WealthManagement Magazine

The Winner's Curse

There is trouble brewing in independent broker/dealer-land. Operating costs are rising, recruiting efforts for advisors are starting to resemble an arms race and marginal reps will continue to be culled. In short, independent b/ds face the broad challenges that financial services firms of all kinds face. But there is a problem unique to the independent b/d. Many advisors independent b/ds recruit have

There is trouble brewing in independent broker/dealer-land. Operating costs are rising, recruiting efforts for advisors are starting to resemble an arms race and marginal reps will continue to be culled. In short, independent b/ds face the broad challenges that financial services firms of all kinds face.

But there is a problem unique to the independent b/d. Many advisors independent b/ds recruit have unrealistic expectations. “The dream of every advisor is to find the support of a Merrill Lynch and the payout of an LPL,” says Philip Palaveev, an analyst at Seattle-based consulting firm Moss Adams. But, he warns, that dream combination of support and freedom isn't possible for all — it is reserved only for the best, most productive reps.

At least that's the way the trend will be moving in 2006, experts predict. FAs want everything: They want full technical and marketing support, as well as help understanding products and asset managers when needed. And, the largest independent b/ds have been able to give it to them. But in the future, that may be a tall order to fill. Some independent b/ds — the ones with a few hundred reps or less — are being forced to figure out which level of core services they offer that can't be cut, in order that may charge their independent contractor reps for the rest.

Cottage Industry No More

Independent b/ds have had a nice run over the last decade. The average independent b/d's revenue is now around $94 million, according to a recent survey by Moss Adams for the Financial Services Institute (FSI), the trade group representing independent b/ds. That's a three-and-half-fold jump from 1995, the first year of the annual survey, when the average annual revenue was $28 million.

“Those that started as relatively small and ambitious firms 10 years ago are now large and well-established competitors in the securities industry,” Moss Adams says.

Their growth is a function of the success of the individual independent advisors: In 1999, the average independent b/d rep's practice grossed $55,000 in revenue. Today, that's close to $100,000. Independent b/ds in the FSI study, which surveyed 49 of the largest independent b/ds, work with, on average, 40,000 advisors who have 1.2 million clients.

“Independent b/ds who started 10 years ago by providing the compliance infrastructure necessary for advisors to be independent have now become sophisticated resource partners, offering a rich platform of fee-based solutions, wealth-management capabilities, marketing support and practice management,” the report concludes.

And therein lies the problem, experts say. The trouble now, after a decade of strong growth, is that independent b/ds still run a high-volume, low-margin business, yet they offer much higher-touch services. On average, independent b/ds netted an operating profit margin of 1.4 percent in 2004, the FSI/Moss Adams report says. That's breathtakingly thin, but an improvement over the rough patch of 2001, 2002 and 2003, when the average independent b/d lost money. Put another way: Independent b/ds' payouts may be too large and might be in need of a trim, at least for some producers, says Matt Bienfang, senior analyst at Needham, Mass.-based TowerGroup. Indeed, independent b/ds pay out an average of 82 percent of their reps' production, according to Tiburon Strategic Advisors, a Tiburon, Calif.-based consulting firm. (Moss Adams puts the average higher — around a 85 percent-to-90 percent payout.) Either way, off the top, the average independent b/d keeps about 10 cents to 18 cents of every revenue dollar its independent-contractor reps generate. “What can you do with a dime?” Palaveev asks.

All but the biggest independent b/ds then are forced to keep overhead low. As FAs demand more and more support, independent b/ds' have had to add additional support staff. Next to rep compensation, internal-employee pay is most expensive, eating up about 60 percent of an independent b/d's revenue. And that's just support staff. Consider the new compliance needs. Five years ago, there was one home-office compliance person for every 100 reps, Moss Adams says. Today, there is, on average, one for each 50. In addition, the number of supervisors — or OSJs (the independent b/d's equivalent of a branch manager) — in the field has doubled in that time.

Play Change

The game for the independent b/d has changed. “To compete and be successful, you have to be large. It's almost grow or die,” says Palaveev. Or, alternatively, if you're a small independent b/d (less than $100 million in annual revenue) and you want to remain independent, you're going to have to offer unique features to your FAs, like a customized platform so FAs can use their own asset managers, planning software, etc. Without deep pockets to offer big upfront bonuses, how else will independent b/ds attract the $300,000-and-up producers that everybody is gunning for?

TowerGroup's Bienfang believes the independent b/d model is facing a serious challenge. “The bottom line is that operating expenses are getting to be prohibitively expensive,” he says. “What charges can they pass along [to their reps]?” He says that independent b/ds were good at making money around the edges on things like directed trades, back when it wasn't looked over by regulators. And, “They're also good at billing back the reps for services like tech fees, licensing fees and, if the reps are getting hard copies of statements, they'll charge for that too.” But he points out that those measures are getting increasingly difficult to continue since there are many more services available and reps will only take on so much.

Tiburon finds that increased compliance costs are squeezing the margins of these firms, but the numbers above add more than just regulation costs to the profit problem. The independent b/ds are going to have to put extra pressure on its reps to up their production if it wants to increase those margins. Still, Beinfang says cutting payout will probably be necessary very soon. “Should [independent reps] be expecting to get paid that much with all the regulation costs out there? I don't think so. It's just going to take a couple of guys to say, ‘this model just doesn't work.’ They don't have any cushion to deal with this kind of payout. Once one firm does it, the others will fall in line and average payout will drop,” he says.

Soon advisors are going to start to focusing less on gross payout and on more what they are getting from their independent b/d. “Are they helping me make money?” Palaveev asks. “Reps will have to balance support versus payout. They will have to leave some money on the table for the b/d,” he says, otherwise the independent b/d will be forced to squeeze it out in other ways, like preferred arrangements with fund managers, proprietary product pushes or in any number of ways. One nice trend advisors can hope for: Perhaps independent b/ds will give up some of the recruiting and instead focus on the advisors they already have.

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