Kitces: How firms should be paying bonuses

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Adding your first full-time staff member as an advisor is often the single hardest hire to make. When you literally double your headcount overnight it can feel like a big financial step backward, at least initially. And then finding mechanisms to reward them — beyond outright raises and promotions — can be especially fraught.

But the question of what’s a proper bonus structure for a paraplanner or any other kind of administrative or operational employee is a common challenge for advisory firms both large and small, with remarkably little data on which approach firms prefer. I do see a couple of fairly common structures, however. Which is best for your firm depends not only on your headcount, but your revenue model and whether you anticipate growing — or not — in coming years.

The first structure I most commonly see involves paying a percentage of all new business that comes in after the employee’s hire. This approach really gets back to our roots as professionals who sold products.

When multiple advisors worked jointly on a client, they would carve up the commission. The rule of thumb that made this work was a clear separation of roles: the finder, the binder, the grinder and the minder.

The finder located the prospect and brought them in; the binder made the sale and converted the prospect to a client; the grinder performed all the support work and analysis; and the minder did the ongoing service and support work thereafter.

And so, the classic commission split for each role was 25% of compensation. Solos obviously got all of it, but if you were the advisor and someone else provided the lead, they got 25% and you kept the rest. If you worked for an advisor and you did the grinding support work, you got 25% of the commission.

While advisory firms are increasingly going to an AUM fee model and are not necessarily on the upfront commission model anymore, old habits die hard, and I find a lot of firms still engaged in these kinds of new business splits.

Supposing a firm brings in $10 million in new assets this year and generates $100,000 in new revenue, the client service administrator would get a $10,000 bonus while the paraplanner might get up to $30,000. The percentages here aren’t necessarily set in stone, but the fundamental structure presumes that new business is split between the advisor and the support team in a way that recognizes and rewards their various contributions.

The second approach that I see commonly is based on percentage of gross revenue. Whereas the prior approach might pay 10% of all new revenue to a client service administrator or 25% to a paraplanner, the second approach presumes a much smaller percentage — as little as 5%, 2% or even 1% for a very large firm. Still, it’s meant to equalize.

If the firm brings in $10 million of new assets but already has $50 million of existing assets generating $500,000 of ongoing revenue via a 1% AUM fee, the staff member’s bonus isn’t based on 10% of the $100,000 of new revenue — which would be $10,000 — but rather 2% of the entire $500,000 of revenue, which also nets out at the same $10,000. Instead of doing a bigger percentage on the new business, it’s a smaller percentage based on the practice’s entire revenue.

I encounter this approach more often than percentage of new revenue for a couple reasons. First, it recognizes that as the industry shifts from commissions that get paid once upfront to AUM with ongoing revenue, it’s important not just to reward getting new clients, but retain them too.

In the early days of the finder, binder, grinder, minder framework, the only revenue was the new revenue. We split new revenue because it was the only thing there was to split. You always had to be going out to get business because otherwise your income would go straight to zero.

But in the AUM model, once you achieve a level of critical client mass you could make a pretty amazing income on fees by simply servicing and retaining 50 or so great clients. This means if you’re going to tie bonuses to the success of the business, it’s good to reward retention of existing clients as well as the winning of new ones.

As practice management consultant Angie Herbers writes, this really makes the employee’s interest much more aligned to the overall interest of the business. If the firm is losing clients, it’s bad for bonuses. If the market is up — which in the AUM model is a material factor for firm profitability — the firm is doing well and the employees are consequently getting bonused better.

And perhaps more importantly for the business’s perspective, if markets are down, the business has a natural buffer because employee compensation will decrease as well. For a firm in a bear market, bonuses based on a percentage of gross revenue naturally trim themselves. That’s the benefit when everybody is tied to the one key, firm-wide benchmark.

The other reason that firms tend to use percentage of gross revenue is that it makes a sensible replacement for profit-based bonuses. Simply put, business owners have too much control of profits to ensure a fair bonusing mechanism. If the owner decides to reinvest for growth, employees see a diminished bonus off the (reinvested) profits. And while the owner might make that back in the future, setting employees up to lose at the outset is not a good dynamic.

And in some cases advisory firm owners can get a little creative about business expenses. Anything you can put through that business P&L as a tax write-off — running your car through the business, hiring your kids into the business — becomes your employees’ foregone bonus. That is not healthy for your employee relationship.

A big caveat to setting bonuses based on percentage of revenue, however, is that businesses with recurring revenue can continue growing. And while that may sound attractive, it can create serious problems when it comes to bonuses.

A good friend took a big leap a few years ago, hiring his first paraplanner when he only had about $15 million in assets under management. It was a big financial hit. And since the hire was a stretch in the first place, my friend decided not to pay what at the time would have been the going rate in his metropolitan area, a $50,000 base salary. Instead he offered $30,000 and a 20% of new revenue bonus, with the goal of bringing in $10 million of new assets. That would represent $100,000 in new revenue.

So ideally, the paraplanner would make her $50,000 on the $30,000 base and 20% on $100,000 of new revenue. But if the business didn’t grow according to my friend’s expectations, he’d save on total compensation. He was managing business risk.

He clearly forgot to consider the ramifications of the opposite outcome. Over the subsequent 10 years, he grew the business off the bottom of the bear market from $15 million to $100 million, which means he’s added $85 million of new assets, almost $850,000 in new revenue, and his paraplanner gets 20% of new business on top of salary. She’s now making $200,000 a year as a paraplanner. And it’s killing his business because he can’t hire the staff he needs to grow because there isn’t enough money left over. And because the paraplanner has been involved in the business for so long, he’s terrified to let her go.

In essence, he’s stuck paying partner money to someone who assumes none of the risk that goes with being a partner. And this situation of his own making is choking off his ability to grow.

I relate this parable because a number of advisory firms — including and especially ones that have been burned by these percentage-of-revenue bonus models — are shifting instead to more fixed bonus structures. For instance, the firm might say the bonus is $5,000 for every quarter the firm brings in at least $25,000 in new revenue. Do the math, and the firm is going to pay 20% of new revenue as a bonus, but the employee doesn’t hear, “You get 20% of our growth this quarter and every quarter forever.” Rather they hear, “You get $5,000 if we hit our goals.”

That’s important because it means next year you can reset the $5,000 bonus to whatever the new goals become. “Hey, thanks to the great growth we had last year, this year we’re hiring a new team member to support our marketing, and the $5,000 bonus now comes when we hit a $40,000 new revenue target each quarter.”

In this case the percentage of the bonus starts going down as the business grows and compounds. That’s nothing nefarious, just a simple recognition that as the business grows, there are more employees who must participate in the bonus structure. You have to change the percentages or you get stuck in my friend’s situation, where one successful employee claims money that might otherwise be used to hire more people.

By setting flat dollar amounts based on concrete metrics, you as the business owner can budget as a percentage of revenue, but you don’t create an expectation in the minds of employees that you can’t actually sustain. Instead, bonuses are dollar amounts for hitting goals, which implicitly recognizes that the goals of the business can and will change over time. That makes the bonus structure more responsive to the needs of the business over time and avoids that compounding risk problem.

It’s worth noting other incentive strategies out there. The bonus might not take the form of a bonus at all.

I first read about alternative incentive approaches in Daniel Pink’s book Drive, which is all about the factors that set us in motion toward goals. Pink argues there are two types of motivators that drive us: intrinsic motivation, where we’re self-motivated by just the good feelings of what we accomplish and do; and extrinsic motivation, where we’re externally motivated by things like money or recognition. Bonuses are a classic example of extrinsic motivation.

And while extrinsic motivators can give us a helpful nudge, we soon adjust and come to expect them. So even if employees previously enjoyed the tasks that were rewarded with a bonus, take that financial incentive away and suddenly the tasks themselves are less enjoyable. In essence, you’ve turned an intrinsic motivator into an extrinsic one.

Pink found in his research that for tasks requiring creativity and original thought — e.g., how to handle complex planning situations in an advisory firm — intrinsic motivators work best. And if you use these types of conditional bonuses — e.g., “If we reach this goal, you get that bonus” — intrinsic motivation can be undermined in the long run and turn what would have just been a natural desire to do well into purely a money issue.

The natural extension of that idea is to pay employees enough in base salary that it addresses their core needs. As Pink argues, big bonuses that may seem motivating in the short term can actually undermine employee motivation in the long run. So if you’re going to have any kind of bonus structure, you might opt instead to do something experiential that everyone on the team can enjoy without actually making it about the money.

Sometimes entrepreneurs and business owners forget that their motivations differ from those of their employees. Many owners want and need these financial motivators. They respond well to them. But that’s not true for every employee. If they wanted a bunch of risk-based compensation, they could work in commissions, sales or something else with a high-risk, high-reward profile. Instead they’re coming to the table as employees, with a host of motivating factors.

This disconnect can lead business owners to place excessive focus on the bonus. Owners should be careful not to project their own desires on their staff, when what the employee may want is a stable salary at a stable job, without participating in the risk-taking inherent in being the business owner.

Obviously some employees may be interested in more upside potential, even with the additional risk. Give them a path to get there that’s not the equivalent of phantom equity revenue sharing, where they ride the wave you’re surfing as the owner. Instead give them the opportunities to have a greater impact on the business and reward them for actually taking on more responsibility and feeding off of it. That rewards them for actually helping create business value rather than compounding their bonuses for the sake of doing the job they always have done.

The bottom line is to recognize that problematic bonus structures are much harder to fix later than they are to structure properly in the first place. It’s much easier to set a sensible bonus structure before a firm scales than to institute a percentage of revenue schedule and later try to change it when employees start seeing the upside.

Alternatively, if you’re already paying a healthy starting salary to a paraplanner, consider foregoing the bonus altogether and instead tying the accomplishment of your quarter or the annual business goals to something maybe a little more fun like a group outing with employees’ families to the amusement park. And taking it a step further, consider allocating the money you would have set aside for bonuses into an emergency fund for your business. You could even tell your employees you’re building up business reserves to ensure they continue to have a job. When it’s framed that way, you may be shocked at how much they appreciate the gesture.

At worst, if it turns out that you’re in a predicament like my friend, and your employee wants more upside, you have a few years to figure out how to deliver it — not by trying to give them a compounding bonus tied to business growth, but by developing them into a full-scale service advisor who manages relationships or a lead advisor who develops business. Who knows? Maybe they even become your future business partner. Then you both get to share in building a bigger pie than you might have been able to make on your own.

This article originally appeared in Michael Kitces
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