The Conflicts Of Interest Between RIAs And Their Custodians (and Brokers And Their B/Ds)

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#OfficeHours with @MichaelKitces Video Transcript

Welcome, everyone! Welcome to Office Hours with Michael Kitces.

With all the buzz of the Department of Labor's fiduciary rule and the conflicts of interest it potentially limits or bans, I wanted to talk about what's actually one of the most commonly overlooked conflicts of interest for fiduciaries. And it's the one that exists between RIAs themselves and the RIA custodian platforms that we work with.

Now, you might be surprised to hear me say there are conflicts of interest between fiduciary RIAs and the platforms that serve the fiduciary RIAs, because the conflicts that arise aren't the ones we often think about. But they're there, and they actually often influence us in very significant ways that we don't necessarily even realize.

Is Your Client The Person Or Their Pot Of Money? [Time - 0:56]

I'll give you an example. In recent years, there's been a huge amount of buzz in the industry about the need for financial advisors to build relationships with their "next-generation" clients; i.e., the heirs of their current clients who are likely to inherent the wealth of their existing clients over the next 10 or 20 or 30 years. Now on the one hand, it sounds kind of intuitive. The typical RIA is focused on doing retirement planning, which by its nature means a somewhat older set of clientele who are at greater risk of passing away. So why not try to build a relationship with their heirs so that you can retain the assets?

But let's think about this for a moment. I'm going to translate it to another industry. Let's pretend that you run a nursing home for affluent seniors who can pay the full price you're charging for your high-quality service. Now, this nursing home is likely to be a very profitable business since you're serving affluent clientele, but it's got one fundamental problem: Like a retiree-centric advisory firm, the people who pay you in a nursing home tend to keep passing away. Kind of a problem. And then their assets that they were using to pay you vanish to the next generation, and you won't get paid for that nursing home room anymore.

So you say, "Hey, I've got a great idea. Let's become a really tech-savvy nursing home. We'll wire up every room with Apple TV and we'll make it so you can lock and unlock your room with your iPhone, and we'll make a cool website that lets you sign up and choose your room entirely digitally, and we'll start doing classes on how to make responsible housing choices for young people." In other words, we're going to do whatever it takes to make this nursing home one that our patients' next-generation kids would want to move into once their parents or their grandparents pass away by building a relationship with them and then making our services more tech-savvy to appeal to a younger generation.

But of course, there's one thing that this nursing home exercise is kind of forgetting in the endeavor. It's a nursing home. It doesn't matter how tech-savvy and Millennial-centric it tries to be, it's a nursing home. Give the Millennials a little credit to realize that they probably don't want to live in a nursing home. They want to live somewhere that's relevant for them. Which means the best strategy for the nursing home with patients who keep passing away isn't to try to get their next-generation heirs to use their inherited money to keep paying for the nursing home room; it's to find new, affluent seniors who would want to move into the empty nursing home room.

And I find this analogy fits quite well for financial advisors. How many advisors have retiree-centric, baby boomer-centric firms and are rolling out next-generation client initiatives to try to build a relationship with the heirs of their clients and trying to be more tech-savvy to retain them, and somehow assume that the next-generation heirs aren't going to notice that you're still an advisory firm for retirees that isn't focused on their needs?

I've written about this before. You can't just make your website tech-savvy and put a robo advisor button between the images of the lighthouse and the Adirondack chairs overlooking the beach on your website and expect to get Millennial clients. It's not going to happen. Or, viewed another way, the key point here is that when you try to pursue the money down the family tree, what you're really saying is "My client isn't actually the human being I'm serving. My client is their pot of money. And I'm just going to chase the pot of money wherever it goes, regardless of who's actually holding it. I don't even care who the person is. I'm just serving the pot of money."

Because again, if you were really focused on trying to be the best you can at serving your ideal client than your clients or retirees who sometimes pass away, your goal would be to find more retirees because that's who you serve. Not chase the pot of money.

But here is the important distinction. For the RIA custodian, they don't have the relationship with the client; we do as the advisors. They, the custodian, literally hold the pot of money because they're a custodian, it's what they do. So for them, the "client" isn't the person, it actually is the pot of money.

And that's why when you look closely, you realize that virtually everything being written about how advisors must pursue their next-generation clients is all coming from the RIA custodians. Because their client is the pot of money. They don't have a relationship with the person. They rely on the advisor for the relationship with the person.

And so, what do the custodians do? They egg on the advisors to chase the pot of money instead of focusing on their ideal client because the custodian is concerned about the demographics of their own pot of money and not the advisor's business. It's a fundamental conflict of interest around practice management advice. Advisors serve their ideal clients until they retire themselves in 10 or 20 years. Custodians serve pots of money and are ongoing, indefinite businesses. So the custodians care a lot more about multi-generational pots of money than advisors ever need to do. And as advisors, we care about our clients.

But the end result? Sometimes, we get what I think is actually really bad advice from our custodians based on what's in their best interests instead of what's in our interest as advisors and advisory firm business owners.

Fiduciary Advisors Exist To Optimize Away RIA Custodian Profit Margins [Time - 5:49]

Now, another way that RIAs sit in conflict with our custodial platforms is that in the end, one of our primary goals as advisors is essentially to proactively minimize the profit margins of our RIA platforms. Think about it a moment...for instance, as fiduciary RIAs, it's common for us to do whatever we can to minimize transaction costs. So we push for lower ticket charges, we pick the lowest-cost share classes that don't have 12b-1 fees or rev sharing to platforms. We choose no transaction fee or NTF funds for our small clients where a ticket charge would be cumbersome. But then we flip back and pay the transaction fees for our larger clients where that would be cheaper than the higher basis point expense ratio of NTF funds.

Similarly, we try to minimize the amount of client assets that sit in cash. We tend to discourage clients from taking on additional risks through margin loans. We even have an obligation from the SEC to obtain best execution pricing, regardless of whether how much the platform might be getting paid for order routing to certain exchanges.

And all this matters because how do RIA custodians actually make money? Ticket charges, revenue sharing from mutual funds, making margin loan interest, getting basis points and NTF funds, making their 25 basis point interest rates spread on money market funds, and order routing revenue on execution. Basically, our primary goal as RIAs is to minimize every point of revenue generation for an RIA custodian. Because every dollar that doesn't go to the RIA custodian as a cost is another dollar that accrues to client. Which improves their wealth, which makes our performance look better, and even to a slight degree, the size of the portfolio that we get to bill on in the future because it didn't to go to RIA platform fees.

And it's a fact that RIA custodians often remind us about. How many RIA owners out there have had a recent conversation with their RIA custodian where they were reminded from the custodian about whether how profitable they are as an RIA on the custodian's platform? Usually right before you begin to negotiate your soft dollar agreements or whether the custodian is willing to make some concession you were requesting for a client.

Because the realities of the RIA custodian business model is built on these incredibly thin margins that rely on huge amounts of dollars in these profit centers to work, even as we try to minimize them. I mean, think about just the cash position alone for a minute. So Schwab has upwards of $1.3 trillion in advisor assets. Now let's imagine for a moment that the typical advisor keeps 3% in cash in their client portfolios. Maybe a little bit is a holdback for fees, some is to fund the client's ongoing retirement distributions. Maybe a little bit of it is new savings or portfolio additions that haven't been invested yet.

Now across $1.3 trillion, a 3% cash position amounts to $39 billion in cash. And so, if Schwab makes 25 basis points on that cash as an interest rate spread in their money market, that's almost $100 million of revenue just from the small percentage of idle cash in money markets. And then, what happens if the advisory firm adopts rebalancing software that makes it easier to identify clients that have idle cash and get it invested? If widespread use of rebalancing software drops the average cash balance by 1%, making client portfolios more efficient and better invested, Schwab loses about $30 million of profit straight off the bottom line by not getting the money market spread. And heaven forbid, services like MaxMyInterest get off the ground.

For those who aren't familiar, MaxMyInterest connects a client's investment accounts to a bunch of outside banks and then tries to automate the process of moving the cash in and out of the custodian's investment accounts and amongst the outside banks to maximize the yield on the client's cash. So if some online bank offers a slightly better yield, MaxMyInterest just automatically shifts the money over to wherever it gets the best yield. Great service for clients, increases their returns, and it's a nice value-add for the advisor. And if it takes the average cash balance down by 2% on average because that money moves to external banks with better yields, Schwab loses $65 million in profits like that. It's a huge conflict.

Now I don't mean to paint an antagonistic picture here between RIAs and their custodians. But it's crucial to recognize that as advisors, what profits the RIA custodian takes money out of our clients' pockets. And what keeps money in our clients' pockets that we try to fight for our clients takes it away from the custodian's profitability.

And so, like it or not, we have a fundamental conflict of interest between being good advisors for our custodial platform and being good advisors that watch out for our clients' best interests. Whether it's trying to minimize cash balances, move money off-platform for better yields, optimize when to pay ticket charges and when to use NTF funds for smaller clients; all of those things that we do minimize profit for the platform.

How Broker-Dealers Are In Conflict With Their Brokers [Time - 10:40]

Now, it's worth noting that this phenomenon actually isn't unique to RIAs either. It's maybe more noticeable because we usually talk about RIAs as being fiduciaries that are minimizing conflicts of interest. But it's equally relevant for those that work for broker-dealer platforms as well. Because, in the end, the fundamental model of a broker-dealer is that they're an intermediary for financial services' product distribution. You can't sell a financial services product without a broker-dealer. And every time you do, the broker-dealer gets a slice of that GDC. The more products you move, the more money they make by getting a piece of every transaction.

By contrast, because their business model is built around being a product intermediary, there's not much money for a broker-dealer when advisors shift to advisory fees, and especially when they start charging separate fees for financial planning. Because the broker-dealer can't make as much by taking a slice of planning fees as they do from products. Not only because payouts from products tend to be lower than payouts from financial planning fees which means the broker-dealer keeps a little more, but also because the slice of GDC isn't even the only way that a broker-dealer makes money on that transaction. When the brokers on the platform do a higher volume of product transactions, the broker-dealer gets to go to the asset manager or product manufacturer and get them to pay money to sponsor conferences, to pay for shelf space and due diligence, or to pay for better revenue sharing terms. Simply put, the broker-dealers profit more from their advisors having them get paid through products for financial planning than when advisors get paid fee-for-service financial planning advice.

And in that context, it's maybe no great surprise that broker-dealers have been so negative on the Department of Labour's fiduciary rule. Because if the advisor on the platform shifts from product commissions to fees, even if they generate the same revenue and do the same services for the same clients, the broker-dealer doesn't make as much money. The client may be just as well served, and the advisor may be just as capable, but the BD gets squeezed. Which results in this bizarre environment that we currently have where one advisor serving after another shows that the overwhelming majority of advisors support a fiduciary rule that acts in the best interest of their clients, including both advisors at RIAs and at broker-dealers. But the broker-dealer community has been the most vocal in fighting the fiduciary rule and the most active lobbying in Washington against it. Not because it's necessarily for the advisors at the broker-dealer, but because it's bad for the broker-dealer itself. And so, the broker-dealer community has been trying to convince its brokers that it would be bad for them too, when it's really not the brokers that are challenged; it's the broker-dealers that need to reinvent themselves after DoL fiduciary.

And these problems crop up in other areas as well. This is why a lot of broker-dealers are pushing their advisors to pursue next-generation clients. They have the same generational challenges as the RIA custodian whose client is really the pot of money, even though the advisor's client is the actual human. And at least some broker-dealers limit product selection on their platforms based not necessarily on what products are best for their advisors or clients, but which ones are most willing to pay shelf space, better revenue sharing terms, or more money at the next conference to sponsor.

And David Grau has written extensively on how succession planning departments at a lot of broker-dealers are encouraging their advisors to take what are actually very bad succession planning deals for the advisor because it facilitates an on-platform transaction which keeps the clients and assets for the broker-dealer, even if it fails to maximize the value of the deal for the advisor who's selling the practice.

Now again, as with RIA custodians, I don't want to paint every broker-dealer in a nefarious light. They're just trying to run their business model as RIA custodians do, and the reality is that they need to make money somehow and it has to come from somewhere, whether it's the advisor or the client or both.

But is the key point to recognize the conflicts of interest that do exist between RIAs and their custodians, and between brokers and advisors and their broker-dealer platforms. Which is concerning, because, for so many advisors, their platforms are the primary place they go for education and insight and practice management advice, often not realizing the "conflicted advice" that they're receiving from their platforms. And these platforms are also the primary advertisers for most of the trade publications, and the ones that push these same issues and topics into the industry media. Again, done in the manner that's ultimately about maximizing revenue for the platform, not necessarily actually giving the best practice management advice for the advisor. This is actually one of the reasons that I originally launched the Nerd's Eye View blog in the first place, because I felt there was a need for some kind of platform where advisors can actually hear objective advice from a colleague not colored by the economics of their RIA custodian or broker-dealer platform.

I hopes this provides some food for thought, as well as an understanding that while a lot of RIA custodians/broker-dealers really do try to help their advisors succeed, it's important, as with any form of conflicted advice, to take it with a grain of salt, and to recognize the potential conflicts that may underlie whatever practice management advice you're getting. Especially since the conflicts of interest between advisors and their platforms do not necessarily get disclosed the way that so many other conflicts of interest get disclosed to clients.

This is "Office Hours with Michael Kitces" at normally 1:00 p.m. East Coast time on Tuesdays, although obviously, I was a little bit late today. But thanks again for joining us and have a great day, everyone.

So what do you think? Do fiduciary advisors inherently eat away at RIA custodian profits? Do many advisors realize these conflicts of interest exist? What could be done to avoid these conflicts? Please share your thoughts in the comments below!