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Riding the Wave

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The registered investment advisor marketplace has rebounded in recent years, with advisors building assets under management and revenues returning to pre-dot-com-crash levels. Yet new and evolving challenges face RIAs as they work toward increasing their businesses’ profitability. Those challenges include an uncertain market and economic environment, rising costs for compliance, an aging customer base that needs healthcare and retirement rollover products, and a more competitive climate.

Rydex AdvisorBenchmarking recently surveyed more than 1,000 RIAs on investment and practice management issues. Our results, gathered by phone and online surveys, highlight critical trends that will affect RIA profitability, client retention, and business success over the next several years. We’ll explore some of the issues that leading-edge investment advisors are currently dealing with, and propose strategies for turning these challenges into opportunities.

Market conditions have improved for advisors, with strong stock performance in 2004 and an overall recovery in assets under management. Our research found that the three-year decline in median assets managed by RIAs reversed itself in 2003, more than making up for losses since 1999 and outpacing gains in the S&P 500 Index.

Advisors themselves are moderately optimistic about the market outlook but remain concerned about the long-term implications of a rising federal budget deficit and a funding shortfall for Social Security. Asked to forecast the U.S. equities markets over the next three years, half (50%) of the advisors polled expected a long-term secular bull market with cyclical rallies and dips, while a smaller group (6%) predicted a genuine bull market. About a third (31%) forecast a directionless market, while one in eight foresaw a secular bear market.

Yet while survey respondents felt positive overall about the markets, they were worried about a number of economic issues. The budget deficit topped the list of their concerns, followed by Social Security and energy prices. Current hot topics like the trade deficit and the dollar’s decline were cited as reasons for caution among about one in 10 advisors.

Meanwhile, our survey respondents’ clients have dramatically moderated their expectations for returns after several years of volatile markets. Six in 10 advisors (62%) say that their clients have realistic expectations for market performance, while only a third (33%) believe that investor expectations are unrealistically high (see chart 1 below).

This adjustment in client expectations has contributed to a growing perception among investors that they will not have sufficient assets to last through retirement. For example, in one section of the survey, advisors reported that among their clients who had reduced their lifetime giving programs, 58% did so because they feared outliving their assets.

One way to profit from these two trends–lower performance expectations and concerns about long-term financial security–is to move the discussion toward higher-yielding alternative investments. Our survey shows that a plurality of advisors (43%) are spending more time educating clients about alternative assets, slightly ahead of the percentage (42%) that is spending the same amount of time on this topic.

Paying for Compliance

The emphasis on compliance in the financial services industry hit RIAs hard last year as legal and compliance-related expenses jumped nearly 153%, according to the Rydex AdvisorBenchmarking Study.

New compliance requirements have changed the way many advisors do business, piling on additional legal, accounting, and insurance burdens. Our survey showed that nearly two-thirds of the RIAs polled (62%) had already developed a written supervisory procedure, while more than half (55%) had hired a chief compliance officer. More than a third had developed a business continuity plan. A smaller, but still significant, percentage of advisors were taking additional, potentially costly steps, including increasing client communications, hiring a lawyer, or augmenting their liability insurance coverage (see chart 2 below).

Leading-edge advisors are working to meet new compliance requirements, but at a cost. Half the advisors surveyed said that developing a written supervisory policy had raised their costs of doing business. Other compliance factors cited as adding to the cost burden were increases in legal fees and insurance premiums, the development of educational materials, and the need to hire additional employees (see chart 3 below).

The dramatic rise in compliance expenses along with increases in staff compensation resulted in a drop in profit margins for RIAs for the fifth consecutive year, despite a 13% increase in net profits. Advisors did reduce the money they spent on advertising and marketing by more than two-thirds and focused on growing their businesses through their current client base. Focusing on their existing books of business paid off for advisors in 2003 as they saw revenues and AUM reach or exceed five-year highs, increasing 15.4% and 22.5%, respectively.

Yet despite the increased cost and administrative burdens, few advisors are ready to sell their businesses. Nearly three-quarters strongly objected to the idea that an increase in expenses would force them to exit the advisory business, while only about 5% agreed somewhat or strongly that higher costs might cause them to sell.

A Graying Client Base

One broad trend that is affecting the RIA marketplace is the graying of its client base, particularly as 77 million members of the baby boom generation reach and exceed retirement age.

This trend is still gathering steam. Our survey found that the largest group of investment advisors (37%) reported that retirees make up between 20% and 39% of their total client base. For many firms, however, the proportion is much higher. Slightly over one in five investment advisory firms (21%) said that retirees make up 60% to 80% of their overall client base, while an additional 27% say that retirees account for 40% to 59% of the total. Investment advisors are telling us that retirees are already an important client base and–given the overall aging of the population, longer life-spans, and greater affluence among the elderly–will most likely become even more dominant in the years to come. Forward-looking firms are looking for ways to meet this market segment’s unique needs.

Health savings accounts (HSAs) represent one potential area of growth. These are relatively new tax-sheltered savings accounts, signed into law by President Bush in December 2003, whose assets can be used only for medical expenses. They are paired with high-deductible health insurance policies so that routine health-care costs are paid out of the HSA, while larger expenses are covered by insurance.

HSAs address one of retiree clients’ main concerns, i.e, how to prevent medical expenses from eroding their long-term financial security. In fact, our study showed that more than 87% of retiree clients were either somewhat or very concerned about the impact of healthcare costs on their retirement savings or income. This is a very real issue for many individuals, as higher costs and regulatory changes push many employers to eliminate retiree health coverage or force retirees to pick up a larger percentage of its cost. A study by employee benefits consultant Hewitt Associates released in June 2004 found that retirees whose medical costs were not subsidized by their former employers may spend up to 20% of their preretirement income on healthcare costs.

Still, despite the fact that retired clients are worried about the effect of healthcare costs, most investment advisors have yet to focus on HSAs as a potential solution. Our survey showed that less than one-third of investment advisor firms reported discussing HSAs at all, and less than two percent considered healthcare expenses an important topic of discussion. Advisors who did not discuss HSAs with clients said they felt that these vehicles were not right for most of their clients (42%) or that HSAs were too new (11%).

The fact that very few firms are selling HSAs will make these vehicles all the more effective as a business-building tool for those who develop expertise in this area.

With the emergence of older individuals as an even more important client base, investment advisors have other opportunities, particularly in the areas of estate and retirement planning. Our survey showed that just 14% of RIAs focused to a large degree on estate planning, indicating another market opportunity.

Lifetime giving programs are one key element in many estate plans, since they allow affluent individuals to transfer, estate- and gift-tax free, up to $11,000 per year per beneficiary (married couples can transfer $11,000 each). Over long periods, lifetime gifting can substantially reduce the taxable estate while providing psychological benefits to the donors. Our survey, however, showed that use of gifting programs was declining slightly, with approximately 20% of clients reducing their gifts to friends and relatives; 17% were increasing gifts.

This subtle trend has been driven by a number of factors, according to the advisors we surveyed. The most important, according to 58% of respondents, was clients’ fear of outliving their wealth, perhaps due to several years of subpar investment results and concerns about higher medical costs. Other reasons for reducing gifts to family included clients’ desire to personally enjoy the assets they had accumulated (16%), and the attitude that they were not obliged to transfer wealth to other generations (12%).

Our survey shows, nonetheless, that gifting programs remain an important element of estate planning. In fact, nearly two-thirds of our respondents said that their clients had made no change in their charitable giving plans. For those who are very concerned about outliving their wealth, investment advisors may wish to open a dialogue about certain estate planning trusts that allow clients to continue enjoying the benefits of their assets during their lifetimes, while reducing the estate tax liability for their heirs.

Retirement planning is another issue that naturally affects an aging client base, and our survey results here showed another area of opportunity. Investment advisors reported that regardless of whether a retirement rollover was triggered by job change, layoff, or early retirement, only a very small percentage of clients were reinvesting all or nearly all of their lump-sum distributions. For example, among job changers, only 8.5% were rolling 80% or more of their distributions into tax-deferred investment vehicles, a figure that dropped to 1.4% of early retirees, and less than 0.5% of laid-off employees. This substantial leakage from retirement savings may be understandable from the perspective of a laid-off or forcibly retired employee, but can have only the most dire consequences for clients’ long-term financial security.

Some investment advisors see a market opportunity in specializing in financial counseling for employees in transition. RIAs can build a presence in this market by developing an expertise in rollover strategies, severance, budget and income planning, and tax issues surrounding job change.

Getting Closer to Clients

In an increasingly competitive market, investment advisors succeed not just by adding new products or services, but also through a genuine commitment to understanding their clients. Advisors can benefit from receiving regular feedback from their clients by asking them a range of questions to determine clients’ level of satisfaction with the firm and its products and services. Asking for comments on the fees charged by the firm can be educational, too.

A client survey or client advisory board can be an effective way to gather such information. According to our survey, less than half of the advisors polled (43%) conduct surveys of their clients or have a client board. Those who do, however, benefit greatly from the information gleaned. For example, surveying allows advisors to understand the level of satisfaction clients have with the advisor and with the firm’s range of services, and helps advisors learn which new products clients might find most appealing. Most important, an effective survey helps advisors understand their clients’ needs and motivations (see Chart 4 below for questions advisors ask their clients).

Advisors who use surveys seem to understand the importance of this tool. According to the latest AdvisorBenchmarking study, the 62% of advisors who have clients with “reasonable expectations” use surveys to ask questions about current services and product offerings. Alternatively, advisors with clients who have “high expectations” are more likely to ask their clients which new services they would like to see offered.

After several years of sluggish returns and pronounced volatility, market conditions have improved, and RIA firms have been able to rebuild assets to pre-2000 levels. Most RIAs we surveyed expect this positive market and economic backdrop to continue. Still, even if the investment environment remains favorable, significant challenges remain in educating and building ties with clients, managing expenses, and operating investment advisor businesses in a profitable manner. Things may be better, but smart advisors will realize that they cannot rest on their laurels if they want to continue their success in the future.

Maya Ivanova is a research analyst with Rydex AdvisorBenchmarking, and can be reached at [email protected]. Information reported in this article comes from the Rydex AdvisorBenchmarking survey of 1,023 RIAs, which was conducted between March 2003 and June 2004, as well as a supplemental survey conducted in November 2004. Rydex PracticeValue is a free practice management program designed to help RIAs better manage and grow their firms. This survey is part of the Rydex Practice Value Research Study Series, which began in 1999.


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