“The economics of advisor recruitment checks, which are structured as forgivable loans to advisors, have changed dramatically in the aftermath of the financial crisis,” says Jeff Spears, in a November white paper. Recruiting payments have come back to bite some of the brokers who signed up for them.
A question nagged at Spears: “Why aren’t more really capable brokers going independent?” The result of that query is his study, “The Illusory Recruitment Check: What’s Next For Wealth Advisors.” Spears is co-founder and CEO of San Francisco-based Sanctuary Wealth Services.
Before, Spears explained, “it made perfect sense to take a six-or seven-figure recruitment check and change firms every five years.” The financial crisis has contributed to changes in the way firms recruit or retain brokers.
Sanctuary offers brokers, who want to leave for the independent registered investment advisor RIA life, services to help them make the transition, including investment, infrastructure and consulting services. Sanctuary also helps established RIAs outsource those services.
The Way Things Were
Spears was at Montgomery Securities when it was bought by NationsBank, which was gobbled up less than a year later by Bank of America. At the time Montgomery, a broker-dealer (BD), was purchased, the bank’s advisors had a fiduciary duty to clients Spears says. After they’d bought Montgomery, the bank had a formidable task: it needed to figure out how to best utilize Montgomery’s broker sales force along with the fiduciary advisors that already were at the bank.
The bank brought in the consulting firm McKinsey & Co. to advise it on how to create client teams that included an advisor who was a fiduciary, and had to put client’s interests first, and a broker functioning under the suitability standard, who did not, according to Spears.
The fiduciary, who was the client’s advisor, was supposed to introduce the broker. One can only imagine how that would have worked out, since, as Spears says, the management consultant’s plan was never used and that project didn’t get off the ground.
Eventually, however, the brokerage side of the bank grew bigger than the banking and fiduciary advice side of the bank—the brokerage side has been more lucrative than the fiduciary side of banking. Now, most investment clients of banks (outside of trust departments) deal with a broker, not an investment advisor, according to Spears. Many clients don’t understand the meaning of that change: not just the regulatory structure—SEC for investment advisors and Finra for brokers—but the move from a fiduciary relationship to the sales relationship. This editor is a member of the Committee for the Fiduciary Standard.
Superfinancials and Independents
All of this, of course, ties in to the movement to open platforms, growth of the independent BDs and growth of the RIA side of the investment business. It also directly relates to the formation of superfinancials, the banks and brokers that merged, sometimes with insurers, to become super-distributors of product, and the question that every advisor at one of those larger firms faces. Do I want to be a product distributor (a business centric model) or an advocate for my clients, (a client-centric model) and part of that decision is, do I want to put my clients first or myself and myself and my firm first?
For some, the question becomes one of money. It was fairly routine, over the past 15 or 20 years, Spears told AdvisorOne.com, to offer a broker with $1million “in production” a recruitment check of 100% to 150% of the trailing 12-months’ production. For that rep, a check for $1 million or $1.5 million would be hard to turn down.
Here’s How it Worked
Let’s use as an example the “broker with $1 million production,” Spears explains, who got a $1 million recruitment check. The rep got the full $1 million recruitment payment in a check. What about taxes? “No taxes taken out initially, because it’s a forgivable loan,” he notes. The broker signed a “five-year contract” with the firm. The loan was, in a sense, a draw against production revenues, to be “repaid over the five years, one-fifth each year.” So the broker’s revenues needed to be $200,000 higher the first year, $200,000 the second, and so on, until the fifth year, when the loan was fully repaid. Instead of paying taxes on the initial $1 million check, the broker paid taxes on the $200,000 each year for those five years.
Since the broker was expected to have $200,000 in addition to the $1 million they came in with in production revenues, each year, it’s important to realize who is actually paying these recruitment dollars to the rep—is it the firm? No—it’s the customers.
What happened if the rep didn’t achieve that extra $200,000in revenue in any or all of those five years? The debt was “forgiven,” Spears. So for the brokers—it was a really sweet deal. Sometimes less so for the firms, Spears says, because “the system could be gamed.” Was their $1 million in production going to take a hit? What if the broker “held information” such as, “a client is going through a nasty divorce and will yank an account?” The broker may “know that their production is going from $1 million down to $800,000 next year. The broker can use the up front money to replace the client that’s going to fire me,” Spears asserts. Or they could get a friend to “park assets with the broker’s firm.”
Why the Big Payments?
So why did the firms recruit using these big payments? Spears notes that the firms “weren’t profitable on the accounting going into [the] wealth management [division] but were profitable on a more global," basis, as the firm would make money on the additional assets the new broker would bring, in the firm’s “money market funds, on margin interest,” shelf space fees and product sponsorships. They’d also “hypothecate the stock,” from these new clients, “to hedge funds.” Spears says that, “the broker doesn’t get paid on this part but the firm does,” and he adds that gathering assets this was less expensive than acquiring clients in other ways.
More recently, over the past three years, says Spears, those up-front recruiting payments ballooned to 300% to 350% of trailing 12-month production, but the terms changed in ways that are much less favorable to the broker. Spears says the 350% payments are “smoke and mirrors.” Now, the broker gets “100% to 150% up front for coming over, but they have to stay nine years to get the rest, and have to achieve certain asset and revenue milestones.” So the brokers would get the first 150% payment up front, vesting as a forgivable loan for the nine years.
But most brokers, and he “talked to 90 of them,” Spears explains, “didn’t make any milestones, didn’t get the other 200%,” yet had to stay for the nine years of their contract. So they get essentially the same forgivable loan amount but stay for almost twice the time. “You could kill somebody and spend less time in prison,” Spears says, wryly.
“Brokers were surprised by a lot of this,” Spears notes, adding, “they were unaware how bad things were with other brokers’ similar situations.” The “350% really didn’t exist without some major strings attached.”
Meanwhile, as word gets out and untethered brokers move to the RIA side of the industry. “Independent practitioners need to really deliver—make the client experience great,” Spears continues.
In addition however, the independents have to overcome the power of superfinancials’ branding, because one challenge is that you get what Spears calls “capable brokers” who are reluctant to move because the large bank wirehouses or large brokerage firms “are minimizing the independent model,” he asserts. One global wealth management exec says, according to Spears, that, “independents don’t have the financial heft and security of,” a big wirehouse bank. But clients at the independent RIA firms get fiduciary advice, and they don’t have to pay for branding and marketing campaigns, either.
Spears counters the big-brand argumentwith the anecdote of the broker turned RIA who had a client with a $10 million account at Lehman. “The light bulb went off for the client,” and “they requested the independent RIA do a proposal, but on a $50 million account, not the $10 million.” The new independents can bring higher share of wallet, more assets, Spears says, and that helps counteract the effect of skipping the up front payments and that clients are paying in total costs for the fiduciary model.
One of the arguments that resonates with clients, according to Spears is when the new RIAs, “tell clients it’s in their best interest to go to the independent firm.”
For more, please see part 1 of this two-part series, “Broker Compensation Not as Advertised at Wirehouses: Sanctuary's Spears.”