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Box O' Reps

It has been an embarrassing time for most big Wall Street banks. In the third quarter of 2007, NYSE-reporting firms posted their worst quarterly performance on record, collectively amassing $3.8 billion in losses. Of course, their balance sheets look even worse. All in all, more than $100 billion has been written off and more damage is expected in 2008. But buried in the bad earnings reports was some

It has been an embarrassing time for most big Wall Street banks. In the third quarter of 2007, NYSE-reporting firms posted their worst quarterly performance on record, collectively amassing $3.8 billion in losses. Of course, their balance sheets look even worse. All in all, more than $100 billion has been written off and more damage is expected in 2008.

But buried in the bad earnings reports was some good news: In many cases, the retail brokerage units of the national brokerage firms performed better than they ever have. At some of the firms, records were set in net revenues and pre-tax income. Asset flows, revenue per financial advisor and pre-tax profit margins also topped previous highs. There can be no doubt: The investing public has come to value financial advice, making wealth management (as retail brokerage is now called) one of the few bright spots in a truly bleak reporting season.

But is retail's performance good enough? Should wealth management in the United States be even more profitable to firms and their shareholders? Compared to their European counterparts, the profitability of U.S. wealth-management operations has a long way to go. In September, a 100-page-plus research report by Bear Stearns International analyst Chris Wheeler took stock of the global wealth-management industry, specifically comparing the European wealth-management arms of firms like UBS, Credit Suisse and HSBC to those of the U.S. wirehouse firms. The Europeans are more profitable (as measured by pre-tax operating profit margins), according to Wheeler, who writes, “The European model continues to prove its worth” and that European firms are “pulling away from their U.S. competitors.” Wheeler did not return requests for comment, but he describes in his report a variety of reasons for this performance superiority: Chief among them is the U.S. compensation model itself, a model that allows the advisor to keep about 40 percent (in some cases more) of the revenue he generates.

Under the salary-plus-bonus arrangement, the firm keeps more of the revenue. The tradeoff for advisors is that salaries are more predictable than, say, commissions. But it's unlikely U.S. advisors would give into such a compensation plan, which makes this nightmare scenario (for advisors anyway) improbable for advisors at U.S. brokerage firms, according to Wheeler. (Although some U.S. private banks like Citi Private Bank, for example, do use it). On the other hand, management and shareholders alike might favor it since such a scenario would drive up pre-tax profit margins. And profitablity is, and will continue to be, a major focus of firms and analysts. “While the U.S. will never move entirely towards the Swiss private banking model, the successful firms will succeed in ‘institutionalizing’ a greater proportion of their revenue streams,” writes Wheeler.


Not to set wirehouse advisors off on a conspiracy-theory funk thinking their firms are out to get their clients and cut advisor payout — but it's true that most firms would like to “institutionalize” retail client assets. This involves tweaking the advisor business model in an effort to improve profitability, “encouraging” them to work in teams and to sell banking products, such as loans, among other things. The industry's move towards a full-service, “holistic” wealth-management model (more like a European private bank) is designed to make assets more “sticky,” and revenue more predictable.

Institutionalization sounds ominous, with reps' fearing they'll become interchangeable agents of the brokerage, where the firm is central to the client experience. From management's perspective, institutionalizing client assets doesn't have to be so bad.

All the firms are devoting more resources to better train advisors on how to gather more of a client's assets, as well as serve each tier of clients more profitably. Fees are the preferred model, of course, but fees are more predictable for advisors, too. As mentioned, firms are encouraging advisors to form teams (with exceptions for top producers). This helps advisors more efficiently serve clients, and allows younger advisors to learn the ropes from veterans — both positives for advisors as well. But it also inevitably means that firms are more likely to hold on to clients and assets when one team member departs.

Firms are encouraging advisors to make use of an increasingly diverse and more profitable product line-up from mortgages, deposit programs and other banking products, as well as an array of alternative investments, many of which pay a smaller percentage of revenue to the rep (much of the revenue is off the payout “grid”). Debt and assets in proprietary alternative investments are harder to move should a client or advisor change firms. Additionally, some firms, such as UBS, are tying more incentives to asset growth as opposed to gross production, the traditional indicator of an advisor's success. So while it's not a European private bank you're working for, it just might be that they want it to look a little more like one — without the salary-plus-bonus.


Perhaps no other CEO in the U.S. wealth-management business fields as many questions from analysts regarding profitability as Marten Hoekstra, CEO of UBS U.S. Wealth Management. That's because while UBS' International & Swiss division rakes in billions of net new assets every quarter, and is the toast of analysts and the global wealth-management industry for its nearly 50 percent pre-tax profit margins, Hoekstra's U.S. Wealth Management is still trying to find its footing. Needless to say, Hoekstra doesn't like the comparison — or think it's fair. “The labor market and structure of the business [in the U.S.] is not going to change,” he says, referring to the higher prices European clients pay, and the far- lower incomes European advisors make. Three years into a five-year plan (2005-2010) to get U.S. Wealth Management to $1 trillion in assets under management and 20 percent pre-tax profit margins, the unit has $750 billion in AUM, and roughly 10 percent pre-tax profit margins — the lowest pre-tax margin among the five U.S. wirehouse firms (see chart at right). Bottom line, Hoekstra has his work cut out for him.

And while Hoekstra says salary-plus-bonus wouldn't fly in the U.S., his firm has taken a step towards challenging the American “grid”-compensation model — an effort Wheeler equates to “fighting City Hall” in his report. Instead of rewarding reps for gross production, its elite “clubs” (called President's Council, or Chairman's Council, etc., at other firms) reward reps for new asset growth. An advisor whose gross production goes up this quarter, but whose net new assets were flat, would lose his “club” status, something no other wirehouse firm currently does. Only a small percentage of a rep's payout — at the most, 8 percent — is affected, but reps don't seem pleased. Advisors at UBS rated their firm the worst in payout in 2006 and 2007 in Registered Rep.'s “Annual Broker Report Card” survey. Advisors — always a paranoid bunch — don't like the trend. (One top veteran advisor summed it up neatly: He said he fears the Swiss parent company is going to turn advisors into “asset caretakers,” like the Swiss private bankers, but he allowed that it likely wouldn't “happen while I'm alive.”) But Hoekstra is clear: To improve profitability, the firm has to grow scale, and that means gathering new assets. “Five years from today, compensation will be more weighted to growth rate and client satisfaction,” both of which can be defined by asset growth, he says.

Analysts have long considered the U.S. brokerage-compensation model problematic: Morgan Stanley analyst Chris Meyer wrote a 40-page report in 2005 that said advisor compensation “destroys the operating leverage in the business, and results in mediocre returns compared to the Swiss offshore model.” Sanford Bernstein analyst Brad Hintz calls advisor compensation “the primary issue” for margin performance at U.S. brokerage firms, and a precarious “problem of balance” between shareholder interests and those of the thousands of brokers. That said, he laughs out loud when asked if salary-plus-bonus is likely in the U.S.

The most recent and best example of what happens when you mess with the payout of a large national brokerage force is what took place at Smith Barney over the last 12 months. The firm has suffered above-average attrition during that period, at least partly due to a perception among brokers that they were to be paid less under a new compensation plan being rolled out. Sallie Krawcheck eventually stepped in and fixed the payout, stemming the flow of reps out the door. “But it's still a sensitive topic around here,” says one veteran. And salary-plus-bonus “is always a fear,” he says. But with nearly 75 percent of his revenues from fee business and more than $1 billion in AUM, he's hardly a drag on Smith Barney's profitability. “This is America. If salary-plus-bonus happened, everyone would leave. I could walk across the street or open my own business and pay myself whatever the market would allow,” he says. And while private bankers may have a more exclusive clientele — no $50,000 IRA accounts — they're looked down upon for a lack of entrepreneurial chops. They don't eat what they kill. “The top guys at Smith Barney make $8 million or so,” says the Smith Barney advisor. “The best bankers might make $1 million.”


Chris Meyer's research report outlined the ways he thought U.S. brokerage firms could alter the effects of such a profit-sucking compensation model in his report titled, “U.S. Retail Brokerage: Flawed but Improving.” And it is, in fact, improving. “If you look at a snapshot of the last five years, the improvements have been tremendous,” says McKinsey partner Alok Kshirsagar. One indicator is surely fee-based assets, which according to Cerulli Associates, have more than doubled from $744 billion in 2002 to $1.93 trillion through the first half of 2007. (Note: This figure includes assets in separate accounts, mutual fund-advisory programs, rep-as-portfolio manager programs, rep-as-advisor programs, fee-based brokerage and unified managed accounts.)

Teams, which were unique five years ago, are increasingly the norm, according to spokesmen at all five wirehouse firms. And for good reason: They're more profitable for advisors and firms while ensuring a limited impact in the event of client or advisor attrition — unless of course, all the advisors leave with all the clients. Members of teams typically generate more revenue than their single producer counterparts do. In fact, a recent wirehouse study published in December on, shows that advisors who work within teams pull in approximately 25 percent more production, and up to 35 percent more assets per team member compared to advisors practicing alone. Teams also allow junior and senior advisors to divvy up client accounts by complexity, and encourage specialization among advisors — investment guy, marketing gal, etc. — which increases the efficiency of the team.

The more profitable banking products are increasingly important to the advisor product mix. CIBC Markets analyst Meredith Whitney discussed profitability with Morgan Stanley's James Gorman in 2007, a year after he was hired to turn the firm around. Given the inflexibility of the compensation model, Gorman emphasized higher-margin, spread-based lending products as key drivers of profits, writes Whitney. Morgan's pre-tax profit margins have improved dramatically since Gorman arrived (see chart p. 36).

One Smith Barney advisor says the firm is definitely encouraging banking products — more loans, credit cards, etc. And he's a picture of success in this area: He did nearly $50 million in mortgage business last year. “We can close a mortgage in 45 days,” he says. The advisor gets 40 basis points for every successful mortgage initiation until the fourth, at which point the advisor gets 60 basis points. “I don't know how much the firm is making off that, but it's a lot,” he says. Yes it is. According to Meyer's report, most of the revenue from banking products like mortgages doesn't fall on the advisor's payout grid, so instead of 40 percent of the revenue, the advisor is getting closer to 15 percent, he says.

Bank deposit-sweep programs are similarly profitable, paying lower rates to clients — between 1 and 2 percent — than traditional money-market funds. But unlike money- market funds, these deposits rest on a firm's balance sheet, allowing it to reinvest those funds and make a profit. Merrill Lynch, which declined to comment for this story, pioneered deposit sweeps in 2000, and made roughly $2 billion in profits from its program in 2006. (An advisor typically gets 20 basis points on client cash “swept” into these programs.) James Gorman, who helped create Merrill's sweep program, has had similar success at Morgan Stanley: Only a few years old, Morgan's sweep program gathered $13 billion in 2006, and raked in $26 billion in 2007. But the profits these firms have enjoyed haven't gone unnoticed: Morgan Stanley, Merrill, Schwab and Smith Barney were all sued in the summer alleging inadequate disclosure in these programs.

Still, the margin improvements may be worth the risk: In his report, Morgan Stanley analyst Chris Meyer estimated that every 5-percentage point improvement in the mix of bank products to a firm's business adds 1 percentage point to operating profit margins. He used the example of Merrill Lynch, which in 2001 began focusing its advisors on mortgage origination and its new bank deposit-sweep product. Between 2001 and 2003, says Meyer, operating margins increased by 8.4 percent, half of which he attributes to this new emphasis on bank products. Further, he estimates advisors can improve their productivity by as much as 20 percent to 30 percent by selling a higher percentage of bank-based products.

“There are, say, 1,000 advisors at each of the large national firms that are driving the vast majority of net asset flows,” says McKinsey's Kshirsagar. “Unfortunately, that's only 10- percent-plus of the force.” But less profitable advisors may just need to be shown a thing or two, says Kshirsagar: “I don't think there's a problem with the compensation model in the U.S.,” he says. “It's more a function of advisors not getting the support they need to maximize the profitability of the model — for themselves and the firm.”


Profitability metrics of advisors at U.S. and European wealth managers: Annualized revenue/AUM per FA by firm.

Firm 1H 2007 2002
Morgan Stanley $775,000/$89.5 million $324,000/$41 million
UBS U.S. WM 696,000/95 million 563,000/55 million
Wachovia 832,000/96 million 658,000/55 million
Smith Barney 648,000/104 million 463,000/60 million
Merrill Lynch 867,000/105 million 628,000/79 million
UBS Intl. & Swiss 1,970,000/200 million 1,873,000/179 million
Credit Suisse 2,741,000/247 million 2,021,000/156 million
Source: Bear Stearns International analyst, Christopher Wheeler


Most of the domestic wealth-management firms have seen substantial increases in pre-tax profit margins. But then so too have most of their counterparts abroad.

1H 2007 2006 2002
Wachovia 26.7% 24.4% 18.6 %
Merrill Lynch 26.4 20.5 12.1
Smith Barney 22 18.9 22.3
Morgan Stanley 15.8 9.2 2.7
UBS U.S. WM 10 9.9 -24
Credit Suisse 41.8% 39.6% 26.8%
HSBC 45.4 41.4 38.5*
Deutsche Bank 30 30 30*
PWM Julius Baer 33.3 27.8 33.6*
Source: Bear Stearns International analyst, Christopher Wheeler


More profitable fee-based accounts continue to attract assets.

% Assets in Fee-based accounts fee-based revenue as a proportion of total revenue
Merrill Lynch 39% 49%
UBS U.S. WM 35 61
Smith Barney 29 51*
Morgan Stanley 29 27
Wachovia 20** 61**
Source: Bear Stearns International analyst Christopher Wheeler
**company spokesman
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