From the January 2005 issue of Investment Advisor • Subscribe!

No Respect

RIAs may be Rodney Dangerfield to Wall St., but who's laughing now?

The implication is that fee-only advisors are so consumed with the "touchy-feely" aspects of working with clients that they forget about selling. That is part of the message of the fee-only movement--they serve their clients and they don't sell. That doesn't mean, however, that fee-only advisors aren't good business people.

In fact, many sales organizations tend to marginalize practitioners who do not overtly or aggressively sell for a living as being "not entrepreneurial." As a partner in a 90-year-old accounting firm, I find this especially amusing. How do they suppose firms like ours--the original fee-only business made up of non-sales people--have lasted as long and grown so large if we didn't have an entrepreneurial bent and weren't good businesspeople?

In the case of financial advisors, a look at the numbers shows considerable value in a business with consistent, predictable income. This is the kind of statement that will make commission-based advisors apoplectic, of course, but both sides can be quite self-righteous about which model is appropriate for their clients. That is not the point of my observations here, however. It's fair to say that both models work under some circumstances, but those who function in a traditional brokerage platform should be careful about their assessment of the competition lest they end up feeding a monster that will eventually devour them.

For instance, the results of our 2004 FPA Financial Performance Study of Financial Advisory Practices challenge the perception that fee-only advisors are not entrepreneurial. While fee-only advisors face challenges in practice management, the reality is that they accounted for most of the practices in our study that have more than $1 million in annual revenue, and many of the businesses we classified as elite ensembles based on their operating performance.

We compared four types of advisors: fee-only, who have no contingent income at all; fee-based, who are more than 90% dependent on fees for their income, but also derive some revenues from non-fee sources such as insurance commissions or 12(b)1 trails; commission plus fees, where compensation is a hybrid of fees and commissions; and commission-only firms. In looking at the data from our 2004 study, we found that both fee-only and fee-based firms far exceeded the performance of their more commission-based brethren. On average, the fee-driven practices generated more than three times the revenue of pure commission practices, and almost three times the operating profit.

The catalyst for this differential is leverage. Every business has two kinds of leverage: financial leverage--when a business borrows money to acquire assets and drive profits; and operating leverage--adding people or technology to serve clients and drive profits. The leverage differential in fee-only firms is nothing short of stunning. The commission-only firms, which averaged 200 clients per professional, typically had five times the number of active client relationships of fee-only firms. Yet fee-only firms demonstrated a higher level of productivity, generating $238,000 per professional staff member compared to $183,000 per professional in a commission-only practice. This is a very big swing and, in itself, would be a compelling argument for those who are still heavily transaction oriented to challenge themselves on their business model.

As if productivity per staff isn't enough, commission advisors should consider the economic relationship of the client in both models: The fee-only firms generated just under three times more revenue per client. Apparently, the nature of the relationship, the ability to be more holistic, to get deeper into the challenges that clients face, allows fee-only advisors to be compensated at a higher level for the services they provide. More likely, though, the ability of fee-only advisors to position themselve as a client advocate rather than one whose income may be dependent on the transaction is a real economic plus for those advisors.

Fee-Only Doesn't Equal Perfect

The results of the FPA Study are only a sample of the universe of advisors--if stacked up against the high-end producers at wirehouses, these numbers may take on a different look. But if the question is whether "fee only" is a legitimate practice model from an economic standpoint, the emerging evidence shows the answer is "yes."

That is not to say that all fee-only advisors are fabulously successful. Many have not achieved the critical mass, or created the leverage, or built a financial structure that will allow them to be effective competitors in an increasingly challenging business environment. There are real costs to being a fiduciary, which is a key difference between a fee-only RIA and a NASD-licensed registered rep. There are also real challenges in continuing to add value at a level that clients perceive justifies ongoing fees.

To measure how well they are facing up to these challenges, fee-only advisors need to concentrate their management focus on their gross profit margins and operating profit margins. The trend of these ratios observed over time can be important leading indicators for future financial performance.

A firm's gross profit is determined by subtracting its direct expenses (the amount paid in fair compensation to all professional staff including the owners) from its revenues.

Its gross profit margin, then, is measured by dividing that gross profit by its total revenues. For fee-only firms that participated in the FPA Survey, the gross profit margins tended to rise as the practices got bigger. This is an anomaly when compared to the profession in general, and illustrates the challenge for smaller firms.

Most smaller practices seem to suffer from a confidence problem in pricing their services fairly, and as a result, their gross profit margins suffer. More importantly, smaller firms are often drowning in opportunity and their productivity tends to suffer. The average fee-only practice showed a gross profit margin of 58%, meaning that for every dollar of revenue, they generated 58 cents of gross profit to cover their overhead costs and produce an operating profit.

While 58% isn't bad, it isn't good either, when you consider that at the same time the average fee-only firm also spent 42% on overhead--things like rent, utilities, administrative staff, marketing, and other indirect costs. That 16% operating profit does not leave enough left over to reinvest and adequately reward the owners for their risk.

The reason overhead costs at most firms are too high (35% is optimal) is either because they are not generating enough revenue to cover their infrastructure, or they have a problem with "creepers": the persistent problem of expense control that eventually cuts the throat of many small business owners. While encroaching overhead is always a problem, controlling them can only take your business so far. The better solution for fee advisors is to capitalize on their current momentum in the marketplace by charging more appropriately for the services they offer. With revenue volume up, and a gross profit margin above 60%, they have a much better chance of not being sucked down by an onerous overhead structure.

Of course, such exhortations are easier said than done. This is why I'm a consultant rather than a financial advisor. The reality is that there are many elite fee-only firms that break through to more consistent, predictable income that continues to grow, while continually dropping more to the bottom line. After all, the goal of increasing operating profit is not inconsistent with being a client advocate. In fact, it's quite in line with that lofty intent. With a more appropriate return, fee-only advisors can continue to invest in the technology, people, expertise, and services that will differentiate them from those who serve their clients in more traditional ways.

Mark Tibergien, a specialist in practice management for financial services firms and partner-in-charge of the Securities & Insurance Niche for Moss Adams LLP, the 10th largest CPA firm in the U.S, can be reached

at mark.tibergien@mossadams.com.

Reprints Discuss this story
This is where the comments go.