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Practice Management > Compensation and Fees

How to successfully transition to a fee-based practice

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Earlier this year Omaha, Nebraska-based CLS Investments published a white paper on the benefits of switching to a fee-based model. The stats reported in the paper show that as of year-end 2014 and for the first time, fees exceeded commissions (46 percent versus 45 percent, respectively) as components of advisors’ revenues. Only 11 percent of the survey respondents were commission-only; the remainder were either fee-only (23 percent) or using a mix of fees and commissions in varying degrees (66 percent).

“The upcoming Department of Labor (DOL) fiduciary ruling is likely to accelerate the switch to fees,” says Gabriel Garcia, head of relationship management at Pershing Advisor Solutions in Jersey City, New Jersey. “Whether you’re a registered representative or a hybrid or a dually registered (advisor), you’re going to be faced with having to deal with the DOL proposal in some way, shape or form. Most likely (it) will be addressed not through the BIC (best interest contract) exemption but through some sort of leveled compensation, fee-based advisory services, if you will.”

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John Anderson, head of practice management solutions, SEI Advisor Network in Oaks, Pennsylvania, also sees the DOL ruling as an impetus for the shift to fees. Additionally, he maintains, existing compensation models overall are evolving. “I think we’re kind of at that crossroads right now or, frankly, within the next couple of years, where advisors are going to be pressured by their clients to justify why you’re getting a commission for selling a product versus what I’m really looking for, (which) is advice,” he says.

Changing your business model entails risks, though, even if you’re adapting to major industry trends. If your transition plan is sound, the move can pay off for clients and you. But if you plan inadequately, you risk ruining a good business and setting yourself back for years. We asked several experts and advisors for their insights on making a successful transition. 

Understand your motivation

Ryan Shanks, CEO of Finetooth Consulting in Longmeadow, Massachusetts, says advisors should first consider the nonfinancial reasons behind their decision. Do they want independence? Do they want the ability to charge fees for financial planning? What is it that they are missing in their current model and what would make them happier? “If you do it based upon all the right reasons, the financial rewards follow,” he says.

Advisors also need to view the transition from the clients’ perspective, says Shannon Reid, CRPC, vice president of Raymond James private client group education and practice management group in St. Petersburg, Florida. Commission-based compensation is transactional in nature, she notes. If you’re going to start charging fees, what value will you add to the relationship to justify those fees? How will you define the value proposition you intend to deliver to fee-based clients?

Forecast your finances

Detailed income and expense projections are essential because fee-based cash flows’ timing differs from commission earnings. Should you decide to give up commissions completely, there will be a lag from start date to your first payments. Reid describes this as a transition from a fairly steady stream of commissions to “lumpy” quarterly fee-based payments. “You can’t go out and sell something to raise revenue in the short term,” she says. “You have to plan for it.”

Brandon Grundy, CFP, a principal with Ridgeview Financial Planning in Sonoma County, California, was working 100 percent on commission when he started contemplating the fee-only model in 2008. He reviewed his client roster to project which clients would follow him. While he was optimistic about the long-term outlook for starting his own registered investment advisory (RIA), he anticipated his income would fall by about two-thirds in his first year and began building up his savings cushion.

He left his former employer in August 2014 and dropped his insurance licenses. His detailed financial projections proved to be accurate, as was his forecast of which clients would stay with him. The new business model allows him to offer hourly planning consultations, which he couldn’t provide previously, and those engagements generate additional fee income and bring in new clients. Overall, he’s very satisfied with his first 18 months’ results.

Grundy left under an onerous noncompete clause that slowed his startup. In contrast, David Shotwell, CFP, a principal with Shotwell Rutter Baer Inc. in Lansing, Michigan, faced fewer restrictions and a smaller impact to his income from transitioning to fee-only. His noncompete restrictions covered roughly half his clients, and less than 20 percent of his income was from commissions. Like Grundy, he ranked clients’ likelihood of following him and he projected the transition’s impact on his personal finances. The results indicated he would have to cut back on personal spending for about six months, but after that his income would return to its prior level.

Shotwell left his former employer in February 2013 and says the projections were accurate. 

Don’t overlook practical considerations

Grundy started a solo RIA; Shotwell joined another advisor. Going solo means taking on the myriad tasks of running an RIA as a business: marketing, compliance, administration, investment management and so on. Over time the advisor’s skill at and enjoyment of those tasks will become clear, at which point he or she can decide which duties to retain. Another option is to join an existing RIA, as Shotwell did, and leverage that organization’s resources. “You can choose to wear all those hats and figure out whether they fit or not and you’ll only do that in time,” says Shanks. “Or you could go to someone who has figured that out, does a better job than you probably would and then just lean on them for that (so) you can focus your attention on your clients. When we run the pro formas, usually the net income to the advisor is higher than if they were to create their own company.”

Consider the hybrid option

Another issue is the retention or disposition of former commission-based clients. Garcia says the advisors and advisor teams coming to Pershing typically derive 70 percent of their income from fee-based sources. They must decide how to transition their remaining book of business to a fee-based model or how to retain it as commission business when retention is in the client’s best interests, which can be the case with insurance products.

If retention is the best solution, Pershing helps advisors transitioning to RIA status affiliate with a broker-dealer that does not require advisors to become employees. That hybrid arrangement buys the advisor time to work out a transition for the commission business or to continue serving those clients. Combining both business models is often the most practical solution, Anderson maintains. “Very, very few people have ever just ripped the Band-Aid off, if you will, and say I’m going 100 percent fee today,” he says. “Most of them do it over a longer period of time.”

Reid agrees that a hybrid transition is often smoother for both the advisor and clients. It also gives advisors more flexibility for applying the right model to each client’s situation. She cites the example of an older client with minimal trading needs in his account and consequently incurs modest commission expenses. “You don’t necessarily want to change that person to fee-based if you’re not providing other services and other benefits to them for that,” she says. “Allowing you to have the option to keep them commission-only is for the benefit of the client.”

Initially retaining commission-based clients can benefit future growth. Shanks notes that advisors’ ability to grow their practice by acquiring or merging with other firms is linked to their firm’s size. He cites the example of an advisor who had $100 million in total investable assets, of which about half were broker-dealer assets. The advisor’s new custodian convinced him to leave the breaker-dealer assets behind so the advisor could adopt the fee-only model.

It would have been more advantageous to bring the entire $100 million, says Shanks. The larger amount would give the advisor more flexibility and clout when approaching potential partners or sellers. “I said if you’re $100 million in total assets, you could get in front of someone $50 million, $60 million, $70 million, $80 million in assets and you could position yourself as a successor to them,” says Shanks. “But if you’re at $50 million as a foundation, you’re going to position yourself to those folks with $10 million, $15 million, $20 million, $30 million in assets. Because if I’ve got $85 million in assets, I’m going to think twice about someone with $50 million having enough of a business construct to support that coming on top of what they already have.”

Keep the bigger picture in mind

The transition from commissions to fees is a major decision for an advisor but it involves more than a compensation model change, says Garcia. Advisors need to understand that they’re not only going from commission to fee, but they’re going from product selling to service purchasing on behalf of their clients. “That’s a big change for folks but one that could be very lucrative from a professional perspective, from a business perspective and from an economic perspective and, then, obviously for their clients that they’re serving every day,” he says.