From the October 2015 issue of Investment Advisor • Subscribe!

Better-Paid Employees Build Better Firms: FA Insight

Better pay can also solve the industry's significant — and growing — succession problem

Firms that pay there employees more tend to have better performance, FA Insight's latest survey found. (Illustration: Ikon Images/Corbis) Firms that pay there employees more tend to have better performance, FA Insight's latest survey found. (Illustration: Ikon Images/Corbis)

Back when I had jobs that involved managing people, probably my toughest ongoing battle with corporate management was over hiring and pay. Often, in their zeal to “contain costs,” as Oscar Wilde said, those in charge “know the cost of everything and the value of nothing.”

It hadn't taken me more than a couple of years of trial and error to realize that when you’re doing something important (I know, putting out magazines isn't curing Ebola, but we do like to get it right), one good employee can be worth two — or even three — mediocre employees. They work harder, work smarter, make fewer mistakes, take responsibility, help (and often inspire) other employees and are way, way more productive. I always tried to hire the best people I could find and pay them on the upper end of the pay scale for their jobs. This sent the message that we valued their skills and experience, and motivated them to do their best work.

Consequently, I was pleased but not surprised to read that one of FA Insight's major findings in its 2015 “Study of Advisory Firms: People and Pay” is that the most successful firms pay their employees — both professional and non-professional — more. At the same time, these firms operate more efficiently, reducing their overall costs and increasing their bottom lines.

This year's “People and Pay” study surveyed 351 advisory firms: 67% were RIAs only (no BD affiliation) and another 9% were primarily RIAs (which means they are independent RIAs, but with a BD affiliation for “conducting limited commission-based business”). The remaining 24% were affiliated with an independent BD, an IBD that has a financial planning RIA, an insurance BD, a wirehouse, or a bank or trust company.

As two-thirds of the participants were independent RIAs and another 9% were almost independent RIAs, it's curious that FA Insight's principals Dan Inveen and Eliza De Pardo would water down this 76% majority of similar businesses with the remaining 24% of not-very-similar businesses that have brokerage, insurance, banking or trust company affiliations. It seems that the data would be cleaner with this 24% broken out separately — and interesting to see a comparison of the two groups.

But the combined data does offer some interesting insights. It's not surprising that median firm AUM growth slowed a bit from 2013 (17.1%) to last year (10.9%), considering that stock markets are trailing off. It's encouraging that client ranks continued to grow (6%) at a rate that's down only slightly from the 6.5% growth in the year before, and that this growth translated into 14% higher revenues in 2014.

As one would expect, overhead (as a percentage of revenue) fell, as firm revenues continue to grow: Median firm overhead expense, as a percentage of revenue, actually fell from 36.6% to 33.6%, which drove up median profit margins from 22.1% to 26.1%.

“The expense drop, coupled with the 14% revenue growth, fueled a dramatic four-percentage-point jump in median profit margin, which reached a record 26.1% in 2014,” the authors wrote.

However, it is surprising that this growth continued at a time when firm staffs — along with the accompanying increased overhead — continued to grow as well. “As firms increased business volume, headcount grew as well,” wrote Inveen and De Pardo. “The typical firm jumped from six to 6.8 full-time equivalents (FTEs) during 2014.”

While that might not seem like much of a staff increase, it is a 13.3% increase in the largest overhead expense in virtually all firms — 78% of all firm expenses in the study are “people-related.”

That makes it even more surprising that the most successful firms actually pay their employees more than other firms. The most successful firms in the study are called “Standouts” (the top 25% of firms, determined by equally weighting revenue growth and owners’ income, in each of four size categories).

“Standout firms paid their team members 5% or more in comparison to other firms,” wrote the authors. “For only one position (associate advisor) did Standouts tend to pay less.” They added that “compensation can be an important factor in recruiting new talent to a firm” and plays a “critical role in retaining and incenting a firm's existing team members.”

What's more, the study found that Standouts also tend to offer better financial incentives for exceptional job performance (one of the other management tools in which I believe strongly). One of the biggest differences between Standouts and the other 75% of those surveyed is the use of performance-based incentive pay. While 74% of Standouts use incentive pay with their professionals, only 34% of the other firms do, and a far higher percentage of standouts consistently offer performance incentives to employees in every other category (management, technical, support, admin).

The benefits of increased support staff, higher pay and financial incentives can be seen across the board in today's advisory firms. The study data shows that from 2009 through 2014, productivity measured as median revenue per professional grew at a compound annual growth rate of 6.4%, reaching a record $528,500 per professional in 2014. Revenue per full time employee reached a record high for the year as well.

“Standout productivity helps to explain the somewhat counterintuitive result of Standouts paying out higher compensation while realizing lower overall personnel costs,” wrote the authors. “While Standouts may tend to pay a premium for their personnel, it is clearly money well spent. With the exception of [the smallest firms], Standouts at every stage generate more revenue per professional than their peers. This trend holds true for revenue per all [full time employees] as well. This suggests that by targeting higher pay for their people, Standout firms are attracting and retaining more capable team members that support a more productive firm. This ability to realize greater productivity keeps costs under control and supports greater profitability.”

So much for the good news. While the authors caution that a market downturn could have a damping effect on the advisory industry's growing success, they also cite a few other dark clouds in their findings, foremost of which may be the aging of owners and other advisors.

“The greatest concern for advisory firms may be people,” Inveen and De Pardo wrote. The average age of a working owner is now 51.8 and climbing, according to the study, compared to the average age of 50.1 in 2011.

“The share of firms with owners who are within three years of retirement has more than doubled in the past four years. Despite this, less than half of study participants (44%) have an adequate succession plan in 2015,” the authors wrote.

At the same time, the study found that “the median age for a lead advisor in 2015 (including owners and employees) is now at 50, up from 47 years old in 2011. And, lead advisors today “significantly outnumber the available ‘reserve pool’ of associate advisors. As of 2014, the industry averaged just one associate advisor for approximately every two lead advisors, which makes for an insufficient pipeline of replacements.”

This lack of younger professionals is also likely to affect the succession of many firms. The study found that firms are three times more likely to promote an existing employee to ownership, rather than bringing in a new owner. This desire drives many firms to better prepare their young professionals.

According to the study: “In general, firms with adequate succession plans were often more capable of taking on inexperienced hires and progressing all team members to higher levels of responsibility. Succession-prepared firms, for example, show a greater tendency to maintain organizational structures that support internal career paths. These firms are also more prone to offer individual development plans and are more likely to provide access to formal training.” However, with the dearth of young professionals at many firms, this entire “succession” system may begin to fade.

Finally, Inveen and De Pardo found that the advisory industry is still woefully lacking in adequate planning for the future. “Year after year, the superior performance of Standout firms stems from minimizing overhead expenses and maximizing team member productivity relative to their peers,” they wrote. “While the majority of firms do well in terms of defining their existing organizational structure, a much lower percentage are adequately relating organizational requirements to the future needs of the firm. Less than 50% of firms maintain documented and updated job descriptions. Just 19% of firms maintain a documented plan for their future structure.”

Kind of ironic, don't you think?

--- Read "Schwab Finds Women Hold Almost Half of RIA Jobs but Have Little Equity" on ThinkAdvisor.com.

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