From the September 2005 issue of Investment Advisor • Subscribe!

September 1, 2005

The Price of Everything...

If you're not adding profit into what each client costs, you're losing money

Conventional wisdom holds that advisory services are under severe pricing pressure. But our research for Schwab Institutional's Market Knowledge Tool (MKT) series revealed that major reductions haven't actually taken place. However, we did find that advisors are being asked to provide more services and more attention for the same fees they charged up to five years ago. As a result, many advisors are experiencing severe pressure on their gross margins, and most will need to reverse this trend to build back up to an optimal level of profitability.

Having evaluated hundreds of advisory practices for both the FPA benchmark studies we've done and the Schwab study, we found some common themes in pricing but few common responses. By digging deeper through our data research, we identified three core reasons for the divergent pricing practices in the advisory business:

  • The cost basis for services
  • Market pricing
  • Value proposition

We also found that advisors who consider these three factors when devising their own pricing strategies, are able to develop a more coherent approach to managing their profitability. This principle is just as true for solo advisors as for ensemble firms, and obviously is more relevant to those advisors who are fee-only or run fee-based practices.

The Cost Basis

Recently, we were engaged by a firm that was evolving its wealth management offering. Its origins were in the life insurance and benefits area, so the firm had a strong sales culture in which its principals enjoyed making deals. Unfortunately, as the office manager pointed out, because of these "deals" the firm was losing mon- ey on every new wealth management client it brought in. "With what we're providing," she said, "it costs us $15,000 per client in staff time alone--not including the cost of the lead relationship manager." One of the principals responded: "We can't charge $15,000 if the market only allows us to charge $10,000!"

Like these principals, advisors are often seduced by attracting more clients, adding more assets, and making more sales, and are less focused on profitability--at least explicitly. There is an unspoken belief that advisors can make it up in volume--that the solution to shrinking margins is to add more clients. Of course, this is only true if the advisors charge those new clients enough to cover their costs or scale down their service offering to match the amount they can charge.

To determine how much each client costs to service, start by adding up all the compensation paid by the firm plus all other overhead such as rent, utilities, and marketing, then divide this by the number of clients. For example, if your total costs are $500,000 and you have 250 clients, your cost per client is $2,000 per client. This gives you a minimum that each client should pay per year to cover your costs. If you have clients that are paying less than this, then unless you truly differentiate the level of service provided, all your larger clients are subsidizing these lower-contribution clients (which is not very fair to your wealthiest clients).

When doing such calculations, I like to suggest that you add a desired profit margin to the minimum you charge each client--in other words, think of profit as a cost that is just as important as salaries and rent. Assume your goal is to achieve a 25% profit margin: divide the average cost per client by one minus the target profit margin, and you'll get the amount of revenue necessary to charge per client. In the above example, $2,000 ? (1 - .25) = $2,666.

We are often asked to provide insight into how other advisors are pricing their services. Through our studies of the profession, we see many different pricing models but not much coherence on how advisors charge.

For example, in the 2004 FPA Financial Performance Study of Financial Advisory Practices, the difference between the highest and lowest fee charged on a typical $1 million client account was over 150 basis points, with nearly two-thirds falling between 50 and 100 basis points.

However one approaches this, it is almost always best to do the fee comparisons in your local market. What one can justify in Raleigh may be different than in San Francisco, and costs will differ, too.

When doing local competitive analysis, identify which firms are directly competitive, define their service offering, and attempt to compare their pricing in that context. However, advisors should also look at local firms that are not directly competitive in terms of service offering but are competitive in terms of the markets they serve, so that they can be prepared to respond to clients who say, "So-and-so is less expensive." If, for example, you are a wealth manager, you can demonstrate why your fee structure is different because your value proposition is different. This allows you to move the discussion from cost to deliverable.

When doing market comparisons, it is easier to evaluate AUM fees than hourly, project, or retainer fees, since the baseline tends to be the same. Nonetheless, it is helpful to discover what others are charging on an hourly or project or retainer basis so that you can be in tune with their models. When you understand the pricing strategies of your competitors, you begin to understand your own competitive advantage or disadvantage.

Your Value Proposition

One of the interesting challenges for advisors is justifying why a $2 million client should be paying more in dollars for what they are getting than a $1 million client when the service offering and attention from the advisor is virtually identical. But this is one of the quirks of the advisory profession's value proposition.

Wealth managers may be able to rationalize the fee differential a bit more easily since they can often add more services or enhance the client service experience to justify the increasing fees. Another option is to staff the client management function differently. That said, one of the great ironies of the wealth management business is that many such managers attempt to position themselves as something other than investment managers, yet due to their pricing scheme, allow themselves to be defined by investment performance. This is one reason why many are moving toward a retainer for a portion or all of the relationship, or in some cases, a project fee for special issues outside of investment allocation and execution.

Five key questions come to mind when developing justifications for your pricing:

  • How comprehensive is your deliverable?
  • Whom are you serving?
  • How are your clients and services different from other firms in your market?
  • Which typical implementation vehicles do you use (index funds, private equity ETFs, stocks and bonds)?
  • What do your clients value?

There obviously is a linkage between the first and second questions. For example, if you are not serving wealthy people, it would not be appropriate to characterize your business as a wealth management business. You may be more of a financial planning firm that provides investment management and risk management solutions. On the other hand, if you are serving individuals with more complex needs and more assets at risk, you may delve deeper into special issues, trusts, business succession, estate planning, tax planning, and alternative investments. To a large degree, the nature of the client and scale of the service offering influences your value, and the sophistication of your offering and your clients can dictate how much confidence you have in asking for your level of fees.

Recently, I was talking to a wirehouse broker who was contemplating breaking away to the independent world. He was frustrated over having just lost a long-time client who sold his company for $15 million and then picked an RIA to advise him. The broker said, "I don't understand it. My fees were about a third of what that other advisor was charging." The mistake he made in sizing up the competition was thinking that the client only sought money management. It turns out the RIA was in fact a wealth management firm that went into greater depth with the client about a variety of complex issues, including wealth transfer, asset protection, special needs, and investment management. Ultimately, the client chose service over price.

Price is only one of many factors that clients consider. Ideally, clients choose the advisor based on the various factors that differentiate them from the competition. When one is a money manager, performance more than cost will be the distinguishing characteristic. When one is a financial planner, attention, patience, and reasonable price may help to differentiate. When one is a wealth manager, sophistication, depth, access to alternative solutions, and a comprehensive, holistic approach may compel clients to select your firm. No strategy is wrong, but obviously it's important to align your pricing with your positioning and your deliverable.

When you are compensated by commissions or even asset management fees, it is somewhat easier to bury the costs to the client since they are charged to their investment portfolio. When one moves to project, hourly, and retainer fees--especially the latter--advisors must be consistent and clear in how they demonstrate their value, because these will need to be negotiated and agreed to each year.

Firms of the future that are serving $1-million-plus clients will likely see a combination of fee structures with one charge for planning, another for monitoring and managing, and a third for execution. Many advisors who use a combination of performance fees tied to assets and a retainer tied to more complex planning are able to consistently demonstrate their value, and minimize their clients' focus on investment performance as the only standard of evaluation.

Mark Tibergien is a nationally recognized 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. You can reach him at mark.tibergien@mossadams.com.

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