Two subjects tend to surface around this time every year: compensation and valuation. These interrelated topics confuse firm leaders. While the numbers in play differ, both issues come down to the same key question: “Am I getting what I paid for?”
Business leaders find compensation particularly vexing because we have been taught to believe that if we pay somebody enough, they will perform exactly as we hoped. Having looked at literally thousands of financial firms, I conclude that the opposite result often comes to pass.
Take, for example, incentives paid for generating business. In the most recent InvestmentNews “Financial Performance Study of Advisory Firms” sponsored by Pershing, we found that while the average Ensemble Practice grew assets by about 18% in 2013, less than half of that growth came from new clients. The rest came from market appreciation or additional assets from existing clients. For firms with a high variable component tied to new business development, this should be a disappointing outcome. Why? Because they paid to get new business when, in reality, much of their growth came from great service and market momentum. Why would you pay somebody for something to which they didn’t contribute?
The captive brokerage world has long experienced this phenomenon. Once a registered rep completes the training period, compensation then shifts to a variable model that rewards financial credits for the sale of certain products like financial plans, annuities and managed account programs. Some of these products now are referred to as “fee-based” solutions that, when sold to a client, pay the rep a perpetual income stream. Once these reps establish a repeatable, predictable cash flow, most of their income comes from existing relationships rather than new ones. In other words, sales drop off and they become advisors or service agents to their clients.
Fiduciary advisors (RIAs) may find it tempting to be self-righteous on this topic because they claim not to be incented to sell. In truth, many advisory firms retain vestiges of the brokerage compensation grid, often paying their people a percentage of the revenue they generate or manage. So while a firm may claim to base their model on client advocacy, their compensation structure often contradicts this philosophy. I mention this to generate awareness that compensation sometimes rewards the wrong behavior.
In theory, the more an advisor is involved in selling, the more his or her compensation should be variable and tied to individual production. Rewards follow sales closely, either in the form of commissions based on revenues or quarterly bonuses tied to growth. The more an employee is involved in service or management, the more his or her income should be fixed, with the variable component tied to exceeding expectations in her primary job. The bonus component is funded out of profits and based on team success. When a person is paid to “produce,” but behaves more as a service agent, one could argue that the compensation model is not generating the desired outcome. I call the above strategy “compensation theory” because the same business people who pay more for production often are surprised when the outcome doesn’t change.
My belief, albeit controversial in the financial services industry, is that compensation is not in itself a motivation factor but rather a means to recognize motivated people who do their jobs well. Clayton Christensen, a business professor at Harvard who wrote the terrific book “The Innovator’s Dilemma,” identifies compensation as a hygiene factor along with status, job security and work conditions. In other words, a fair compensation plan is necessary to keep people engaged and on task, but by itself does not drive positive behavior. He identifies motivation factors such as challenging work, recognition, responsibility and opportunities for personal growth.
Compensation models for business developers often recognize the uncertainty of sales. So while the payout is on a variable basis, allowing the firm to hedge its costs, the payout to the salesperson is often high relative to the total value of what’s being sold. As a result, firms that continue to pay advisors on a variable compensation grid even when the advisor is not generating much in new business are often overpaying. What was conceived as an “eat-what-you-kill” reward structure has become, in many cases, a veritable buffet for the so-called producer who now lives off an annuitized income stream without having to generate much in new business each year.
Interestingly, the variable compensation model causes expenses to rise in proportion to revenue growth. A variable cost structure is very appealing when a company’s business is flat or declining. When the company is growing, however, it is harder to gain any financial leverage. Advisors often say they want a variable compensation model in place to protect their profits when things go bad, but this hedge against down markets compromises firm income, especially considering that growth cycles always are longer and greater than decline cycles.
From a business economics standpoint, a high payout that floats with growth creates a huge management challenge. Assume for this purpose that the optimal advisory firm should generate a 25% operating profit after all expenses are covered. Also assume that the overhead of this firm should be no more than 35% of revenue. This leaves just 40% (100% – 25% – 35%) to pay professional staff.
That 40% can’t be allocated to sales alone, but also has to cover compensation to people doing the work for the client, such as portfolio management and financial planning. Firm leaders must determine how much the new sale is worth and how rewards are paid. Should you recognize it over the life of the client by spreading payments over several years? Or should you pay a big lump sum immediately? If you have a high payout for the revenue generation, how will you cover the cost of advice?
By now, the implications for the value of your business should be clear. Several simple elements drive value: cash flow, risk and growth. If your cash flow is low because you are paying too much compensation and not getting an adequate return on investment, your business value will be lower. If your future revenues are imperiled because of a high dependency on one person or because of an aging client base that is not being renewed, then your value will be diminished. If you do not have a growth engine separate from market lift, your business value will be at risk.
Compensation costs make up at least 70% of an advisory firm’s total expenses. In an environment where there is a shortage of talent—not just at the advisory level but in areas like operations, compliance and administration—costs likely will continue to rise.
While it may feel easy to mimic the compensation model of another firm, it will be far more effective to put your compensation plan into the context of your strategy. How do you want to be known in the market? What roles do you want your people to play? How will you define excellence in those roles? How will you reward performance? How much will it cost you to recruit qualified talent? What will you have to generate in revenue to cover those costs and produce a reasonable profit? Does the structure of your plan reinforce the behavior you seek, or is it driving you in a different direction?
Keep in mind, a borrowed strategy will only produce an equivalent outcome if the firm operates exactly the same as yours. Would you deploy the same investment strategy for an 80-year-old pensioner and a 40-year-old corporate executive? Their circumstances and goals are different, just as your circumstances and goals are unique to your firm.