From the May 2009 issue of Investment Advisor • Subscribe!

Formulas for Success: Are You Overpaid?

Will compensation for Main Street advisors be scrutinized next?

Several months of populist outrage over the sins of Wall Street have stunned the financial community. With every action comes a louder reaction. The proposed 90% tax on bonuses paid to executives employed by TARP-recipient companies was the ultimate expression of rage that could throw sand in the gears of the firms that received capital infusions and the economy in general. At a time when the market is seeking leadership and direction, people in power keep changing the rules and searching for demons. This is scaring even the innocent and those who want to help.

As cathartic as it may be to lash out at everybody who has ever touched a stock, a bond, a loan, or a lien, if the torch-and-pitchfork crowd goes after financial services companies for all their perceived and real transgressions, the rest of us may end up with our own Marie Antoinette moment.

For readers who are saying "that will never happen," be aware that Barney Frank, Rush Limbaugh, and legions of other bloviators are seeking the heads of anyone who may have contributed to the decline in our nation's economic well being. Soon there will be no one left to blame. Who is to say that advisors who oversaw client portfolios that declined 30%, 40%, or more are not going to get their public skewering as well?

Hope as we might that President Obama's counsel to channel anger into productive solutions will take root, I fear we have entered another "McCarthy Era" featuring incrimination by association. This is not to defend bad decisions and acts of malfeasance by regulators, business executives, and financial product manufacturers, but to urge caution against unpleasant unintended consequences of our anger.

We know clients are feeling this rage as well, perhaps out of hopelessness or fear.

For example, advisors have been relating how some clients are demanding that they not be assessed an asset management fee on the cash that is held out of the market. This is a real value perception problem.

How will this changing dynamic influence your business decisions?

Assuming this dialectical spiral will touch retail advisors eventually, advisors need to justify their own worth. Consider two key touch points:

What do you charge the end client?

What do you pay yourself and others within your advisory firm?

Clearly, the two questions are linked. If the advisory firm is under pressure to reduce or eliminate certain fees, how will you structure payments to yourself and your staff? Even more importantly, how much will you be able to afford to pay them?

Advisory Fees

In these times advisors really earn their keep. Part of their responsibility is knowing when to move assets in and out of asset classes and when to keep liquid. If a client doesn't think that his advisor is doing his job by keeping substantial portions of client assets in cash, the advisor himself may not have done enough to demonstrate his value in good times. Especially disturbing for financial planners who also manage portfolios, this perception suggests that the rest of what you do is "not worth it." Further, it implies that the client believes he is buying a product and that you should be paid by transaction--much like a commission--rather than seeing you as advising him holistically on his total financial life.

Aside from this shocking development, advisors will also have to justify how they can command high AUM-based fees in a negative or low return environment. Should you charge a separate fee for financial and estate planning, special needs analysis, or college funding? If your clients value their attorney or CPA as hourly-rate advice providers, is that the next logical step in your pricing strategy? Will you have to distinguish between the planning and the implementation process in terms of how you generate revenue?

My goal with these questions is to disturb you enough to think about your value proposition. Can you define it, measure it, and assign a value to it? Can you benchmark it to comparable professional services?

Many clients may need to be resold on your services and convinced that you are worth their investment in the relationship. There are three elements to a pricing strategy: 1) cost to deliver the service; 2) market value of comparable services; and 3) value of what you deliver. If you can clearly articulate your proposition in a way that clients value, you will have a more sustainable business.

Personal Compensation

For the traditional "producer" within a brokerage firm, there has often been confusion between revenue to the practice and compensation to the broker. In this model, the payout one receives from the broker/dealer has always been regarded as the personal reward, or compensation. But for independent contractor registered reps and independent RIAs who own their own businesses, what flows in on the top line is properly regarded as revenue and not compensation. Revenue is the starting point from which compensation, overhead expense, and bonuses are paid.

The theory of compensation says that the more you are responsible for direct sales, the more your compensation should be variable. Conversely, the more you are involved in service, the more your compensation should be fixed.

One tradition on Wall Street that defies this logic is the practice of granting people at the highest levels a relatively low base salary and an extraordinarily high bonus. In most cases the bonus is a profit distribution not based on ownership but rather on rank, responsibility, and contribution. A Managing Director in charge of a division could be paid an annual salary of $200,000, but with a year-end bonus in the millions, often split between restricted stock and cash.

Many advisors who have come out of accounting practices, money managers, and wirehouse firms have adopted a similar model, partly because it is familiar and partly because it is common in firms from which they are attempting to recruit talent. In addition, for owners of such firms, there is something appealing about having a low fixed cost tied to compensation and a high variable cost tied to results.

The structure for such bonuses is often only visible to a few senior executives or a compensation committee. The question for financial firms is; should base salaries and bonuses be more aligned with the value of each position and a measurable outcome?

Many well-run companies determine base salary by evaluating the expectations of the job. A CEO would be paid a higher base salary than a relationship manager, for example, because the CEO's impact on the business would be higher and his role more valuable. The position also carries more risk because the buck for every decision stops with that person. When base salaries are relatively equal, how does one adequately distinguish the value of each role?

Every incentive plan has two essential components: how it is funded and what defines eligibility. First and foremost is whether the firm can afford it. In this environment, it may be better to tie incentives to company profits rather than revenue. Consider creating a pool that accrues a certain percentage of profits so that you can fund the incentive plans if everybody hits their marks.

Assuming you can resolve the funding question, what should you and your partners and associates be paid, over and above the base, for exceeding performance expectations? The best designed compensation plans will align this reward with several considerations such as individual behavior and the company's goals. Because expectations on both fronts may change over time, it's also feasible that the incentive plan design changes periodically.

Going forward, I recommend several filters when redesigning an incentive plan to reflect true value.

1. Do you want to reward individual or team behavior?

2. Do you want to put a value on managing risk, such as client selection and termination, following protocols, or seeking a second option before rendering an opinion?

3. Do you want to reward new business development?

4. Do you want to reward client retention or client profitability?

5. Do you want to reward individuals for developing staff?

6. Do you want to pay a reward for completing a personal succession plan that helps to ensure business continuity?

As several pundits have observed, a crisis is a terrible thing to waste. Changes in our relationships with clients, changes in our economic well-being, and the psychology of clients and staff should cause us to evaluate how we do business going forward. So before you are asked to justify your worth, try to understand it yourself so that you can frame your value proposition and compensation models in ways that others can accept and appreciate.

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