September 21, 2006 A PRIMEDIA Property
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Brokerage Firms and Their FAs: Fighting for Dollars

By John Churchill


The retail brokerage model in the U.S. is flawed. Why? Because advisors get too much of the revenue pie. That's right, advisors are making too much money, the firms too little, and it's dampening industry operating margins.

At least that's the conclusion of a report published recently by Morgan Stanley, titled U.S. Retail Brokerage: Flawed but Improving. The report argues that operating leverage in the U.S. retail model is being squashed by the amount of money going to FAs, resulting in mediocre returns for firms.

It's the age-old push and pull between manufacturing and distribution, says one commentator. Put another way, the argument continues over who owns the client: the firm or the advisor?

What's the problem for the firms? The advisors control the client relationship, says André Cappon, principal and co-founder of the CBM Group, a New York-based consulting firm to the financial services industry. "Most of the value in this business -- the revenue -- ends up in the pockets of the distributor. Why? Because if it doesn't, he can pick up and take 80 percent of his assets to LPL or another independent," says Cappon.

The exception, says Cappon, is Merrill Lynch, where departing advisors manage to take only between, on average, 40 percent and 50 percent of their books with them. That's because Merrill has managed to create a brand that retail clients value and trust -- even, apparently, over their relationship with their advisor.

Because of the sticky relationship with their clients, Merrill can demand to keep more of its advisors' revenue. And it shows: Merrill enjoys higher operating margins, of between 18 percent and 20 percent, says the report. By comparison, the average operating margin for full-service brokerage firms in 2004 was a paltry 15 percent, although Smith Barney also enjoyed Merrill-like operating margins. In contrast, the average for regional brokers A.G. Edwards and Raymond James was only 12.6 percent. The RIA world is significantly better: A typical fee-based practice has 23 percent operating margins, according to the 2005 FPA Compensation and Staffing Study, put together by industry consulting firm Moss Adams.

But compared to the 30-plus percent margins seen in asset management, prime brokerage and trading, and the 50 percent at Swiss private banks (UBS, Credit Suisse) in their offshore private client businesses, those numbers are measly, says the report. "Retail brokerage in the U.S. suffers from the fact that the financial advisor has been garnering an increasing share of the economics at the expense of the retail brokerage firm," says the report.

So advisors are making off like bandits, eh? Payout ratios for FAs now average above 41 percent, according to the SIA. Recruiting packages for top producers fetch as much as 120 percent of trailing 12-months production in upfront signing bonuses (compared to 70 percent to 100 percent as recently as five years ago), the report says. It gets worse for the firms if you factor in that 10 percent of FAs quit or are fired every year. On average, it takes a firm five to seven years to recoup its costs for a rep producing $425,000 per year. And the economics for trainees is about the same.

"Break-even economics for recruiting and training is not attractive...the retail brokerage firms are big losers," say the analysts.

Philip Palaveev, a senior analyst at Moss Adams, doesn't think payouts have gotten out of hand, but agrees firms have become "overly enthusiastic" with recruiting packages. "It's the 'winners curse' -- the highest bidder is quite often the loser, overbidding the value of the item," he says. "The firms need to ask, 'What are we getting for this cost?' -- because they're certainly providing motivation for advisors to keep switching firms."

That said, at the leading firms -- the report names Merrill Lynch, UBS and Smith Barney -- "the quality of the retail brokerage model is improving," according to the report. These firms use bank products like mortgages and deposits that pay closer to 15 percent of revenue to advisors (instead of 35 percent or 40 percent with stocks and mutual funds), and they are increasing average productivity by cutting the bottom producers. Additionally, fee-based revenues at these firms now account for nearly 50 percent of total revenue, and teams of advisors -- "that make revenue streams less associated with individuals and more with the brokerage firm itself" -- continue to grow.

Finally, the Morgan analysts say, "the industry needs to consolidate" to further improve margins. Interestingly, the analysts say economics of scale could be had by two 10,000-plus advisor firms coming together. Such a merger would improve operating margins by as much as 5 percent, they reckon.

Or perhaps more firms will rid themselves of their advisor forces -- like American Express and Legg Mason did this year. "With more full-service brokerages looking at open architecture, I think you're likely to see more separations between manufacturing and distribution," says Palaveev. "And reports like these will force the issue -- investors are going to read them and demand to know from directors, 'Do we really need distribution?' " (For more, see Registered Rep.'s August cover story.)



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Charles Schwab Drops Service, Order Fees
In a nod to the smaller investors who gave the firm its early success, Charles Schwab Corp. has eliminated its remaining account service fees and its $3-per-order handling charge on equity trades.



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Merrill Gets Advest Cheap
Merrill Lynch reportedly paid $400 million for the purchase of the Advest Group from AXA. The purchase includes the private client group, an asset management arm and a capital markets group. According to analysts, Merrill got the firm cheap.



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