Understanding the Financial Services Industry
If there is one industry that can be a very confusing, it is the financial services industry. Over the years, I have had the misfortune of witnessing firsthand the consequences of poor financial decisions made by the public based on recommendations by those active in the industry. Often, these recommendations were based in part on the narrative created by the very companies who develop and market the products. Even more troubling, there have been occasions when those same individuals display scant knowledge of the very financial industry that they are engaged in.
The Financial Advisor is a widely accepted generic title used by many who are active in the financial services industry today. For the public, the challenge is to understand how financial advisors are licensed, who they represent, and how are they compensated.
Today, it is common to see advertising on bank marquees that tout “Banking-Insurance-Investments”. From the bank’s perspective, this creates the ultimate one stop shop, so it appears. Let’s begin with a quick overview of the four, primary, consumer driven business models.
Commercial Banks provide services to the public in the areas of mortgages, installment loans, credit cards, checking and savings accounts, and certificate of deposits. What government regulators are involved in the regulation of the bank will depend on whether the bank is federally or a state chartered. The banking and regulatory structure in the United States is complicated. To learn more, go to www.federalreserve.gov
Insurance Companies are in the business of creating products that allow the consumer to transfer risk. The risk can be subdivided into two primary categories property & casualty (auto and home) or life & health (life, health, disability, and annuities). Some companies may focus on one specific product area while others may try to cover a full range of products. Their distribution and marketing channels may differ as well. Some companies may have a captive channel (the career agent) or may distribute their products using insurance agencies who act as brokers who offer a range products from several competing companies. Both insurance companies and their agents are licensed and regulated by the state insurance departments. To learn more, go to www.naic.org
Broker-dealers are companies that transact the sale of securities. They may act as a broker (selling a security for someone else), or they may act as a dealer (selling a security from their own inventory). Broker-dealers may be large, privately owned companies with a large captive sales force, others may be publicly owned companies with a large independent sales force, and many may be owned by banks and/or insurance companies. FINRA (Financial Industry Regulatory Authority) regulates broker-dealers as well as registered representatives of the brokers. According to FINRA, there are 3,800 broker-dealers with 635,000 brokers as of 04-17-2017. To learn more about FINRA, go to www.finra.org
Registered Investment Advisor is a company that is engaged in the business of providing investment advice. The advice may be limited to investments or a broad range of advice services may be offered. Under the Investment Advisors Act of 1940, registered investment advisors (RIA) and their investment advisor representatives (IAR) are required to register with the U.S. Securities and Exchange Commission (SEC) and/or individual state securities departments. In addition, both the RIA and IAR fall under the supervision of either the SEC or the Secretary of State Securities Department. Registered investment advisor companies may be publicly traded while most are privately held and many are owned by either broker-dealers or insurance companies. To learn more, go to www.sec.gov
Today, financial advisors can come in various combinations and may be licensed in several different combinations. For example:
- State Insurance License – Life & Health and/or Property & Casualty or both
- FINRA – Registered Representative
- SEC – Investment Advisor Representative
- Life & Health and Property & Casualty, FINRA – Registered Representative, SEC – Investment Advisor Representative
While the state Insurance departments currently do not have any form of disclosure requirements for their insurance licensing, the regulatory authority for the financial industry does. Affiliations must be disclosed between the financial advisor and broker-dealer and between investment advisor representative and registered investment advisor. These affiliations are typically disclosed on business cards.
For example, Sara Sample is a financial advisor of Sample Financial Management, a registered representative of PLM Investments and an investment advisor representative for Crow Bar Investment Services. Sara’s disclosures will state that securities are offered through PLM Investments, a registered broker-dealer, member FINRA/SIPC and investment advisory services are offered through Crow Bar Investment Services, a registered investment advisor. In addition, the disclosure will also state whether the two firms are affiliated.
Let’s focus on the two types of advisors, registered representative (RR) and investment advisor representative (IAR), and how the advisors are regulated and compensated.
The registered representative (RR) is registered with a broker-dealer and regulated by FINRA. The primary regulatory criteria for FINRA is based on the concept of suitability. Because the RR is acting on behalf of a broker-dealer, the RR is either selling something for someone else or selling something out of the dealer inventory. In either case, this is a transaction based relationship, and the RR is paid a commission on the sale of the security.
FINRA and the broker-dealer are responsible for determining whether the sale was suitable for the investor at the time the sale was made. All security products sold by a registered representative are some form of a commission product, and the sales transaction is held to a suitability standard. Furthermore, all insurance products are designed for a transaction based relationship and pay commissions.
The supervision of investment advisor representatives (IAR) affiliated with registered investment advisor is based on a fiduciary standard. The regulatory framework for this standard is from the Security Exchange Commission along with the state. Because fees are charged for their advice, IARs are prohibited from receiving commissions as part of their compensation. Therefore, IARs are considered fiduciaries. Per the SEC, “As an investment adviser, you are a ‘fiduciary’ to your advisory clients.This means that you have a fundamental obligation to act in the best interests of your clients and to provide investment advice in your clients’ best interests.”
So there you have it. Pay commissions and hope your decision was suitable for your situation. Or pay commission-free, on-going fees and establish a collaborative relationship based on a fiduciary standard.
