March 11, 2003

The Truth About Wealth Management Part II

In the last issue of Practice Edge, we examined the current sentiments in the advisor marketplace concerning wealth management, as well as the key trends driving advisors to expand their practices and offer a holistic range of wealth management services.

In this issue, we discuss those considerations in more detail and address the challenges facing advisors in building a successful wealth management practice. We also examine the financial makeup and best business practices of a typical wealth management firm.

For any advisory firm aspiring to become a wealth manager, there are three primary considerations:

  1. Demand: Is there a need among my clients for my wealth management services?
  2. Economics: How will this affect my financial performance?
  3. Products and Services: Will I able to offer these services competently to my clients, and should I do wealth management in-house or outsource some or all of it?

Demand

While offering wealth management services will most certainty increase your chances of attracting new and bigger clients, it is critical to understand that your existing client base is the sole market for your new wealth management services in its early phases. There is no point in incorporating into your practice an executive compensation advisory service, for example, if none of your current clients are executives with complicated compensation packages. The potential that this new service will lure new executive clients does not alone justify the cost, time, and risks associated with adding such a service.

Therefore, you should first determine which clients might potentially need your new services; what kind of services they are likely to require; and to what degree or how often they are likely to utilize such services. If you know your clients as well as successful advisors should, then you probably have the answers to some of these basic questions. But then again, if you're aspiring to become a wealth manager, you likely are currently offering a narrow range of services, such as investment management, and are not deeply involved in the rest of their financial matters. But the fix for that is rather simple: Ask them. Survey your clients, especially the big ones, and learn more about their other financial needs beyond the current scope of your services. Once you quantify the demand, zero in on the specific range of services they need. Do they just need estate planning and tax planning? Or Do some of them require more sophisticated trust services and business advisory counseling? After you have gauged and confirmed the need for your new services, move on to the next step: determining the financials.

Economics

Before we delve into the financial aspect, remember this equation: if you determine that offering a new service, such as tax preparation, will be profitable to your firm, but none of your clients demand it, then don't offer it. However, if you determine that your clients demand tax preparation, but you conclude that there is no clear profit potential in offering it, then do consider offering it. What, operate at a loss? No, we're not suggesting that. Offering your clients an additional service that they need--provided you can do it competently, which we will discuss in the next section--will pay off in more ways than immediate profits. For one, your client retention rate is likely to increase. More directly, however, you may be able to increase your AUM fees under an all-inclusive type of pricing in light of these added services. To be sure, as chart 1 below shows, according to AdvisorBenchmarking.com research, the average wealth management firm (defined as one offering two or more services) charges average AUM fees of 1.21%, compared to 1.12% by the average single-offering advisory shop. For a firm with $50 million in assets, this nine-basis-point difference amounts to $45,000 in additional revenues. (See Chart 1: Average AUM-Fees)

On that note, there are various pricing options available to advisors offering comprehensive wealth management. Most wealth management firms usually offer a combination of the pricing models listed below to the same clients or offer different pricing models to different clients, based on their size and other factors:

  • All-Inclusive Fee: An AUM fee that gives clients access to the entire range of wealth management services. This fee should be higher than what would otherwise be charged for asset management only.
  • Two-Tier Pricing: Certain clients are charged an all-inclusive AUM fee, while others who require fewer service or only one service (usually asset management) are charged a lower fee. Those clients would have to pay separate project fees if they ever need additional services.
  • Project Fees: Charged to all or some clients who require separate services beyond asset management. As mentioned in the two-tier pricing model above, clients who pay an all-inclusive AUM fee do not get charged project fees.
  • Retainer: Clients who meet a certain asset size requirement may pay a fixed dollar amount upfront, in addition to or in lieu of an AUM fee, that covers the entire range of services.

No matter which option you choose, new wealth managers have to make sure their clients understand that their value extends beyond asset management. Charging a retainer, a trend that has been on the rise lately, is one pricing model that serves to boost the perceived value of the advisory firm since it takes the focus away from asset management as being the main determinant of cost to the client.

The more crucial economics question to ask, though, is this: How will offering wealth management services affect my firm's profitability? Below are a series of charts comparing the average wealth management firm against single-offering firms in areas of financial performance and organizational structure, based on 2001 financial performance data from AdvisorBenchmarking.com. The data reveals much about the financial make-up of wealth management firms. (See Chart 2: Average Assets Under Management, Chart 3: Profits, Chart 4: Profit Margins, and Chart 5: Number of Employees.)

As the charts above show, the average wealth management firm is much larger than the single-offering shop ($129 million in assets vs. $79 million) and employs 14.7 associates compared to 6.3. Needless to say, this is not to suggest that your firm will balloon in size over night, but it's a clear indication of the growth potential of offering wealth management services. Further, one notable statistic not shown above that further suggests this growth optimism is that the average wealth management firm has a business tenure of 7.1 years versus 6.4 for the single-offering firm. This minute difference in tenure indicates that the large asset size and number of employees of wealth management firms are not simply driven by their longevity in the business.

Not surprisingly, the average profit margin for wealth management firms is higher (24.25% vs. 21.22%.) This is directly attributable to the higher fees charged as mentioned earlier, 1.21% vs. 1.12%. With such a broad array of offerings, wealth managers can justify this higher fee and garner healthier bottom lines accordingly. In 2001, the average wealth management firm saw net profits of $378,049 versus $187,033 for the single-offering firm.

Products and Services:

Provided you were able to properly address both the demand and the economic considerations discussed above, the next critical question is this: How you are going to offer these new services? The two choices are simple, do it in house or outsource some or all of it to third parties. Either path offers its pros and cons, although most wealth management firms (81.2%) outsource at least one service to an outside expert. Once again, we need to point out that the range and degree of services you offer should be predicated on your earlier assessment of demand and profit potential, including the costs associated with the new services.

Providing the services in house will probably entail hiring additional specialists and more support staff. As shown earlier, the average wealth management firm has 14.7 employees, 7.7 of which are dedicated support staff. But the quality, not the quantity, of those specialists is what matters most. You need to hire and retain the best talent, as well as ensure that they operate efficiently within your firm and when interacting with clients. Of course, you can offer the service without any additional hiring if your firm already has the necessary expertise.

The typical wealth management firm has multiple client teams consisting of a relationship manager, usually a principal, and a client specialist who acts as the project manager directing the client's needs to a pool of specialists, including attorneys, portfolio managers, analysts, and so forth. Some key advantages of having those specialists in house include the control you're likely to have over the client relationship, as well as the coordination of duties amongst the various firm members. Last, but by no means least, having the specialist in house means added revenue, as separate project fees performed by that specialist will go to the firm instead of to outside parties. On the downside, there are certain liability and client-alienation risks that should be considered, especially when launching the new service without having extensive experience in the subject matter. An outside estate attorney who handles hundreds of such cases a year is likely to be less prone to making an error in drafting an estate plan, for example.

Outsourcing some or the entire range of services to an outside party also has its share of advantages and disadvantages. On the positive side, these experts are likely to provide better advice in their respective fields, reduce your chances of liability, pose no direct cost to your firm, and are replaceable fairly quickly if you're not satisfied with their performance or if you decide to back away from offering their relevant services to your clients. On the downside, outsourcing means that the special-project fees will go to pay for those experts and your profit potential will be limited to the additional fees, if any, you charge to your clients. Further, it is nearly impossible to ensure as much control over their interaction with your clients when they're not part of your firm. Lastly, while those experts might be well-versed in their fields, there is no guarantee that they will offer your clients the same level of personal attention and handholding that you provide and might even alienate clients. All in all, whichever path you choose, it should be a clear function of your firm's overall business strategy, mission, and long-term goals.

In summation, the decision to become a wealth manager is not an easy one. The demand for the new services, the profit potential, as well as your ability to offer these services as competently as your other core services are all important considerations to make before you jump on the bandwagon.

Stay tuned for more research on Wealth Management from AdvisorBenchmarking.com. To benchmark your practice against other advisors and wealth managers, log to www.AdvisorBenchmarking.com and participate in our confidential survey.

To receive a customized benchmarking analysis report of your practice, visit the free online tool www.AdvisorBenchmarking.com

AdvisorBenchmarking.com is a free online resource of research and analysis on the RIA marketplace. The service is aimed at helping advisors grow and enhance their practices. By participating in the online surveys, advisors can see how their businesses fare against other advisors, as well as learn best practices based on the most successful advisors in the business. The instant analysis they receive offers valuable insight that can help them take their practices to the next level and weather the challenging market conditions.

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