From the December 2010 issue of Investment Advisor • Subscribe!

Share the Wealth

Advisory firms that pay employees based on revenues are simply more successful

One of the things I do for my advisor clients in my consulting practice is to take over the management of their employees: Not only does that take a time-consuming headache off their plates, but the presence of an objective third party often reduces any tensions that crop up. Over the years, I’ve become pretty good at hiring the right people, anticipating problems, and motivating them to be happy and productive members of their firms.

But out of the nearly 200 employees I’ve managed in recent years, there is one employee that I just have not been able to get through to. He’s certainly talented enough, but doesn’t seem to have his head or his heart in his job. So, the other day, I was thinking about what I can do to work with this guy when an interesting thought hit me: I wondered how much of employee motivation is really the result of compensation structure?

So I took an afternoon and conducted an analytical survey of my past and current clients and their employees: comparing employee motivation with how their bonuses are structured, and then comparing firm bonus structure against revenue growth. No, this isn’t really a statistically significant analysis: I’m only looking at a couple of hundred employees at a few dozen firms. But the results were so clear, and so striking, that even I was amazed—and I’ll bet you will be, too.

Now, I’ve always been a big fan of revenue-based bonuses, where you simply pay out each employee a percentage of the firm’s revenues. Usually, my more entrepreneurial advisor clients are good with that: They like sharing a bit of the risk and the fact that their employees have a direct stake in the success of the firm. To really have the desired impact, it’s important that employees are told the firm’s total revenue upon which their bonus was based. This enables employees to understand the firm’s current financial situation and how it impacts them. My more technical, analytical advisors, on the other hand, don’t like the uncertainty, variability, and often the disclosure involved in a revenue basis, preferring instead to pay more predictable, and controllable, bonuses based on profits or on merit.

I strongly recommend against arbitrary bonuses for reasons which I hope are obvious, so my merit-based clients pay fixed bonuses based on completion of specific projects or tasks, or upon reaching predetermined goals. I’d suspected these bonuses weren’t as motivational, but until I did my analysis, I hadn’t quantified my theory or had any idea how big the effect was. And as it turns out, the impact of bonus structure has radically changed the way I manage employees.

To get to the bottom of the effects of different bonuses, I first listed 162 of the employees I’ve managed in recent years (including professional employees, those in operations and client service, but excluding lower-level employees such as receptionists and admin assistants), and scored each one on their motivation level: 5 for highly motivated down to 1 for low motivation. Next to each employee’s name I wrote down their firm’s bonus structure: Revenue-based, profit-sharing, merit-based, and in one case, an arbitrary Christmas bonus. Then I set the sort function on high to low motivation and hit enter.

And there it was, staring me in the face: Virtually all of the 5- and 4-level motivated employees were paid revenue-based bonuses. In fact, motivation level correlated very neatly into groupings based on bonus structure—with revenue at the top, profit sharing in the middle, and merit-bonuses at the low-motivated bottom. The evidence, at least in my small sampling, is very clear: Revenue-based bonuses are a much better motivator of employees than the other structures.

Then I wondered how much of an effect those more highly motivated employees had on the success of their firms? So, I compared the revenues of each at the lowest point following the 2008 meltdown with their projected revenues at year-end 2010. Again, the results were, at least to my mind, boggling. When I ranked percentage annual revenue growth from their low points to this year-end, they broke down into three neat groupings. At the top, with between 29.1% and 44.3% growth were the revenue-based firms; in the middle, ranging from 16.4% to 24.7% growth were the profit sharing firms; and at the bottom, with between 12.7% to 10.8% increases were the merit bonus firms.

It doesn’t get more clear than that, folks: The merit bonus firms averaged an 11.8% revenue recovery from the meltdown, the profit sharing firms recovered to the tune of 19.1% on average, and the revenue-based bonus firms came back an average of 39.9%. The increased motivation and identity with the fortunes of the firm created by revenue-based bonuses (including the quarterly disclosure of firm revenues) has an extremely high correlation with the revenue growth of the firm—at least when it comes to recovering from a major catastrophe. And I don’t see any reason to suspect this revenue growth advantage wouldn’t hold true during other times, as well.

Frequent, regular payments based on the firm’s success are highly motivational, as we have seen. To increase employees’ drive to find ways to help boost revenues, we typically use a tiered payout system: the higher the revenues, the larger each employee’s percentage share of them.

I used to sometimes use revenue bonuses combined with a small merit bonus for specific goals. But, advisors usually aren’t very good about setting merit goals, and the amounts were so small compared to the revenue portion, that it just wasn’t worth the effort. We just gave everyone a little bump in revenue participation and dropped the merit part.

Finally, I thought about whether I manage employees at firms that pay revenue-based bonuses differently than I do employees at the other firms. And I realized that I do, not out of any predetermined plan, but simply because they are much easier to manage. Revenue-based firms have far fewer employee problems—the employees know what their job is, understand how they contribute to the success of the firm, look for ways to make the firm better, and tend to do the best job they can.

Consequently, we don’t do employee reviews at those firms anymore. For one thing, we don’t have to give merit raises because that’s built into the growing revenues of the firm. We simply make a cost-of-living adjustment to base salaries every year, and let the bonuses do the rest. What’s more, because the employees are highly motivated to do a good job, they are almost always doing a good job. They don’t need feedback, direction, or guidance. If anything, the employees are constantly making suggestions about how things could be done better.

About four years ago, I had one client who wanted to get rid of his revenue-based bonus program and simply increase the employees’ salaries. The employees strongly objected, and talked him out of it. During the downturn in 2009, none of the employees at firms which paid bonuses based on revenue complained about lower or no bonuses; they could see the impact of lower AUM on the firm.

Firms that pay fixed bonuses, pre-set merit bonuses, or fixed raises really struggled when the markets went south. Many had to stop making those payments, often deferring them until, well, now. Making those catch-up payments can really take the fun out of an advisor’s recovery.

Employees with skin in the game really do contribute to the success of their firms. Even if you’re one of those analytical advisors who is uncomfortable with the vagaries of revenue sharing, I’d strongly recommend that you give it another hearing. It will make your firm better, your employees happier, and your life so much easier. Now, if I can just get my one problem employee onto a revenue basis.

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