Why Your Broker Doesn’t Put You First

Posted on June 24, 2011 at 11:41 AM PST by

Have your heard this old tale? During a flood, a kind-hearted frog lets a scorpion ride to safety on his back. But, just as they reach the middle of the river, the scorpion stings the frog. As they both sink beneath the waves, the frog asks, “Why did you sting me?”

“It’s my nature,” says the scorpion. “That’s what I do.”

When you choose someone to help you with financial advice, it is important to know “what they do.”

In professions where the provider is helping individuals with highly personal and important areas like health, credentials mean that the person has earned the right to be trusted. There are understood standards and norms. Doctors are credentialed for his field of medicine. Chiropractors have a different type of training and certification than an oncologist. We know who we are seeing and what they are supposed to be able to do. Attorneys who have passed the bar went through law school and have the legal right to practice.

Such clear certification is very confusing in financial services. It may look like a professional broker at Merrill Lynch or Morgan Stanley provides the same service as someone who is a registered investment advisor. But nothing could be further from the truth. This distinction is critical to understand no matter how much you trust the individual.

A person who is a broker, is just that. He acts as an agent between a buyer and seller of products, usually for a commission. Legally, an individual who works for a “broker/dealer” must pass a “Series 7” exam, which teaches one about the stock market and securities to prepare the individual to sell commissioned products. Brokers operate under a “suitability standard” under which the broker is required to make investments he judges to be suitable for his clients. He can’t sell micro-cap volatile stocks to old ladies. Brokers and their firms are regulated by a “self regulated organization” (not a government agency) called FINRA. In the industry, brokers are measured by the amount of commissions and fees that they generate from selling products. Product providers pay more for “distribution” through brokers.

Registered investment advisors (RIAs) help individuals manage their money. They must pass a “Series 65” exam, which tests how well one knows how to help a client invest and operate under a fiduciary standard. That means an advisor is required to act in his clients’ best interests, and disclose to them all conflicts of interest. These advisors are either registered in the state in which they operate, or with the Securities and Exchange Commission (SEC). RIAs are usually measured by assets under management (AUM) because the more assets they manage, the more their fees. They submit lengthy ADV II forms online showing any conflicts of interest, sanctions from the SEC, and exactly how they are paid.

RIAs can’t use customer testimonials in advertising and must disclose when they pay for client referrals. Brokers can use testimonials and hide fees they are paid for referrals.

Under Dodd-Frank, legislators are now considering implementing a fiduciary standard for brokers. They are fit to be tied. The central issue is that if they are required to put your interests ahead of theirs, they will have to disclose conflicts of interest and fees. FINRA is spending a fortune to fight this because if they disclose all fees they receive from all parties, investors will get wise and they will earn less. FINRA’s CEO earned nearly $3 million last year, and FINRA’s top 10 employees all earn over $1 million. They don’t want their members paying them less, so everyone is pulling out all the stops.

A good analogy for the broker versus investment advisor is the difference between an optician and an ophthalmologist. An optometrist conducts eye exams and makes sure that you have healthy eyes but makes money primarily selling you glasses and contact lenses. When you have a cataract, or something serious, you go to a medical doctor—or an ophthalmologist. He has taken a Hippocratic oath to practice medicine ethically. He sells nothing. He puts your health first and can also examine your eyes.

Do you want to trust your money to someone who is just paid for advice? Or a broker who makes money providing advice in order to sell products?

Just remember: If you’re carrying someone across the river, you may want to check on “what they do.”