Breaking the Barrier

Do you feel as if you’re working harder for about the same, or even less, compensation than you used to? If you feel that way, you’re not alone. Many financial advisors these days are indeed victims of their own success. They may have more clients and assets under management, and greater revenues, yet they are working harder, have less free time, and are reaping fewer benefits than they did before.

How can this be? The 2004 FPA Financial Performance Study of Financial Advisory Practices, produced by Moss Adams for the Financial Planning Association and sponsored by SEI Investments, offers some penetrating insights into both the existence of this conundrum and the reasons behind it. The good news is that there are solutions, as evidenced by the most successful practices. To find them, advisors need to understand the causes of this industry-wide malaise and proactively take steps to overcome them.

To begin, our Study found that assets under management at advisory firms were way up in 2003–increasing an average 34% at the 215 firms that participated in the survey. In fact, last year more than one in five of the participants had over $1 million in revenue, double the percentage in the study just five years ago. Half of that growth came from straight portfolio performance and the other half could be attributed to new assets coming from either existing or new clients. When we looked at a breakdown of this increase by practice type, the numbers came out like this: On average, ensemble practices increased their AUM by $48 million, while solo firms were up $12 million.

Yet if you feel as if you’re working harder for less, you probably are. Consider that while ensembles were racking up those substantial increases in AUM in 2003, annual revenues at those firms increased an average of only 14.3%, from $700,000 to $800,000. The pretax income of those firm owners only went up from $150,000 to $170,000, an anemic 13.3%.

What’s more, if you have a solo practice–like the majority of advisors–the picture was worse. At the same time the 67 participating solo practices were increasing their AUM, their revenues shot up as well, from $215,000 to $265,000 (at 23.3%, a bigger proportionate jump than the ensembles experienced). Owners’ pretax income at solo firms stayed essentially flat at between $106,000 and $109,000 (see Chart 1).

The Million-Dollar Barrier

What’s going on? Simply put, most financial advisors today are feeling the effects of the most significant insight into practice management in recent memory. We call it “The $1 Million Barrier.” A quick glance at Chart 2 reveals what we are talking about. Notice that as advisory firms increase their annual revenues from under $250,000 to between $250,000 and $500,000 and then from $500,000 to $1 million, total overhead expenses actually increase. That’s right: as your firm gets bigger, your gross profit margin actually goes down. It’s only after you break through the $1 million mark that firms realize the economies of scale that start to bring down the overhead expense ratio. Moreover, it’s not until an advisory practice brings in more than $5 million a year that it reaches a truly acceptable overhead margin of 35% of revenues (the optimal overhead expense ratio is between 30% and 35%).

Chart 3 shows the effects on the owner’s income of approaching, and then breaking through, the $1 million barrier. As a typical firm grows from under $250,000 in annual revenue to between $250,000 and $500,000, the owner’s income increases a healthy $73,000, or 128%. So far, so good. But look at the next jump: as the firm doubles in size from under $500,000 to under $1 million, the owner’s income only increases $30,700, a sluggish 23.6%, on double the revenue. The principals at these firms are clearly working harder–probably much harder, and certainly longer hours–for very little increase in income. Once they get past $1 million in revenues, though, firm owners are off and running. Income increases a healthy 42.4% from $160,600 to $228,700, and life is starting to look pretty good again.

What’s so magic about the $1 million mark, and so deadly about revenues between $500,000 and $1 million? We’re glad you asked. The simple answer is that more assets under management–and the greater numbers of clients they usually come from–require more staff to deal with the phones, clerical work, client communications, technology, compliance, trading, and other back-office functions. Take another look at Chart 2. The bottom line on that graph represents support and administrative salaries–notice that as a percentage of revenue, they double from 6% to 12% as a firm grows to revenues of $1 million.

This increase in staff salaries directly correlates with our data regarding increases in staff personnel. Typically a practice with under $250,000 in annual revenues has one principal and one administrative person, the latter often working part time. As the firm grows, the principal brings on the admin person full time and adds another support person. This enables the advisor to delegate more of the clerical duties, freeing him to generate the greater revenues and profits that we saw above. As revenues increase above the $500,000 mark, the firm usually hires a staff professional and another support person, bringing the total staff to four, and the staff-to-principal ratio to 4 to 1. By the way, this is the highest staff-to-principal ratio that most planning firms have until after they reach $5 million in annual revenues and different economic dynamics come in to play. At this point, although the additional staff leverage enables the principal to generate more revenue, in most cases it isn’t enough revenue to offset the increased staff costs, causing the overhead margins to climb and the profit margins to fall. At the same time, the principal now has to supervise the staff of four in addition to servicing all the additional clients. It’s no wonder the advisor feels squeezed.

Beyond the $1 million barrier, things change dramatically. To get to the next level of revenues, virtually all advisory firms add another principal, transitioning from a solo to an ensemble firm (a solo practice has one professional; an ensemble firm has two or more professionals, including the owner). Even though these firms typically add two more staff professionals and another administrative person, the staff-to-principal ratio falls to 3 to 1, and the increased revenues from the new partner more than offset those costs, so the overhead margins fall, while the profit margins climb. What’s more, the role of at least one of the staff professionals often changes at this point, from purely supporting the principals to generating at least some revenues on her own, resulting in an additional boost to the revenue and profit picture.

The Power of Leverage

Don’t get us wrong. Merely transitioning into an ensemble practice is not a guarantee of economic success. In fact, there’s a big gap between successful ensemble firms and the rest of our sample. In 2003, our data shows that despite growing assets under management and revenues, the average overhead margins at ensemble firms remained steady at 39%. Yet some ensemble firms are certainly prospering. According to the Study, last year the top 25% of ensemble firms, the elite ensembles, averaged revenues of $1.3 million vs. $550,000 for the other 75%. What’s more, those elite firms paid out over 3 times the pretax income to their owners–$360,000 vs. $100,000–than did the average ensemble firm.

One major reason for this better revenue and income performance of elite firms is leverage. Simply put, the more successful firms have more support people, significantly more in fact, that the average firms. A typical, non-leveraged ensemble firm with two principals will have one other staff professional and three administrative staffers, totaling 4 employees, with a ratio of staff to principals of 2 to 1. Compare that with a fully leveraged two-principal ensemble with 5 staff professionals and 9 administrative and support staff, bringing the total staff to 14, and the ratio of staff to principles of 7 to 1. While such a high ratio might suggest economic inefficiency, the advantage that these firms have is that at least some of their staff professionals are generating revenues, creating much greater economies of scale.

In fact, this significantly greater leverage translates directly into operating efficiency: while non-leveraged ensembles average overhead expenses of 41% of revenues, leveraged firms post overhead expenses of just 34%. Put another way, even though leveraged firms have higher expenses due to larger staffs, that leverage translates into far greater revenues–so much greater, in fact, that the higher costs make up a much smaller percentage of overall revenues.

To make larger staffs work, elite ensembles also manage overhead much better. Direct expenses (including professional compensation) are effectively the same from elite to other firms at about 45% of revenues. But overhead expenses at elite ensemble firms average 34%, compared to 43% at the others. While nine points might not seem too significant, it means that a practice generating $1 million in annual revenue is spending $90,000 more per year on overhead than elite firms. That translates directly to the bottom line: While other firms average profit margins of 10% of revenues, the elite firms, which managed their overhead much better, averaged 21% to the bottom line.

The Limitations of Going Solo