From the November 2009 issue of Investment Advisor • Subscribe!

November 1, 2009

People & Pay

The premiere FA Insight Study shows how the best firms get and stay that way: by investing in their people

Investment Advisor readers can purchase a specially priced copy of the complete FA Insight Study by visiting www.fainsight.com. Click on "Order" and enter the discount code "IAREADER" when prompted to receive a 30% discount off the $250 price of the study.

If the seeds of destruction are sewn in good times, then the seeds of success are sown in challenging ones. As advisory firms await a clear and sustained economic recovery, a unique opportunity exists to learn from the human capital challenges illuminated by the trials of the recent economic downturn. These lessons will serve firms well both now and in the future. Even in the best of times, there will be external economic pressures beyond the control of the firm owner that will invariably challenge firm growth and profitability.

In 2008 about three of every four dollars spent by advisory firms was related to compensating or developing people (see Chart 1: Investing in People). People can be an overwhelming cost component for firms, especially in the current business climate. Much more than simply a cost, however, human capital is an asset that must be constantly invested in, nurtured, and allowed to grow in order for firms to enjoy long-term success.

People are without question the engine that drives client satisfaction, client retention, business efficiency, and financial performance for advisory firms. While managing costs is important, costs can be controlled in ways that avoid compromising the skill and talent that sets a firm apart in a competitive marketplace.

Sponsored by TD Ameritrade Institutional and with Investment Advisor as its media partner, the inaugural 2009 FA Insight Study of Advisory Firms aims to guide business owners facing serious decisions about people and pay. Without unduly risking the firm's chances of surviving through the economic downturn, how do advisory firm principals best position their firms in order to exploit new opportunities when the economy ultimately rebounds?

To help answer this question, FA Insight analyzed survey results submitted from 200 advisory firms. To be included in the study, firms were required to have been in business for at least 12 months and report minimum annual revenues of at least $75,000. In the comprehensive survey, firms generously shared their experiences and expectations concerning people and pay practices as well as firm performance. The survey, which was administered exclusively online, was fielded between May 1 and June 29, 2009. Participating firms invested 45-60 minutes of their time to complete the survey. They were required to provide a thorough financial statement, detailed information on up to 33 advisory firm job positions and the individuals that fill them, and answer 37 questions relating to the firm's operational characteristics and human capital practices. The results yielded a trove of data for better understanding how success correlates with a firm's capabilities to organize, motivate, retain, and develop people.

The Good, the Bad, and the Ugly

Borrowing from the epic 1960's spaghetti Western film, financial advisory firm performance over the past year can only be characterized as equal parts good, bad, and ugly.

The bad came in the form of dramatically shrinking investment portfolios, a decline in profits, and a workload that climbed in the opposite direction as advisors struggled to calm clients' frayed nerves, retool financial plans, and get clients back on track toward meeting financial goals. The ugly came in the form of scandal and misrepresentation, led by Bernie Madoff and a variety of mini-Madoffs. The publicity devoted to these negative events largely drowned out the good, which formed an overlooked but significant subplot to the drama of the past year.

We include among the positive developments the facts that client growth continues, the industry is maintaining and even adding to employment levels, and profit margins, at least through 2008, have remained healthy. Despite an 18% annual decline in AUM during 2008, the typical firm ended the year with the number of clients increasing 6% and gross revenues up 5% (Chart 2: A Slowdown in AUM). As a result, the typical or median firm earned a very respectable 2008 pre-tax operating profit margin of 18%.

Firms Remain Committed to People

We were encouraged to find in this year's study results that so many participating firms are maintaining their commitment to their colleagues and employees. The typical participating firm expects to maintain the same level of five staff members in 2009 that the firm maintained in 2008 and 2007. Our data show that in 2009 just 8% of firms plan to let staff go as a result of weak financial performance. In fact, many of the best firms in our study, the ones we call Standouts, are taking advantage of a suddenly available talent pool and adding staff instead of cutting back. Due to these planned hires, participating advisory firms are anticipating an average 3.5% increase in staff for 2009.

With the exception of possible contractions in incentive compensation, firm owners are similarly steadfast with respect to pay. While most owners do not anticipate any 2009 adjustments to salaries as a result of economic conditions, of those that do plan to make a change, more say they are apt to be raising salaries than decreasing them (See Chart 3: Raising the Salary Bar).

Reasons for Concern

While the patient may no longer be in critical condition (assuming it ever was), the recovery process for advisory firms is far from complete. Reasons for concern remain as growth rates ratchet down while firms struggle to contain expenses. Especially if the current recession lingers on and a financial market recovery fails to hold, the profit margins firms enjoyed in 2008 will not be sustainable through 2009.

Client growth among participating firms in 2007 was an estimated 8%, with firms expecting 5% growth for 2009. Annual revenue growth, as a result of shrunken portfolios, is off more dramatically. Median firm revenue growth, dropping from 21% in 2007 to 5% in 2008, is expected by firms to dip to -2% in 2009.

While revenues are trending down, the opposite is true of firm workloads. As clients demand increased attention to restore their damaged portfolios and lost sense of confidence, it's been a struggle to contain costs. In 2008 about 45% of revenue was related to overhead, defined as those expenses not directly associated with generating revenue. Normally this ratio should be in the range of 35% to 40%.

Advisory firms' recent challenges with overhead expenses, particularly evident among the larger practices, are similar to trying to brake a runaway freight train. As revenues began to contract in 2008, overhead expenses could not be reigned in quickly enough. The fact that advisors still had the same or greater number of clients to serve, all of whom were requiring more attention, compounded the cost challenges for firms.

Standout Firms Really Stand Out

While no firm was able to completely escape unscathed from the effects of the economic downturn, a sub-set of firms in our study fared remarkably well, particularly with regard to their ability to keep overhead expenses under control.

In order to better understand what makes an advisory firm successful, Standout Firms were distinguished at each of four stages of development. We defined these firms according to two key criteria related to building firm value:

o The ability to generate income for owners

o The ability to grow (as measured by revenue)

The top third of firms ranking highest across both factors in each of the four stages of firm development were distinguished as Standouts. Both the owner income and growth criteria received equal weight.

By definition, Standout Firms best demonstrated the ability to grow and generate income, key factors that build sustainable value for firm shareholders. Depending on the firm stage, Standouts generated 40% to 90% more owner income, experienced revenue growth at rates five to eight times higher, and achieved profit margins that were typically double that of their peers. Management of overhead expenses, however, was among the most impressive advantages of Standout Firms, where firms held a 13 to 17 percentage point difference over their peers.

People and Pay Make Firms Stand Out

For Standout Firms, people and pay are largely what separates Standouts from their peers. The Standouts are a shining example of the benefits that can be achieved through disciplined people practices, particularly the way these firms continue to build their organizational structures, compensation plans, and staff development practices despite market conditions.

Standout Firms have systems and processes in place that allow them to get more out of a dollar's expenditure on compensation and achieve other cost-saving advantages as well. Standout Firms are based on thoughtful organizational structures that put the right people in the right places. Well-defined and clearly communicated work flow processes, coupled with formal training programs, assure that staff of Standout Firms know how work needs to be conducted.

Training is an especially key distinction for Standout Firms. At every firm stage, Standouts are more likely to make formal training programs available to their staff, and they are more likely to offer them across every position group (See Chart 4: Those Who Can, Train).

The use of dedicated management and incentive compensation at Standout Firms reinforces the firm's policy that work behavior be aligned with the overall objectives of the firm.

These measures combine to yield a more efficient deployment of staff which, most importantly, enables Standout Firms to delegate non-advice related activities away from professionals. Through delegation, the firm is less dependent on its professionals, freeing their time to focus on revenue-generating activity. As a result, Standout Firms can make more use of lower-cost labor while getting greater productivity out of their highest paid professional staff, ultimately devoting a smaller proportion of revenue to compensation as compared to peers.

Standout Firms of all stages also demonstrated a commitment to growth and acquiring talent. To assure they have the best people and sufficient capacity, Standouts are more apt to hire and more apt to give raises, despite an uncertain economy.

Particularly notable are the intentions of the industry's largest Standout Firms--Standout Innovators--to invest in new talent. Of the Standout Innovators, 55% view college graduates as a key recruiting source, as opposed to just 27% of other Innovators. Their greater willingness to take on college graduates is not only a bold investment in the future but also a sign that these larger, better-performing firms offer developed career paths and formal training that can accommodate and groom younger professionals.

Room for Improvement

In the course of our research two important human capital practices became evident where even Standout Firms seemed to struggle: staff performance management and equity distribution.

All firms show the potential to better link performance incentives to the areas of the business that each role can directly influence. No matter how junior a position, each staff member can have a marked impact on the success of an enterprise particularly when working toward specific objectives that are within the individual's span of control. For example, as well as using business-wide performance measures to determine rewards, support staff performance measures may include developing initiatives that will enhance the client experience and increase client satisfaction.

In a related area, while most firms tend to have a performance-management process in terms of measuring and evaluating the contributions of staff, the full benefit of this practice is yet to be realized. Even among Standouts there is significant opportunity to more actively manage individual performance. Depending on the firm's stage of development, 8% to 56% of Standouts do not conduct performance evaluations, and of those groups that do, only 8% to 43% rate their performance-management process as highly effective.

Turning to the subject of equity as it relates to retention, a notable 46% of our survey's largest firms reported they admitted a new partner over the prior 12 months. Firms that did so reported placing greatest emphasis on ensuring the new partner had the values and character that were most consistent with existing partners. In addition, prospective partners needed to demonstrate an ability to lead and contribute to the management of the firm.

Of the new partners, 85% were promoted from within the firm, a positive sign for retention of talent. That said, a resounding 84% of all firms surveyed do not have a broad ownership distribution plan in place (See Chart 5: Close to Their Chests). This failure suggests a dramatic opportunity to better leverage equity planning. Not only does a robust equity plan support the retention of key talent, but it will also help to address increasingly difficult succession challenges by spreading ownership over a larger number of people.

With the right management practices, any firm can move beyond simply surviving to truly thriving. As for where to focus, following are the most important lessons from our research.

A firm's organizational structure and human capital plan must be in solid alignment with its business strategy. This includes structuring a compensation plan that aligns staff behavior with firm strategy and client service objectives.

Firms cannot grow without growing their people. This means actively managing the organizational structure, building a training capability, and adhering to a hiring strategy that anticipates growth as well as the need to move people into increasingly specialized positions with more concentrated expertise.

People are best motivated when they stand to gain personally from improved performance. Incentive pay linked to achieving specific objectives is a powerful tool for motivating team members to contribute additional effort in order to achieve firm goals. The opportunity for key individuals to earn equity shares is an effective motivator as well.

Proactive performance management can reduce subjectivity regarding the measurement of individual contributions and more clearly tie compensation to performance. Meaningful performance measures, consistently monitored and managed, will drive positive performance outcomes.

No matter how dire the revenue picture, a firm's top priority must be to protect its investment in people. Before cutting salaries or laying off staff, exhaust all ideas for how people can be made more productive and used more efficiently.

How a firm prioritizes these lessons is up to each individual owner. Executives are encouraged to apply these People and Pay findings to their own specific situations in order to identify where they are most vulnerable. Much is to be gained by implementing a plan to shore up human capital weaknesses. People are a firm's most valuable asset and core to its competitive advantage. Disciplined people practices, particularly those related to organizational structure, compensation planning, and staff development practices will assure a firm's success and longevity through the good times as well as the bad.


Dan Inveen is the principal who leads market research for FA Insight. He can be reached at Dan@FAInsight.com. Eliza De Pardo is the principal who oversees FA Insight 's consulting services. She can be reached at Eliza@FAInsight.com

Dan and Eliza are former senior members of the Business Consulting Group at Moss Adams.

Investment Advisor readers can purchase a specially priced copy of the complete FA Insight Study by visiting www.fainsight.com. Click on "Order" and enter the discount code "IAREADER" when prompted to receive a 30% discount off the $250 price of the study.

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