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Why the Wirehouses Hate the AUM Business Model

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Some 20 years ago I was on a plane from somewhere to Houston and found myself sitting next to an affable gentleman who revealed that he was a stockbroker at a major wirehouse. Being a curious sort, I started asking him about his business and his clients, etc., and his chest actually puffed up when he revealed that he was not only his firm’s “biggest producer” in Texas but one of their biggest in the whole country.

Then he dropped down to whisper, and told me that in the prior year, he had generated over $1 million in gross commissions. After I offered a few appropriately appreciative responses, I asked if he wouldn’t mind sharing what kind of payout he got on those impressive revenues. Beaming even more brightly he said that as one of their biggest producers, the firm paid him 50% of his commissions.

At the time, I’d spent the previous 10 years covering independent financial planners, who usually received payouts between 70% and 90% from their independent broker-dealers, so I just couldn’t stop myself from asking what he could possibly get from his firm that was worth $400,000 a year? After some hemming and hawing about Shark machines, Bloomberg terminals, research reports, a nice office and a secretary he shared with three other brokers, his enthusiasm visibly waned, and we spent the rest of the flight talking about pro football.

That conversation popped into my head as I was reading Jamie Green’s September 28 story on ThinkAdvisor, DOL Fiduciary Has Many Advisors Mulling Career Change: Fidelity Survey. As the title implies, the survey reveals that more than a few financial advisors appear to be questioning their vocations following the Department of Labor’s new rules, which place a heavy regulatory burden on retirement advisors who receive sales commissions.

And while I’m not terribly surprised by brokers’ hostility to the new rules, I have to admit that I’m been a bit baffled by the broker-dealers’ resistance to transitioning to an AUM model—until now.

Here are the numbers from Fidelity’s poll of 459 advisors: 21% of whom are RIAs, with the remaining 79% are various stripes of brokers. While 29% of the advisors said they expect the DOL rule to have a positive impact, “10% of the advisors in the most recent survey said they are planning to leave or retire from the field earlier than they expected because of the rule,” while another 18% said they are “reconsidering their careers as advisors,” wrote Green. “Those numbers are even more startling,” he continued, “considering the average age of survey respondents was 46.” 

Now as I said, I’m not terribly surprised by these numbers. Brokers have been paid on commissions since forever, it’s the way they’ve always done business and the vast majority of brokers/RRs I’ve met genuinely seem to be trying to do right by their clients (despite incentives inherent in the brokerage system to do otherwise).

Now, the DOL comes along and says: “You can keep doing business this way, but now you’re going to have to jump through a bunch of hoops to prove that you’re acting in your clients’ best interest.” I can see how that might make some folks kind of cranky (even though managing assets is a better business model; the big plus is that you don’t start each new year with zero income.) 

But what I have been scratching my head about for the past couple of years is why the brokerage industry has been so steadfastly against converting to the AUM model, and have been against it since it became popular in the independent channel back in the 1990s. Of course, since then they have grudgingly added asset management to the menu of client services, but have also doggedly clung to the old commission model as well.

In part, brokerage firms cling to commission—and their lack of a client fiduciary duty—because the cost and risks of the products they sell aren’t required to be in their clients’ best interest. Yet they also know as well as anyone that AUM is how the world’s largest financial institutions got that way. It is, in fact, better for business at the institutional level than it is at the retail level. 

So why all the caterwauling, I wondered? Then I read Jamie’s story, and remembered that Houston “big producer” and my question about what a wirehouse could offer that was worth 50% to 80% of the revenues that brokers generate. And I realized that back in the day those revenues were commission revenues. And to get commissions, you have to hang your securities license with a broker-dealer.

But what if brokers didn’t charge commissions? What if some or all of their revenues came from AUM fees? Yes, I know that broker-dealers are happy to take a cut of brokers’ AUM fees as well these days. But to me the big question is why brokers continue to share those revenues with their BD. 

After all, as every independent RIA in the country knows, you don’t need a brokerage firm to charge an AUM fee. Instead, you just park your clients’ assets with a custodian, and let 100% of the AUM fees roll in, quarter after quarter. And there you have it: if brokerage firms went to an AUM business model, their brokers won’t need them any more—nor will they need to share their AUM fees. 

And we’ve all seen evidence of just this. As Jamie also wrote in his Aug. 10 story, Advisor M&A Maintains Record Pace in First Half: DeVoe, over the past three years, breakaway brokers have accounted for 37%, 54%, and 43% of all mergers involving independent RIAs.  

(Dave DeVoe will be speaking at Schwab Impact 2016 on Oct. 28 in a session titled, ‘Mastering M&A: How to Build Your Firm Through Mergers and Acquisitions.’)

Which means that, at least on the retail side, the wirehouses will have to become custodians to retain some share of the retail market, albeit a much smaller share. And many independent BDs have already gone that route. But without a change of business model, the flood of breakaway brokers is only going to grow, riding the transition to managing client assets.