From the June 2008 issue of Investment Advisor • Subscribe!

The New Model: The Fee-Only Broker/Dealer

Independent B/Ds must tackle head-on the causes of their frustration if they wish to survive

There is one overriding question for broker/dealers today: Who needs one, and why? After all, RIAs are prospering quite nicely without having to use the services of a broker/dealer. Moreover, the number one revenue source for broker/dealers in 2007 was actually advisory fees--a business that by definition does not involve a broker/dealer. On top of that, when we consider the sources of profitability for independent broker/dealers, we will find that the sources are essentially anything but the broker/dealer business. Broker/dealers are profitable from the fee business, markups on trade tickets, charges to reps, and revenue sharing from investment managers rather than the net revenue retained after making payouts to advisors. Considering all of that, then who wants to be a broker/dealer in the first place, and why?

Today, close to 80% of the independent professionals (120,000 ) affiliate with a broker/dealer, while some 35,000 professionals practice inside an RIA. (Source: Moss Adams, "Uncharted Waters 2008," published by Pershing LLC.) Tomorrow there may be many fewer broker/dealer-affiliated advisors. In fact, I would venture a forecast that in 10 years there will be over 100,000 professionals inside RIAs while the number of B/D-affiliated advisors will stay flat. In other words, there will be a roughly equal number of B/D- and RIA-affiliated advisors.

Don't get me wrong--I am not suggesting that the current independent B/D firms will disappear or that advisors will roam the financial services landscape unaffiliated. I do believe that in the next five years, we will see a transformation of the traditional broker/dealer into a business entity that will be focused primarily, if not exclusively, on the fee business. The value proposition of that fee-only broker/dealer will also change dramatically and focus entirely on the ability of the broker/dealer to help the advisor build a practice; either through branding and business development or through business and practice management resources.

Why Change Is Necessary

Today's broker/dealer is an organization of dedicated people who work incredibly hard for their advisors and are compensated significantly less than any other part of the value chain. They are tired and frustrated, and have been painted into a corner by a combination of regulation and competitive forces. The industry has to change. It either has to disassociate itself from its distribution past and accept a fiduciary role next to the advisor; or find itself pigeonholed in selling variable annuity, variable life, and other products through an ever-shrinking population of specialized advisors and a dwindling group of clients whose investable assets would place them below the minimums set for fee-based accounts.

To begin with, the term broker/dealer does not describe a business model but rather a regulatory entity that is required by FINRA as a supervisor of any transaction that involves commissions. The largest source of revenue for broker/dealers today, however, has nothing to do with commissions. It is the fee-based business governed by SEC regulation that has absolutely no requirement for the involvement of a broker/dealer. In 2007, the average independent broker/dealer derived 17% of its business from fees with the remaining 83% coming from variable annuities (20.7%), mutual funds (18.2%), trail commissions (15.5%), and variable life insurance (11.8%), according to 2007 FSI Financial Performances Survey, produced by Moss Adams LLP. Note the significance of the life insurance and variable annuity businesses. In fact, if we exclude the insurance broker/dealers from the sample, the typical independent broker/dealer today gets 22.8% of its revenues in fees (these are numbers for 2007) and is rapidly growing. In 2004, using the same sample of firms, the average broker/dealer reported that only 13.9% of its revenues came from fees.

What is important to realize here is not merely the growth of fees in the revenue mix of broker/dealers but rather the growth in fees in the revenue mix of advisors. It is not a secret that advisors are transitioning their business to fees and in most cases have done so already. The largest investment-oriented advisory practices today derive more than 80% of their revenues from fees, with commissions representing a shrinking legacy rather than an area of growth. As they complete that transition, each and every B/D-affiliated advisor will eventually ask the question: Why do I need my broker/dealer?

Already Looking in the Mirror

This process is nothing new to broker/dealers themselves and many are not surprised to hear the (spoken or unspoken) question coming from their reps of "Why do we need you?" In fact, many broker/dealers themselves may already be asking themselves, "Why are we doing this?" Consider the profitability of the typical independent broker/dealer in fiscal 2006, a fairly successful year: it was only 0.9%. If margins are 0.9% in the best of times, what are they going to be when markets are worse? The answer--negative 4.2%, as it was in 2002, according to Moss Adams data. The financial issues behind this profitability picture are well-known. For example, the typical independent firm pays out 83% of the total revenue generated by advisors, pays 3.4% of its revenue to the clearing firm, and then has operating expenses of 17.1%. At this point you may accuse me of fishy math--after all, these expenses sum up to 103.5%. How can they turn a profit?

Here's where it's necessary to relate the story of Milo Minderbinder--a character in Joseph Heller's novel Catch-22 who buys eggs in Malta at seven cents an egg, only to sell them for five cents an egg and somehow still make a profit. To make a profit (in the case of broker/dealers, not Milo), a portion of the revenue is not paid out to the advisors and in fact accounts for most of the profit. Items such as fees to reps, markups on tickets and charges, and interest on margin account for nearly 7% of total revenue (those items also account for an additional 1.2% in expenses), according to Moss Adams. This means that the typical broker/dealer makes money on everything but the brokerage business.

This problem does not only apply to independent firms. Full-service firms are subject to the same issues. While I don't have many statistics in this part of the industry, my experience is that wirehouse firms pay out 40% to 50% of their revenue in the form of cash or other compensation, run the local offices at about 30% overhead, and have a home-office expense of about 20% of the revenue payable to advisors. Profitability is again found in product margins and product-like margins--trading, interest, account charges, etc. (Source: 2007 FSI Financial Performance Survey)

Back to B School

The broker/dealer problem is almost a classic MBA value chain exercise. Consider how many investment intermediaries generate revenue when an advisor invests the client's money in a mutual fund held inside a brokerage account. The mutual fund manager and advisor, the clearing firm, the broker/dealer, and the advisor are all involved. Considering the number of parties at the table, it is no surprise that some of them will experience at least some pressure on their margins. The question is, who will feel the burn the most? Generally, that tends to be the link in the chain that is most uniform in characteristics and quality and therefore becomes commoditized the fastest. The bargaining power, the scale necessary to compete, and the ease of entry will play a role, as Harvard Business School Professor Michael Porter's classic writings on competition teaches us. Independent broker/dealers that provide a regulatory function and borrow most of their technology and capabilities from their clearing firm not surprisingly end up with the short stick. Clearing firms have scale and bargaining power on their side, mutual funds have their managers' styles and performance as differentiators. Broker/dealers have payout, which is a rather unfortunate choice.

Compare this situation with the same mutual fund bought by an advisor on behalf of the client in a fee account. The mutual fund advisor and manager still get paid, the custodian charges a ticket charge (or not if the fund is part of its lineup), and the advisor receives an advisory fee. No broker/dealer is involved and one of the links has been eliminated.

The Kernel of the B/D Problem

This simple counting exercise between the broker/dealer and advisory channel lays out the key problem ahead of the entire broker/dealer industry. The broker/dealer (or any other entity participating in the value chain) has to either add value to the chain or advisors will perform simple regulatory "arbitrage" and go to the channel with the fewest participants. As the overall investment business has already substantially shifted to fee-based pricing, the broker/dealer industry has to quickly define that value-added role. While the actual number of business models for that role is unlimited, the general directions are not that difficult to foresee. The choices are branding and business development, business management and advice, operations and management, or training.

Today, most broker/dealers approach the fee-based future rather mechanically. They seek to play the same role they play in the commission business, only this time applying it to the fee business. By now, most independent broker/dealers have established their own RIA entity and allow advisors to affiliate with that entity in order to transact their fee-based business. So if we have XYZ Capital broker/dealer, they most likely have XYZ Advisors LLC which is registered as an RIA. The typical XYZ Advisors entity today has $1.7 billion in assets under management (AUM) and has been growing by 35% in the last couple of years.

In general, broker/dealers handle the advisory business in three ways: broker/dealer RIA, advisor RIA, or TAMP (turnkey asset management platforms). The future model may very well be for the broker/dealer to become a custodian (it appears that LPL is ahead of the curve here, see The B/D Custodian sidebar, page 52).

In a broker/dealer RIA (practically every broker/dealer has one) the advisors function under the Form ADV of the broker/dealer-owned RIA (called BDIA) filed with the SEC and disclosing the nature of the service, general investment approach, fees, and so forth. Very importantly, the BDIA has the contract with the client. Nonetheless, the advisor typically sets the fees charged and may in fact direct the assets and even have discretion. Generally speaking, the advisor "owns" the client relationship, even though the BDIA's name is on the contract. This issue is resolved in a separate contract between the BDIA and the advisor that governs compensation and specifies who can take the clients should the advisor wish to change affiliation.

The BDIA will typically charge 15 to 20 basis points for its services, most of all portfolio management, billing, and performance reporting. The BDIA will also generally determine the funds and managers on the platform and thus may be able to receive additional revenue from those parties by charging "access fees" and marketing fees like 12b-1s. This is where the BDIA will become the key source of profitability to the broker/dealer. The 15 basis points on as much as $1.7 billion in assets will bring $2.5 million in revenue. The three employees (I am not exaggerating, unfortunately) in the advisory department and other costs--such as technology and clearing--will need to be deducted from that revenue, but the fact remains that this department will be very profitable. The charge or fee has been transferred to the consumer and thus away from the advisor's payout focus and the severe payout competition.

The value-added component of this role for the BDIA is operations and, to some degree, the due diligence and selection of managers (although advisors usually double up on that effort and do their own research). This is good for the advisors because they do not have to perform the operations functions, but it may be somewhat problematic for the client who pays the 15 to 20 basis points in administration fees. Arguably, the advisory fee in this model may be lower to offset an advisor's lack of administrative responsibilities, and thus perhaps the client is not in a bad position either.

Fee Models Compared

The BDIA approach has been a successful path for many broker/dealers in their initial foray into investments, most notably LPL, a pioneer in this model which has helped carry that firm to more than $80 billion in assets and huge success. The problem strategically is the differentiation. If the value added is the operations function, how would you differentiate it? Everyone uses the same portfolio management software, everyone produces statements, so what would make you stand out? Customized performance reports are one possibility, but how far would that go to differentiate the broker/dealer?

Advisors have also been suspicious of this model, to some degree, since they always wonder if in this environment they really own and control their fee-based practice, or if it's more ambiguous. In addition, the management of the broker/dealer and the BDIA is the same and it is difficult for the compliance department and the operations department to behave very differently, since the advisor now affiliates through a different entity. Most of all, advisors are somewhat nervous about the value of their practice in a model like this. Some advisors will always be concerned that the practice would be worth more if it were not with a broker/dealer (which probably is not true, by the way, though that is a discussion for another day).

The second model is for the broker/dealer to allow the advisor to own and operate an RIA. Here the broker/dealer plays the role of either outsourced operations center, which is similar to the first option, or merely allows for the existence of the RIA while processing the commissions of the same advisor or advisory firm. This model allows the advisors to continue receiving commissions while owning the RIA. This is an almost ideal solution except for a couple of problems. One is that most broker/dealers are not comfortable with this model. They either do not like having compliance liability for a business they do not own, or they can see that this proposition is only as strong as the stream of commissions the RIA puts through the broker/dealer. As a result, 40% of broker/dealers do not allow for this model and the remaining 60% impose a number of restrictions. Still, Cambridge Investment Research is the one broker/dealer that fully espouses this model (one could say it pioneered the approach) and has been tremendously successful with it.

The issue here is that the advisory firm may very well be using the model as a transition point toward becoming an RIA-only firm. As the commission stream becomes less and less significant, the advisor may be less and less interested in maintaining the relationship. For practices that are strategically committed to commissions, this is a perfect model. Achieving differentiation in this model is again problematic, however. It will either come in the form of regulatory lenience or operations support, and both are rather weak. Raising payouts is always an option, but they are the "nuclear option" of broker/dealer competition.

TAMPs are option number three and from the start this was the place where a lot of the assets went. From a broker/dealer perspective, though, this only adds unnecessary stress. If the broker/dealer model has an extra-step problem relative to RIAs, then this is doubly troublesome.

A Modest Proposal

So where is the solution? I submit that broker/dealers can productively only go in the direction of either branding and business development or business management and training.

Training is what the wirehouses and insurance firms used to do. Developing new advisors and helping them grow will always add tremendous value to the industry. This is true even if it may seem like a losing proposition since one organization makes the investment only to see another recruit the product away. In the end, I am convinced that with the right contracts and career opportunities, the training systems will always find enough value to add, whether to commissions or fees. This will become especially true if the compensation mentality of "eat what you kill" is solved.

More interesting is the possibility of branding. In this industry, where insiders can't even agree on the definition of wealth management, for example, an organization that stands for quality of advice can attract a tremendous number of consumers under its banner as well as a tremendous number of advisors. The only issue is the cost of creating the brand and subsequently resisting the temptation to compromise it for distribution purposes.

If advice is indeed dramatically different than product and if advice has changed the industry, isn't it time for an advisory brand to emerge de novo rather than for the industry to try and recycle the old product distribution brands? It is not clear who will have the capital for this worthy goal, but I can definitely foresee some of the consortiums of advisors that are forming today (think Focus Financial or Fusion) headed in this direction some day.

Finally, the option that is near and dear to my heart--practice management. Most broker/dealers do it, but somehow it all seems to come down to a lot of PowerPoint slides and very little change at the advisor level. Today a broker/dealer (or any other party) has no clear method for becoming involved in the practice of an advisor. The signs of change are on the wall. The practice management divisions of many firms now include numerous experienced consultants. The quality of people in these endeavors is very high with credentials from Accenture to McKinsey.

The broker/dealer of the future will most likely not be a broker/dealer. It will be an organization that affiliates with advisors--affiliation being an intentionally broad term here. It will be breaking out of old distribution models and will instead focus on practice management, branding, and training. It will also have a high respect for the client and never put itself in a position where its interests diverge from the client or the advisor. Today's broker/dealers are already starting down that path, but their past and the immediate issues of their economic present get in the way. Still, today's broker/dealer is already fee-based but frustrated. It is time to admit it and deal with the source of the frustration.


Philip Palaveev, a regular contributor to the magazine, was until recently a principal with Moss Adams LLC. He has since joined Elmsford, New York-based Fusion Advisor Network as president and a shareholder in the firm. He can be reached at ppalaveev@fusionadvisornetwork.com

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