangement (‘fee-based’ compensation or model).”
Which Service Is Right for You?
Of course, what services you want will depend on your unique circumstances. Quoting SEC Chairman Jay Clayton: “It really comes down to what you are looking for, for example how often you plan to buy and sell securities; how involved you want to be in the decision to buy and sell; whether you want someone to manage and monitor your portfolio on an ongoing basis; and whether the costs line up with the services you need or want.”
Chairman Clayton suggested thinking about your situation this way: “Do you want someone managing your account on an ongoing basis based on your broad financial goals and needs and movements in the markets? If so, an investment adviser may be best for you. Or, do you plan to buy a few stocks, bonds, mutual funds or exchange-traded funds (ETFs) and hold them for the long term with a few adjustments over the years? In that case, a broker may be best for you.”
One additional consideration is the standard of care that applies to brokers versus advisers. When the SEC initiated its rulemaking, it addressed who is and is not a fiduciary, which is the highest legal standard of care.
Investment Advisers Are Fiduciaries, Brokers Are Not
Investment advisers are held to the highest standard of care under the law, that of fiduciary. Quoting from the SEC’s Best Interest release: “In the investment adviser context, an investment adviser’s fiduciary duty under the Advisers Act comprises a duty of care and a duty of loyalty. This combination of care and loyalty obligations has been characterized as requiring the investment adviser to act in the ‘best interest’ of its client at all times.” The SEC’s “Commission Interpretation Regarding Standard of Conduct for Investment Advisers,” effective July 12, 2019, addresses that fiduciary standard of care.
What’s important about these regulatory developments, which were a very long time coming, is this: The SEC established a new standard of care for brokers. The new standard (called Best Interest) is more than the current “suitability” standard, but it is less than a fiduciary standard that applies to registered investment advisers. (“Regulation Best Interest will enhance the broker-dealer standard of conduct beyond existing suitability obligations and make it clear that a broker-dealer may not put its financial interests ahead of the interests of a retail customer when making recommendations.” June 5, 2019, release, “The SEC Adopts Rules and Interpretations to Enhance Protections and Preserve Choice for Retail Investors in Their Relationships With Financial Professionals.”)
There will be four new obligations for brokers to comply with: disclosure, care, conflict of interest and compliance. What’s most important? From my point of view, conflict of interest.
New for Brokers: Conflict of Interest Obligation
Brokers will need to comply with the new conflict of interest obligation, which is designed to:
- “Mitigate conflicts that create an incentive for the firm’s financial professionals to place their interest or the interests of the firm ahead of the retail customer’s interest;
- “Prevent material limitations on offerings, such as a limited product menu or offering only proprietary products [products sponsored by the firm], from causing the firm or its financial professional to place their interest or the interests of the firm ahead of the retail customer’s interest; and
- “Eliminate sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time.”
This new best interest standard will evolve over time as it begins to be applied in the real world. We will see how this plays out in the future.
Identify Your Needs
Those approaching or currently in retirement should consider whether they need a different kind of financial professional, based on changing needs. From my perspective as someone who has had experience in both the broker-dealer and registered investment adviser settings, the distinction is pretty clear: Retirees would want a broker for discrete investment recommendations on a transaction-by-transaction basis. Wealthy retirees who need to produce income to cover living expenses and protect and grow capital at the same time would want an investment adviser for ongoing investment management.