Brooke’s Note: Recently we wrote about an odd circumstance in which the Department of Labor set out fiduciary rules so stringent that trade groups like NAPFA and FPA found themselves siding with their traditional foe, the FSI. The Committee for the Fiduciary Standard was alone in defending the DOL’s position. See: As DOL contemplates stiff fiduciary-related penalties on advisors, NAPFA and FPA find rare concord with FSI. So who is right? Even among advisors there is considerable disagreement. Larry Steinberg, president of the Steinberg Financial Group, a hybrid RIA in Arizona, and Jeff McClure, president and chief investment officer of The Personal Wealth Coach, an RIA in Texas, debated the issue in the aforementioned article and here is their back and forth based on what they have lived and breathed.

Larry Steinberg: The problem is not having fiduciary standard, it is making it so difficult to comply with that advisors can only afford to work with the wealthy.

Jeff McClure: I read the referenced article about the “dark side” of the rules and frankly cannot figure out what the problem is. I was a broker for 25 years and in retrospect realize that there were far, far better solutions to rollover and other IRAs, but I was restricted by my need to meet production minimums and to make a living. For all my justification and self-induced blindness, I gradually migrated to the highest commission products. How is it that the small investor will not be properly served when the current standard is to offer the highest commission that can be legally charged? See: A conversation between a wirehouse advisor and a senior citizen who seeks trust.

Our problem with attempting to serve smaller accounts in our RIA is already in place. The record keeping, disclosure, and analysis standard is the same for a small account as for a large one. We have already figured out though that we could, if we wanted, make a good profit there by creating a two tiered approach in which we provide a set of standardized portfolios for those smaller accounts. The remaining problem is that we probably would not be able to handle the number of new clients we would face. See: Which three of DOL’s new 401(k) rules represent the biggest land mines for financial advisors and plan sponsors.

Having been a broker I can say without hesitation that vanishing few “financial advisors” would recognize the term “fiduciary” if it hit them in the face. See: Fiduciary leaders splinter into two advocacy groups over divergent views.

It is a potentially very profitable area over the long term but involves some serious up-front commitment to training, software, record keeping and standard setting. It took me four long, hard years to transition back to a reasonable profitability as I stopped being a securities salesperson and assumed the fiduciary investment advisory mantle. No, I no longer have a million-dollar house, or drive a car that will turn heads, but I now make a steady, good living that puts me in the upper 3% in America. Meanwhile I now have nine employees instead of two assistants. The firm has the same revenue today as I had as a broker in 2007, but today we are confident we are doing as good a job as is possible for a very reasonable fee. I make about 1/3 the gross income I did back then, but I have no question that what I am doing is for my clients and not to inflate the earnings of a corporation, and enrich myself.

Jeff McClure: It was once true that an RIA client was far more expensive to maintain than a B-D customer, but not now.
Jeff McClure: It was once true
that an RIA client was far
more expensive to maintain than a
B-D customer, but not now.

If I were interested in forming a major company, there is no doubt in my mind that we could provide service to those $25,000 IRAs. The Mutual Fund Store, an RIA, apparently is doing that already. See: How Warburg Pincus plans to grow The Mutual Fund Store several-fold.

If we want to ultimately be seen as a profession instead of as sales jockeys, we need to all assume a fiduciary standard. Physicians, clergy and even lawyers are held to that standard. It can be done.

What about the little guy?

L. S. We know that the bottom end RIA limit is basically $25,000. What about the people, especially young people, who are just starting out and can only put away some monthly savings amount? As a hybrid I have some of those clients. How do we help them? A well-written fiduciary standard would not exclude those people if it is truly a step in the right direction.

J.M. The bottom end of our fee scale (meaning least dollar amount under management) is 1.5% per year. We also have the option of charging a fixed fee. So, lets consider the low end of the spectrum. If a person wants to invest $200 per month, the typical broker-dealer re-allowance is about 4%. If a registered representative of that broker-dealer is seeing people with $200 per month (to contribute to an account), I cannot imagine he or she would be on more than a 75% contract. So, the B-D will get $96 and the rep will get $72 per year.

When I hear that the small investor will get left out, my immediate question involves this example: The record-keeping requirements of the B-D are at least as onerous as for an RIA. The time requirements for rep and B-D are no less than an RIA could spend. The issue here is that a highly compensated professional simply cannot afford to spend the necessary time educating, disclosing and disclaiming for that amount of money, no matter which model is being used.

The B-D model to solve this problem is to arrange to create a bigger commission. For example, many whole life/universal life insurance products have a total payout that exceeds 100% of first year premiums. With a surrender charge schedule that equates to 100% for the first several years, they can afford to do that. USPA & IRA used to use “contractual” funds with a 50% commission on a “contractual” amount paid in during the first year. On our $200 per month example, that amounts to $100. They would also sell a whole-life insurance policy and would commonly convince the customer that they really needed to spend another $200 per month on that. So their solution was to arrange for the broker/dealer/insurance agency to have a gross margin in the first year of about 75%.

As I monitor the B-D community, I have seen that most broker-dealers that deal with the smaller investor have come up with perhaps less extreme, but certainly no less creative ways to separate the small investor from a very significant share of his or her “invested” money so as to be able to afford to make a nice profit on relatively poor customers.

So, let’s think about another model. The nice thing about the RIA business is that most of the rules are written by the individual RIA. No, you won’t find a set of rules from RIA IN A BOX, Inc. that will address this problem, but if one is willing to forgo the standard boilerplate ADV and Procedures Model, I believe there is a solution. To put all of this in perspective, Vanguard, the champion of no-load investing, does not take retail accounts unless the investor has at least $3,000 to invest. So what is the client paying us for if they can use Vanguard without a fee?

The importance of customer service

I believe the Ace Hardware model is what they are paying us for. Within a reasonable distance from our house are two big-box “home improvement” stores, which are really just big hardware stores. A bit closer is an Ace Hardware store. Lowe’s and Home Depot have lower prices, but I have to find what I want myself. The good people there do not greet me when I enter the store and ask, “How can I help you?” The overall experience is sometimes positive and sometimes very frustrating. See: Fidelity, Vanguard and Schwab have top 401(k) brands but plan sponsors like the service of off-brands better, study shows.

At the local Ace Hardware store, I am greeted at the door by a knowledgeable, friendly person who will spend half an hour helping me find a 75 cent screw. As a result of that kind of personal service I have chosen to purchase several thousand dollars of equipment, paint and hardware there.

I use Vanguard mutual funds where they are appropriate for my clients. They pay me to read the prospectus and understand the complexity of how to properly invest. I, as the rainmaker in our firm, spend significant time each quarter figuring out which funds we want to use and recommend. That is part of what they pay us for.

If that small investor with $200 per month is also (as a couple) putting $500 per month into a 401(k), and the employer is matching, what we are now talking about is $14,400 in the first year and (presuming no market growth) $28,800 in the second year. A 1.5% annualized fee, charged monthly would produce $117 in the first year and $333 in the second year.

Receiving $450 over two years will not pay for first-class analysis and planning, but at that level of investment there are limited options. I would need to select the fund they should be using in their employer-sponsored retirement plans and pick probably at most a couple of mutual funds to use in their “other” account. We might also set up a 429 as some of them will take $50 per month.

Using a full commission and not going down the USPA & IRA road (the path that leads to destruction), a broker-dealer would get about $100 in year one and another $100 in year two. Because a RIA can advise on the retirement plan, the gross revenue could easily be $450 instead of $200.

Medical model

In order to afford to do that, I think we need to look to the medical profession. The last time I went in for a routine visit to my local clinic, I met with a physician’s assistant. There is nothing that says that a RIA cannot have a two-tiered level of service or for that matter, a three- or four-tiered level of service. If you are a broker-dealer rep, you are required to “know your customer” under FINRA rule 17a3, so you are required to make contact with that customer and reevaluate their needs and the product you recommend on a regular basis. See: Part One: Investment Advisers: Is our path toward, or away, from a true profession?.

From my worm’s eye view it sure looks to me like you could do that as a fiduciary for probably twice the revenue that you are getting by using a full front-load, 12(b)1, and “partner fees” from the fund company. The difference is that you would “come out of the closet” and disclose what the client is paying. See: How the new 12b(1) fee restrictions could transform the financial advisory industry.

So, as I said, “What’s the problem here?” From my perspective it is simple. The broker-dealer community is used to charging commissions so high that if the customer knew what he or she was paying they would flee. Yes, there is no way a fiduciary could set up a program that takes 50% of first year invested funds, but by “spreading the revenue base” and being up-front about it while actually providing real expertise and working for the client, twice the revenue is potentially available.

The case for hybrids

L.S: I appreciate Jeff taking the time to give his opinion on broker-dealers, but I have to disagree. There are plusses and minuses to both broker-dealer side and RIA. I am a hybrid and do both. The reality is that their are certain costs that have to be covered in every account. My information is that an RIA account costs about $100 year just to exist. A regular brokerage account or direct account with a mutual fun costs far less.

The simple fact is that there is no way to even break even on a $200 per month RIA account. It is thus much easier for me to use mutual funds directly or a regular brokerage account for smaller accounts. It is more cost effective for the clients and for me.

I generally use Class C share mutual funds for smaller accounts figuring I will eventually grow them into advisory accounts. In doing this I am aligning myself with the client just like with an advisory account. Just because an account operates in the broker-dealer FINRA world does not make it any more or less ethical than it being in the RIA SEC world.

I am for a fiduciary standard as long as it doesn’t prevent me from having smaller accounts, which it will assuming they don’t do some major revisions. Not only does this hurt smaller investors, but it hurts me helping larger clients where we might need some smaller accounts as well.

Investing in clients

Jeff McClure: I have been deep in the books and bowels of broker-dealers and now am the majority owner and president of an independent RIA. I am also licensed as a FINRA series 24 principal and am an OSJ. It was once true that an RIA client was far more expensive to maintain than a B-D customer, but not now. If anything, the reverse is true. The B-D I contract through has roughly tripled the internal staff in the past few years while adding about 30% to the number of customers. That is why small indie B-D firms are vanishing.

Again, as an RIA, we make the rules. If you have a set of standardized templates for small RIA clients and an assistant-level person who can actually meet with and handle the account, those small RIA clients can be profit centers. I just went though a series of small-dollar value clients we have accepted because of a family relationship with a prime client. There is no question that we made a profit, albeit a low dollar value per client. On the other hand, we have found them to be very low maintenance clients. We mail them a letter each year to ask if anything has changed and update their portfolios with any fund changes on a batch basis.

As an interesting aside, in the process of reviewing those “dependent” clients I was surprised to discover that about half of them now meet our minimums for a new stand-alone client! More, some of my larger-dollar value clients are people I started working with decades ago who only had a few hundred dollars per month to invest.

The back side to this is that I have seen the absolutely monstrous complexity in forms and procedures imposed on IARs by the dually registered firms. The reason for all that complexity and those detailed procedures and rules is the inherent conflict and potential for confusion by members of the public when an IAR is also a securities salesperson. The liability there goes off the scale. We absolutely do not sell new investment products to anyone, therefore we have no conflict. We state that in our firm brochure and we hold to it. That change makes having an RIA client phenomenally less expensive.

As I wrote above, on average we find having a fiduciary relationship with even a relatively small-dollar value client who is investing monthly to be much more remunerative over a three year period than if we were still in the sales business. Admittedly, the net to me is smaller because we have a heck of a lot of overhead as an independent RIA. Still, with reasonable automation, it is profitable to serve small-dollar clients. In fact, I believe when a relatively large number of people are involved (some will drop out, some will not continue to invest) the overall result is a good, steady income in the short term and a high dollar value in the long term.

In short, if you are really a long term investor, then bringing in those young people who are steadily putting money away each month is how you will replace the old codgers who have the big bucks today.

Larry Steinberg, president of the Steinberg Financial Group, is a financial adviser who speaks across the country on investment topics including Asset Allocation, Capital Formation, Exchange Traded Funds, Alternative Investments, and 401(k) Plans. Licensed in Arizona, California, Colorado, Iowa and Texas. Securities and Investment Advisory Services offered through Berthel Fisher & Company Financial Services, Inc. (BFCFS) Member FINRA/SIPC. The Steinberg Financial Group and its divisions Steinberg Financial Advisers, Stone Mountain Retirement Plan Advisors, and Steinberg Insurance are independent of BFCFS. CA Insurance License 0B19683.

Jeff McClure, an advisor with The Personal Wealth Coach, an RIA firm in Salado, Texas, about 50 miles north of Austin.