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The Money Squeeze

There's one thing that stands between the big retail brokerage firms and the high profit margins that the executives of these firms and their investors seek: the financial advisor. Yes, the wirehouses including embattled Morgan Stanley have wrapped up another healthy year, but much of the success is due to M&A activity, proprietary trading and investment-banking revenue. The health of retail brokerage,

There's one thing that stands between the big retail brokerage firms and the high profit margins that the executives of these firms and their investors seek: the financial advisor. Yes, the wirehouses — including embattled Morgan Stanley — have wrapped up another healthy year, but much of the success is due to M&A activity, proprietary trading and investment-banking revenue. The health of retail brokerage, meanwhile, is improving going into the fourth quarter, according to analysts, but management continues to focus on the costs of retail marketing. FAs, who already have been squeezed by lower compensation, higher quotas and rising ticket charges, can look forward to more pressure as firms continue to try to boost the bottom line.

Indeed, between big bounties to haul in top brokers, training costs for new recruits and broker turnover, the costs of maintaining an army of financial advisors threatens to “destroy operating margins” at brokerage houses, concludes Morgan Stanley analyst Chris Meyer. In a September report on the sector, Brokers and Asset Managers: U.S. Retail Brokerage: Flawed but Improving, Meyer says the firms are getting some things right: doing more fee business, further institutionalizing client relationships and generating more revenue from products like mortgages. Alas, it's a pity that the “flaw” in the U.S. retail model is still “that the financial advisor extracts too much of the economics and leaves enough to generate only mediocre returns for the retail brokerage firm,” Meyer says.

Brad Hintz, a Bernstein & Co. research analyst, agrees that the cost of reps is a performance issue for the firms, but also says the firms are in a tricky position. “It's really a problem of balance, and it isn't easy, I wish there was an easy answer,” he says. “Management has to balance broker happiness with stockholder happiness — if you give reps too much, there isn't enough for stockholders. If you don't give them enough, you're going to feed the growth of the independent broker/dealers.”

Bonus Inflation

Meanwhile, recruiting costs have gotten out of hand, the Meyer report concludes. The top 50 percent of reps account for 80 percent of the revenue, and they can command huge sign-on packages. According to industry recruiters, million-dollar producers with growing businesses are receiving between 100 percent and 120 percent of trailing 12-months production. According to the Morgan Stanley report, that's an escalation from five years ago when the package was between 70 percent and 100 percent, and 10 years ago when it was 50 percent to 70 percent.

But this bonus arms race, combined with an industry turnover rate that the Securities Industry Association says was 14 percent in 2004 (high, but down from 19 percent in 2003), “destroys the operating leverage that a business with such a high fixed cost should enjoy,” Meyer says. Because of the large upfront payments, even “good” producers (those with production of $600,000 a year or more) can take five to seven years in production to produce net profits for the company (top producers take four to five years). The report says a rep staying beyond the typical five-year “lockup” agreement and reaching profitability is “by no means a high probability event.” The net result of lush recruiting packages and high attrition rates, says the report, is that a “typical retail outfit” with 10,000 advisors, will experience a nearly 6 percent drag on margins over six years.

But, in a race to get more assets under management, firms are not likely to stop throwing money at reps with big books. “At the top they're going to get more and more,” says one former Merrill branch manager. “It's the average Joe Broker who is going to get less and less,” he adds. Recruiting packages may cost a lot of money, but they solve a temporary problem, he says. “In this environment, when a branch is told to increase revenue, that translates directly into, ‘Go recruit some big guns.’”

But if throwing money at top reps is a necessary evil and not likely to abate, then firms will have to keep cutting from the bottom. Most recently, Morgan Stanley chopped 1,000 of its lower-end reps in an effort to reverse a profit slide. Pretax profit margins at the firm were barely 12 percent in the first half of this year, and have been the lowest among the wires for several years. Many firms are also requiring trainees to meet production minimums within one year now, instead of two, says Frank Fernandez, chief economist at the SIA.

Middle Ground

“The firms are paying out too much — but really only to the biggest and smallest reps,” says Rebecca Pomering, a principal with Seattle-based consulting firm Moss Adams. “It's the ones in the middle that are easier for them to support,” she says. Calculating how much of the compensation goes to each quartile isn't easy since firms have different grids, different pricing on products and services and even segment their reps differently. But according to the Morgan Stanley report, as a percentage of total revenue, a “typical brokerage outfit” follows an 80/50 rule: The first, second, third and fourth quartiles account for 50 percent, 30 percent, 15 percent and 5 percent of revenue, respectively.

While supporting the middle may be easier for the firms, it does not mean they are making more money or are in hot demand. Nick Ferber, a recruiter with Sanford Barrows, says firms continue to raise the bar on expectations, and it's getting tougher to move anyone who's not at least third quintile. “I sent a $225,000 producer to one of the lesser wires — a rep with seven years of experience, $35 million in assets — and they didn't take her,” says Ferber, who adds that this no longer surprises him. “The branch manager said she wasn't profitable enough to justify the hire.”

Charlie Johnston, head of Smith Barney's private client group, says gross production per rep is the metric that the firm continues to put a “big focus” on. He guesses that rep break-even production is somewhere between $200,000 and $250,000, but stresses that merely breaking even is not acceptable. “If you want robust margins, you have to keep growing gross production per FA,” he says. According to research compiled by Guy Moszkowski, an analyst at Merrill Lynch, Smith Barney's private client group is in third place among the wires in this category with roughly $546,000 (as of the first half of 2005) in average annual production per rep. However, the firm's profit margins — nearly 22 percent for the past two-and-a-half years — are the best in the business, and have led the brokerage field by a substantial margin for the past few years.

One UBS broker in the south says he's worried how much longer he'll be considered an asset, not a liability. He was a $400,000 producer at A.G. Edwards three years ago, but has been stuck just above $300,000 since coming to UBS. Currently, $250,000 in production puts a rep in the “penalty box,” at which point they get a 25 percent payout on everything. Right now his payout, based on the grid, is about 35 percent, he says. But, in reality, he gets about 30 percent after various charges. His business is 30 percent fees, which helps a little — UBS brokers get a 4 percent kicker on fee-based business — but reps expect the firm to level out the grid in January, which may put an end to that. “Muni-bonds don't pay anywhere near what they used to, commissions on B and C shares have been slashed — in addition to caps being put on how much money you can put in them — it's more work for less pay these days,” he says.

What Goes Up?

Reps like this guy don't take kindly to the idea that their payouts are too high, as the report states. According to the report, average payouts across the industry have “risen in the last five years despite the bear market in equities.” While that may be true, average compensation has not: “Compensation has actually been falling since 2001,” says the SIA's Fernandez, “and the rate of compensation has been falling longer than that,” he says. But at the top — among CEOs, top management and top producers — compensation has been growing. “You have to keep the people who really drive revenue to the bottom line and you do that by paying them more,” says Fernandez.

Pomering says that until firms and reps can truly differentiate themselves to clients and reps on service, instead of economics, all parties — the firm, the rep, the client — will likely have to compromise if margins are to stay up. “As it stands right now, firms are providing more and more services to an increasingly needy client without increasing fees at the same rate,” she says. “Either fees to the client must go up, or minimum production levels of reps need to keep going up.”


For better margins, firms pump up production, assets and trim operating expenses.

The chart below, supplied by Merrill Lynch equity research analyst Guy Moszkowski, shows the underpinnings of four of the five largest retail brokerage outfits (Wachovia Securities is not included) and what is driving (or ailing) profitability levels.

MWD Individual Investor Group Smith Barney Private Client Services Merrill Lynch Private Client Group UBS Wealth Management USA
2004 2005YTD 2004 2005YTD 2004 2005YTD 2004 1H05
Total Net Revenues ($MM) 4,615 3,721 6,485 5,044 9,831 7,852 4,245 2,259
Total Operating Expenses ($Millions) 4,244 3,389 5,016 3,973 7,958 6,295 3,632 1,928
Pretax Earnings 371 332 1,469 1,071 1,873 1557 613 330
Pretax Margin 8.0% 8.9% 22.7% 21.2% 19.1% 19.8% 14.5% 14.6%
Financial Advisors (Global) 10,962 9,311 12,138 12,111 14,140 14,690 7,519 7,474
Revenue per Average FA $418,632 $489,452 $532,758 $554,690 $711,360 $726,280 $555,477 $602,589
Operating Expense per Average FA $384,978 $445,782 $412,076 $436,911 $575,832 $582,264 $475,205 $514,448
Total Client Assets ($ Billions) 602 619 978 1,015 1,359 1,395 595 598
Total Client Assets per Average FA ($ Millions) $52.93 $60.23 $77.63 $82.19 $95.01 $95.53 75.39 $79.59
* 2005YTD is as of 3Q05 (8/31/05 for MWD and 9/30/05 for Smith Barney and Merrill Lynch)
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