This is the final article in a three-part series on the challenges facing fee-only advisors, focusing this month on how advisors can use benchmarking tools to fine-tune their practices. Part 1, which appeared in the December 2003 issue, addressed advisors’ marketing challenges. Part 2, in the January 2004 issue, explored ways that advisors can use technology tools to increase their efficiency and competitiveness.

As with all small business owners, successful fee-only advisors ultimately reach a stage of development that calls for a greater focus on the business aspects of the practice. They need to know how well the practice is functioning, whether policies and strategies need improvement, and if the firm’s fees and expenses are appropriate. One way advisors can address these issues is to compare their practices against others in the industry.

While benchmarking in this fashion provides critical information, it can be a difficult task for independent fee-only financial advisors. By definition, they are sole practitioners, single-partner firms, or small partnerships. An unfortunate drawback inherent in this structure is a certain degree of professional isolation. The lack of a natural forum to interact with other advisors makes it difficult to identify benchmarks against which to measure the efficiency, profitability, or standards of an advisory practice.

Most advisors crave insight into what their competitors are doing and benefit from the ability to compare their practice with successful peers. The opportunity to measure oneself against others comes naturally to brokers and even financial planners who operate in a group environment. On the other hand, independent fee-only advisors must make a strategic decision to benchmark their practices. Once a practice has been in existence for three years or reaches a reasonable asset level, such as $25 million, it is probably time to make a concerted effort to benchmark.

Comprehensive benchmarking shows how one practice differs from the average advisory practice, as well as from above-average practices. Identifying these disparities does not necessarily mean the firm has to change anything, although it is likely to pinpoint some specific areas for improvement. It does enable the firm to take a critical look at the differences and determine whether each one is an asset or a liability.

For many advisors, the issue is not whether to compare their practices to an industry standard, but how. Their infrequent interaction with colleagues makes informal benchmarking virtually impossible. However, several benchmarking tools are readily available. The Financial Planning Association’s annual FPA Compensation & Staffing Study, for example, provides comprehensive data on compensation, staffing, and financial performance of financial planning practices. Charles Schwab and several other financial services firms also provide comparative data to their affiliated advisors. Benchmarking tools have been popping up online as well. Tiburon Strategic Advisors, where co-author Chip Roame is managing principal, has established a series of Web sites that allow all types of financial advisors to submit information about their own firm and in return receive compiled information on almost 4,000 other advisors. This tool for fee-only advisors can be found at www.FABestPractices.com. (AdvisorBenchmarking.com, an affiliate of Rydex Global Advisors that supplies Investment Advisor with content for its monthly Practice Edge electronic newsletter, offers a separate online benchmarking tool.)

Tiburon’s FABestPractices.com database is free to financial advisors and updated periodically. Its data can be sorted by the size of the advisory firm or by custodian. This allows advisors to compare their own practices to similar or larger ones. It also allows them to analyze the results of advisors using a particular custodian. We will present key averages from the data within this article.

We recommend two methods for advisors to effectively use the benchmarking Web site, depending on the advisor’s individual objectives. On the FABestPractices Web site there are 35 questions, with approximately 400 charts. The first method is to answer all 35 questions without spending time reviewing the related charts. This takes about 45 minutes. At the end, the advisor can print a free copy of a research report detailing the data Tiburon has collected from the site. When advisors are ready to take a step back and look at the practice as a whole, they can complete the entire survey.

Alternatively, they can use the second method if they need insight into a specific aspect of the business. They should review the list of questions and go directly to the question or questions that impact current decision-making. After answering those questions, they can review and/or print the related graphs. Some sample questions that begin the process are these:

o What year did you start or join your current business?

o Which licenses or designations do you hold?

o What are the primary sources of new money your clients invest with you?

o What are your primary sources for attracting new clients?

o What asset allocation software do you use?

o What were your client assets at year-end 2003?

o What were your revenues for the full-year 2003?

Benchmarks for Financial Performance

Although it can be useful to compare any aspect of a practice to an appropriate benchmark, the most commonly used benchmarks relate to financial performance. Five areas can be evaluated:

o Firm Profile

o Income Statement Averages

o Client Profitability

o Partner Profitability

o Employee Productivity

Tables 1 through 5 enumerate the results for each of these areas, based on Tiburon research.

The tables describe the average advisor in the survey, and it should be noted that the survey has attracted a group of very large, successful advisors.

Each table also provides space for advisors to list the statistics of their own practice for comparison purposes.

Several of the figures are worth examining more closely. In Table 2 (“Income Statement Averages”), the return on assets for an advisory practice is the ratio of its revenue to the assets it manages. In layman’s terms, this would be the average fee; it generally ranges from 65 to 100 basis points. Another important number in this table is the profit margin, determined by dividing total pretax profits by total revenues. The profit margin can indicate whether expenses are out of line with revenues. According to Tiburon research, this number ranges from 30% to 60%.

One set of benchmarks that can be extremely valuable in evaluating and improving the functionality of a practice are those related to client profitability. The series in Table 3 identifies exactly how profitable the average client is. It includes assets per client, revenues per client, and profits per client. If these statistics fall far short of the average advisory firm, a practice may want to take a harder look at individual clients to determine which ones are profitable and which are not. Focusing a practice on profitable individuals or profitable categories of clients can improve overall profitability.

An analysis of partner profitability (see Table 4) could help decide whether another partner would be beneficial to the practice. This may be the case if the number of clients per partner is far above the average, but the revenues or profits per partner are below average. In that situation, the heavy client load may be hampering service to individual clients as well as marketing efforts.

Reviewing employee productivity (Table 5) can also be informative. By looking at clients per employee, assets per employee, revenues per employee, and profits per employee, a practice can determine whether its staff is meeting average productivity standards. It will also have a reasonably sound estimate of the potential added value from expanding staff.

Although financial results are perhaps the most widely used benchmarks, advisors can benefit from comparing any area of their practices to others. Those seeking to enhance their marketing strategy may want information about methods that are highly effective for other practices. Some who strive to improve their use of technology may want to know specifically what software and systems are used by the most successful practices, while an advisor considering a change in custodian may want to compare the popularity of prospective vendors.

Some Useful Perspectives

Based on Tiburon’s analysis of the financial advisor database–particularly on comparisons of advisors with larger and smaller asset bases–we offer these perspectives on some unexpected and somewhat counterintuitive findings:

o Leveraging people does not increase assets. Contrary to popular opinion, larger advisors generally do not work their staffs harder or achieve any higher level of productivity than smaller ones. Larger advisors, however, do hire more employees, and that appears to be one of their successful strategies for increasing assets under management. According to Tiburon data, advisors with more than $500 million in assets average 8.4 employees, compared with an average of 4.1 for all advisors.

o More clients are not necessarily better. Tiburon has found that top advisors may actually have fewer clients per employee or fewer clients per partner, but their clients have substantially more assets, which equates to more assets per partner and more assets per employee. This is a more profitable scenario.

o A lower return on assets can equal greater profits. Larger advisors may tend to have a lower return on assets, that is, a lower average fee. This relates directly to the fact that they typically serve larger clients, and hence offer discounted fees. It is critical to look beyond this to recognize that 40 basis points on $10 million are still better than 100 basis points on $200,000.

o Larger advisors also tend to have lower profit margins. Whereas small firms might achieve a 60% profit margin, larger firms might have a 30% margin. Hiring more people and attracting larger clients, though key to building a larger practice, can also increase expenses and drive down margins. More successful advisors have learned that such investments in the practice can ultimately increase absolute profits.

No “Ideal” Results

There are no ideal or target ratios for advisors. The statistics from these analyses are only averages, and they vary significantly based on the type of practice, the objectives of the partners, and the size of the business. In our opinion, the most effective use of this information is to compare results to the average or to the data for a specific category of advisor, and then ascertain why the results differ.

We caution against misinterpreting the results of a comparison and offer one example. Tiburon has found that the average return on assets or average fee is 74 basis points. If a firm’s average fee is 100 basis points, it may mistakenly conclude that it is overcharging and its fees are not competitive. However, if the practice also takes into account average client size compared to the benchmark, it may find that its fee correlates correctly with the average size of its clients. The way to lower the average fee is not to charge small clients less, but to attract more large ones.

The Value of Benchmarking in Succession Planning

For many fee-only advisors–whose average age is 45–concerns about succession planning have yet to reach a priority level. However, this will change in the next decade as the average age of fee-only advisors rises. Advisors older than the average may need to establish a succession plan and begin positioning the practice to maximize the capital it will generate. In addition, advisors still years away from retirement should question whether they are following their own advice to clients. If the practice is their most significant asset, they may want to consider selling part of it to reduce non-diversification risk and improve liquidity.

Benchmarking is a valuable tool in succession planning, given that one of the greatest challenges of any succession plan is valuing the business. Acquirers of fee-only advisory practices have begun using a basic approximation for valuing a practice, generally estimating that the average advisory practice is worth 6 to 8 times current cash flow.

Benchmarking has two meaningful benefits in succession planning: It provides insight into how to make the practice more profitable and more valuable to potential buyers, and it arms the advisor with the information to negotiate a higher price for the practice. Knowledge gained from comparing the practice to a benchmark can show the buyer that the firm is worth more than the average practice. The advisor will be able to demonstrate that the practice has a higher average fee, a higher profit margin, more profitable clients, bigger clients, or whatever conclusions the benchmark analysis has revealed.

Most advisors have limited options for exiting their practice. Buyers typically fall into two categories: systematic and situational. Systematic buyers seek to buy multiple advisory firms. Of these, financial buyers generally aim to take their aggregated practices public, while strategic buyers such as banks or CPA firms seek to add investment advisory capabilities to their existing services. Financial buyers and hybrid buyers, who are partly financial and partly strategic, have not had much success and are not realistic options in today’s environment. Strategic buyers, on the other hand, are eager to be in the profitable business of investments and have a track record of buying medium to large advisory firms.

Situational buyers, including competitors, partners, and employees, are a much more feasible solution for most advisory practices. These buyers may be in a position to acquire one practice, but are not in the business of acquiring multiple practices and rolling them up into a larger firm. There are several caveats for seeking a situational buyer:

o Competitors may feign interest in the practice to obtain proprietary information about its clients and financial situation.

o Employees may have difficulty raising the capital to finance the purchase.

o Larger advisors might pursue a strategic sale to a CPA firm or a bank that would have the structure and necessary capital to complete the purchase. For advisors who intend to sell to a partner or employee, the key is to begin the process well in advance. To groom junior partners who would maintain the practice indefinitely probably requires five years of planning, compared to a strategic sale which could be completed in as little as six months.

The Final Steps

Probably the greatest value in benchmarking is the dialogue it inspires. A benchmarking tool is as useful for the questions it raises as for those it answers. Here are some suggestions for maximizing the impact of benchmarking tools such as www.FABestPractices.com:

o Complete the benchmarking survey, print the research report, and schedule a series of meetings with your staff to compare the results to the financial advisor universe. Establish targets for areas that could be improved and brainstorm strategies for reaching those objectives.

o Organize a discussion group with five to ten advisors in your area. Have each one complete the benchmarking tool and then meet to discuss the results and share ideas for enhancing your individual business models.

These strategies are aimed at accomplishing the same goal–taking a harder look at how to manage the practice. Incorporating benchmarking into management can help ensure that the practice provides the greatest possible return on the capital and time invested in it.

Chip Roame is managing principal of Tiburon Strategic Advisors in Tiburon, California, and Kenneth Tollmann is an executive director of Morgan Stanley Investment Management in New York. Roame can be reached at croame@tiburonadvisors.com; a free summary of Tiburon Advisors’ benchmarking report is available at www.fabestpractices.com. Tollmann can be reached at kenneth.tollmann@morganstanley.com.