From the January 2006 issue of Investment Advisor • Subscribe!

Balancing Act

The broker/dealer model is changing, spurred by business and regulatory pressures, and reps may stop talking to their clients

What a remarkable time these last few years have been for independent broker/dealers. The markets have recovered from a bubble, a crash, a grinding bear market, investment industry scandals, and corporate debacles. An aging population has realized that big corporate--or public--pension plans are, in many cases, gone or at least eviscerated, and that they generally are on their own, saving and investing for a long retirement. Tremendous wealth has been created. Scads of investors have realized that they want--and need--advice about managing their money, whether from a local independent advisor or a representative of a wirehouse, bank, or insurance company.

Many of the challenges broker/dealers face are client-driven. Even many of the regulatory issues are, in a roundabout way, the result of client complaints or client demand. Savvy individual investors are demanding value, unbiased advice, and scrutinizing that advice more closely than ever. Yet broker/dealers are seeing their margins shrink, and for better or worse, regulations are changing the face of the investment business, sometimes in surprising ways. For instance, some reps may stop asking clients questions about their goals in the planning process, fearing being labeled a fiduciary under the SEC's "Merrill Lynch" rule.

To take the industry's pulse, we talked with some of the leading independent broker/dealer executives to get their views.

The Local Impact

"Demand for advisors has never been better," says Mark Casady, president and CEO of Boston- and San Diego-based LPL Financial Services. He says investors are much more sophisticated than even five years ago, and very well informed about everything they buy, including investment advice. Part of the reason for that shift is that the majority of retail investors are Internet-savvy; before they buy, they check out everything--on the Web. They want to deal with a person in the community, and local advisors have become "true impact players," according to Casady. Consumers are inspiring vast changes at broker/dealers; they are demanding more comprehensive service that includes product choice, unbiased advice, and a long-term relationship with a "trusted advisor," typically someone recommended by a friend or relative.

One trend that seems especially positive for independent B/Ds is that investors don't seem to be as influenced by the big branding and advertising campaigns of the wirehouses. Today's client may possess a newfound healthy skepticism after the mutual fund stale trading, research conflicts of interest, and corporate scandals of the past few years. If a friend recommends a trusted advisor who happens to be at a full-service brokerage firm, fine, but if the recommended advisor is with an independent B/D in the community, that may be even better. "I think consumers are really smart and understand the difference between advertising and delivering a real relationship. I think they are going to go to the person that they see in their community as having a real impact, whether that's an impact with a friend--in terms of achieving their financial goals," or on a nonprofit organization or politically in their town, says Casady.

But what clients want out of that lasting relationship has been shifting too, because clients' needs have changed and because they can more easily compare what is being offered to them. Joe Deitch, CEO of Commonwealth Financial Network, in Waltham, Massachusetts, says "financial advisors are a very highly valued commodity--all the people that I know who have substantial income or assets--what they need is someone to help them bring sanity to their life, and to be organized, so they can focus on working and enjoying life." But Deitch has noticed an odd thing, "Most experienced, talented advisors don't appreciate how valuable they are," he claims. "When I speak with people who own businesses, I am often told that the luxury in their lives is to find a trusted advisor, whether it is medical, financial, whatever."

Assets under management was always the sweet spot of financial planning, according to Deitch, and now there is a growing emphasis on wealth management. The wealth management model is "much stickier," says Deitch, because it adds risk management, retirement planning, and estate planning to the relationship. While Deitch says that model is a "much more labor-intensive relationship to build, and it's a lot more difficult to disengage," if the client does have "a wealth manager, a financial planner, they don't want to disengage. A talented wealth manager is anything but a commodity, and can in fact charge a premium for those services." Rather than seeing more advisors switching to wealth management, what Deitch observes at Commonwealth is advisors adding more wealth management services to their asset management business.

The Regulatory Impact

To say there has been an emphasis on regulation in recent B/D history is an understatement. Regulators have fundamentally shifted the way B/Ds are made to conduct business, and in large part the new regulations have to do with conflicts of interest, including firms selling their own products and excluding similar products from other manufacturers that may perform better or have lower fees. There is "tremendous movement away from independent B/Ds owned by insurance companies," most of which were bought between 1995 and 2000, according to Lon Dolber, president and CEO of American Portfolios in Holbrook, New York. Regulatory scrutiny of manufacturers is supposed to lead to more disclosure and less conflict of interest. "If the public loses confidence in the markets, we're all doomed. If the goal of the regulators is to increase confidence in the markets, and if the public believes that the capital markets are fair--that's a good thing, ultimately."

The breakup of manufacturing and distribution is a huge trend. "Manufacturers that owned distribution traditionally relied on a high degree of their products being sold by their advisors, and that really isn't as easy to do in this environment. If somebody had 60% or 50% penetration of their own products in their own system, those numbers have dropped pretty dramatically--probably in half over the last couple of years--as more disclosure and more open architecture of product has occurred. That makes distribution less economically viable for a manufacturer to own," argues LPL's Casady. He says that's a key reason why they're splitting up. When manufacturers bought outlets, they never really integrated them--and perhaps that wasn't part of their game plan. The value of manufacturers buying distributors made sense at the time, even without integrating the firms. It was a good model for a number of years, notes Casady, but in addition to more cumbersome regulatory issues, the "demands of the end consumer for open architecture, plenty of product choice, and the desire for unbiased investment advice has changed the economic equation," of manufacturers owning distribution.

He cites the closure of the deal between Legg Mason and Citigroup in early December, with Legg Mason transferring its advisors to Citibank's Smith Barney. Legg Mason now will be out of the distribution business, but its manufacturing operations will grow, since Citigroup's mutual funds will be brought under the Legg Mason umbrella. Insurance companies have been consolidating "massively" over the last 12 to 18 months because they need to integrate their manufacturing plants, and they need scale, according to Casady, pointing to the Jefferson Pilot-Lincoln Financial merger, targeted to close next quarter, and the John Hancock/Manulife deal that closed in 2004.

Along the same strategic lines, LPL has beefed up distribution by purchasing two broker/dealers from Hartford-based The Phoenix Companies: W.S. Griffith, also in Hartford, and Main Street Management in Wallingford, Connecticut. "We're quite interested in purchasing distribution companies that may come up for sale, whether it's in '06 or beyond," says Casady.

LPL isn't just buying; it's selling. The company announced the sale of a 60% stake in itself to two private equity groups in a deal scheduled to have closed by year-end 2005. Hellman & Friedman LLC and Texas Pacific Group will share equally in the majority interest. "This investment is so different from anything that's come before it," says Arthur Grant, president of Cadaret, Grant & Co., in Syracuse. Here are independent investment firms, "whose judgment was that LPL was worth investing in as a going business, instead of as a distribution arm or as an adjunct to an insurance company." It's a growing company with good earnings, and a standalone business, says Grant.

Not Asking Questions

There is a lot of confusion among brokers about how to cope with the broker/dealer exemption rule, also known as the "Merrill Lynch Rule," that is scheduled to take effect at the end of January. Back in the days when transactions ruled, brokers got paid to make a sale, period. "Over the years, brokers evolved into a more consultative existence, and they undertook some level of financial planning; they kind of bought into financial planning. They didn't necessarily charge a fee, they didn't necessarily call themselves formal financial planners, but they started by asking questions rather than trying to make a sale. I thought that was a good evolutionary occurrence, and now we've got a rule that's advocated by 10,000 or 20,000 financial planners that will affect 400,000 brokers, and it says that 'If you ask too many questions, then you're engaged in financial planning, and therefore you become a fiduciary,'" says Grant, arguing that brokers will now back away from asking those questions. He says that "400,00 brokers are now not going to be asking questions; they will meet the exact letter of the suitability requirements, because if they go beyond the letter of the law on suitability requirements, they risk exposing themselves to being called fiduciaries." Grant says most brokers want to do well for their clients, and asking questions is good for clients if it helps a representative do a better job of matching recommendations to the needs of a client. It's ironic that the rule may turn out to be the flip side of what was intended by regulators, "the unintended consequence of overregulation," he says.

Another worry common to B/Ds large and small is whether regulators will determine that something that has been a routine business practice for years is suddenly illegal--creating huge potential liabilities for B/Ds, according to Jeff Auld, president of NEXT Financial Group in Houston. This could lead to another unintended consequence--that very small shops with one, two, or 10 brokers may find that it is not feasible to stay in business alone. The compliance issues that a tiny firm must deal with can add enough overhead that "many of them are throwing up their arms and saying, 'This doesn't make sense for us, the scale isn't there,'" says Auld. Because NEXT is rep-owned, Auld says some very small firms have chosen to join the B/D "because they can still have ownership, they can still have a voice in the way we do things."

The Impact of Rep Portability

Jonathan Henschen, president of Henschen & Associates in Marine on St. Croix, Minnesota, places advisors with independent broker/dealers. He says some reps are leaving firms that are being acquired because of a disruptive change of culture or a culture clash. They are typically going to smaller firms that are known to be rep-friendly or rep-driven, and to have a wide selection of product offerings. He says some reps have been penalized at wirehouses for going to a fee-based compensation model, so they also may be looking for B/Ds that are open to that model.

Mitch Vigeveno, president and CEO of Turning Point, Inc., a consulting and executive search firm in Safety Harbor, Florida, echoes the sentiment that reps are moving from larger to smaller firms, but says they are also moving more carefully because of various types of "golden handcuffs." When they do move, they are looking for more personal contact with top management, better customer service--responsiveness, returning calls quickly. He says companies that are gaining reps are generally those that are on top of providing service to the reps, and have invested in technology that enables small firms to compete with big firms. He says the clearing platform makes a difference too, citing technology at Pershing and National Financial that is "outstanding."

Brian Murphy, president of Woodbury Financial, says it's all about relationships: reps want stability. "Four or five years ago, reps looked at broker/dealers as an economic and regulatory necessity. Today they understand that changing broker/dealers creates a big upheaval in their practice." It is much harder for reps to unplug from one broker/dealer and plug into another. They are looking for a very long-term--maybe for the rest of their career--relationship with one company.

Changes in payouts, some caused by regulations against preferred "shelf space," are an issue at some firms, according to Vigeveno, because revenue at some B/Ds depended on the preferred vendors. Now there have been adjustments in payout schedules, and an increase in fees, ticket charges, or costs to the rep for other services. He says reps continue to navigate toward a fee-based business structure because they feel it's better for clients, it provides an ongoing revenue stream, and as reps start to think about succession, the value of their business is determined partly by the amount of cash flow it generates, so going to a fee-based model can make sense.

The Impact of Graying Reps

Not only are aging clients a huge factor for B/Ds, the industry itself is getting older, notes Peter Grifo, VP for recruiting at Cadaret, Grant. Succession planning has jumped to the front burner, as reps look to take advantage of the businesses they have built. Perhaps they want to sell or they want to continue to work but at a reduced schedule. One reason the industry itself has an aging demographic is that it's "harder for new people to get into the business," says Grifo. "There are fewer firms with the model 'Come on in and we'll train you.'"

That ties into two other trends: tighter margins for broker/dealers, and the reluctance of wirehouses to retain older brokers who may wish to semiretire. At wirehouses, a large part of the commission dollar goes to training neophytes and to proprietary research, according to Commonwealth's Deitch. Wirehouses want full-time advisors. If an advisor wants to retire, he says, they are asked to sell their book and leave. As an independent rep, an advisor can move into semiretirement, keep their best clients, and stop focusing on marketing. "We have advisors who, as they get older, maybe they work half time," says Deitch. "Their revenues go down but their overhead goes down as well. These people are netting sometimes as much now as they were before--working half-time."

While there is not always the kind of compatibility that advisors may wish for, Grifo says one way to bridge the gap between new representatives and seasoned brokers who want to explore succession issues may be to pair up junior and senior advisors, who might evolve into "buyers and sellers of practices."

The Impact of Slimmer Margins

The cost of running an office is going up at the local level, says LPL's Casady, echoed by most executives interviewed for this article. Pricing continues to be under pressure. Clients are demanding the best value for what they do--price literally meaning what they pay for a service; or price because they got a better relative return. Efficiency is extremely important, and a number of advisors want to go to a B/D that has scale, that really gets what advisors do for a living, and has a unique platform that allows an advisor to deliver top-tier services to their clients.

It's been a roller-coaster ride for B/Ds and it remains thrilling, if sometimes frustrating; a delicate act of balancing on the high wire while juggling the enormous opportunity to guide investors toward the tangible and intangible benefits of wealth, the heavy responsibility of remaining compliant, the challenge of succession, and the changing demands of clients. In the end, B/Ds who can provide advisors with what they need to serve their clients well--unbiased, open product choices, a rep-centric attitude, a say in how things are done, and access to top management--will continue to represent the state of the art.

Staff Editor Kate McBride can be reached at kmcbride@investmentadvisor.com.

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