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Kitces: Fees outpace commissions — over time

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Since the late 1990s, the broker-dealer community has been transitioning away from traditional commission-based accounts and toward fee-based alternatives. Facilitated first by a proposed 1999 exemption under Rule 202 that would allow broker-dealers to offer fee-based accounts without being registered as investment advisers — and then transitioning fully to dual-registered or hybrid RIA arrangements after the proposal was struck down in 2007 — the shift has been substantial, with leading broker-dealers going from less than 10% of fee-based revenue to more than 50% today.

Given regulatory winds around the globe have been blowing increasingly toward no-commission fiduciary advice, the shift is looking permanent. That’s not to say it’s for everyone — or for every client.

Successful salespeople have always had a lot of opportunities to make money. The classic compensation for salespeople — commissions — provided in most industries a sizable payment for each deal or transaction. As any salesperson knows, part of the cost of the commission is not just the time it takes to work with the client who says “yes,” but also all the “no” respondents encountered in the process of finding those affirmative answers. In other words, it’s not about the size of the commission for each completed transaction, but how the commission averages out across the business over time.

The challenge, however, is that operating as a salesperson fundamentally limits your ability to build a true business. After all, it’s only possible to see so many prospects and find opportunities. And it’s only feasible to make so much on each transaction. This means that if you want your income to grow, you must either see more people, close more sales or earn more on each sale — which means either doing bigger transactions or selling products that pay bigger commissions.

For most salespeople, they hit the wall on growth in that order as well. First, it’s “The Game of Numbers” they must play to reach more prospects and find at least a few who will say yes. Then it’s learning to sell better, so that they can close more prospects and convert more business from the meetings they’re having.

Every January 1, you wake up and have zero income until you go see people, close them and get some sales.

But at some point, anyone in the commission-based business starts to top out. You’re seeing as many people as your time allows, and closing as many as you possibly can. There’s just no more room to increase the volume, because you’re out of time. At that point, the only path left is to try to move upmarket and grow your income by hunting bigger fish — presuming you can locate and land them — or switch up what you’re selling for a product that pays a better commission.

The fundamental challenge is that as a business, it’s a purely transactional model that’s still constrained by you and your individual time and capacity to go out and make transactions happen. It doesn’t grow beyond you, because it’s difficult to hire staff and expand resources when every January 1, you wake up and have zero income until you go see people, close them and get some sales. At best, you might have a little bit of ongoing income from prior trails, but it’s usually not enough to build much infrastructure beyond perhaps a staff support person whose salary is covered by the 0.25% 12b-1 servicing fees.

This means that in the end, it’s not really a true business at all, because it’s entirely reliant on your individual ability to do the work of finding prospects and closing them. When you don’t work, there’s no income. When you slow down, the business slows down. And when you retire or pass away, the business ends. If you try to sell it, at best a buyer might pay 1X your trailing 12-month revenue, for what is basically just a list of warm leads that a new salesperson can call on to try to make some new sales.

A fee-based advisory business that pays an ongoing assets-under-management (AUM) fee is fundamentally different. Getting paid an ongoing 1% or some other advisory fee is not a transactional business model; it’s a recurring revenue business model.

For many people starting out, that’s a huge challenge because it takes even longer just to reach a point of breakeven. After all, if you’re using A-share mutual funds, getting a $100,000 rollover may pay you as much as $4,000 in just a week or two assuming a 4% commission breakpoint. With an advisory account, meanwhile, the first payment may not come until quarter’s end, when you’ll receive just $250 — the first quarterly billing of a 1% AUM fee.

It’s hard to build a business earning just 1/16 of the upfront revenue when a new client comes on board.

However, the compounding effect over time is very different. For instance, imagine two advisers who start at the same time. They both manage to gather $2 million in assets their first year, $4 million in the second, $6 million in the third, $8 million in the fourth and $10 million in the fifth as they steadily refine their prospecting, sales process and value proposition to get bigger and bigger clients.

The commission-based adviser averages 5% in commissions in the first year, but drops to 4% in year two, and 3% by year four, as the bigger clients coming onboard hit higher breakpoints. We’ll also assume a 0.25% ongoing 12b-1 fee. By contrast, the fee-based adviser generates just a steady 1% AUM fee on the cumulative assets under management.

As the chart below reveals, over the first five years, the fee-based adviser is behind — substantially so in the early years, and somewhat less as the asset base grows. However, by year six, the two are equal to each other, as AUM fees on the cumulative asset base catch up to the upfront commissions (plus 12b-1 trails) on new business. By year 10 though, the fee-based adviser is earning 50% more. By year 15, the fee-based adviser has more than doubled the income of the commission-based adviser, and more than quadrupled it when comparing fees to commissions alone, without 12b-1 trails.

Notably, if at any point both advisers stop trying to bring in new clients, the fee-based adviser’s income also still continues, while the commission-based adviser’s income will drop precipitously if he/she’s relying on only the 12b-1 fees. The caveat is that the fee-based adviser had better be doing some ongoing work to validate that ongoing AUM fee as well, and support the growth of the practice. The good news, however, is that it’s actually quite feasible to provide deepening ongoing client service because the recurring revenue makes it safe to hire staff to support and service those clients.

After all, by year six the adviser is generating $400,000 of gross revenue, which means the adviser could hire another adviser for $80,000 per year just to give great ongoing service to the existing clients.

Notably, that adviser would have no business development responsibilities — just an expectation to provide valuable planning advice, great service and whatever else it takes to retain and serve the clients well. Every year the clients stay on board, they’re paying $400,000 of fees, and the adviser who services them is paid just $80,000 to do so — which to say the least is a very healthy gross profit margin, with $320,000 of net profit after the cost of the servicing adviser.

Of course, most advisers wouldn’t be able to keep the whole gross profit. There may be a cut for the broker-dealer if they use one, as well as some staff overhead. But the fundamental point remains: Now it’s a real business, with a recurring profit, that is not purely dependent on the adviser/owner to keep selling to new clients to generate income.

The key point is the recognition that it costs far more to get a client than it does to keep one. That’s why, over time, it’s feasible to hire advisers to serve existing clients — and still have a profit left over — with ongoing AUM fees. And as the business grows, it’s feasible to reinvest even more into what clients are provided, further improving retention, attracting larger clients and making the endeavor even more profitable.

Unfortunately, the incredibly low initial revenue when building a fee-based business from scratch is not feasible for many advisers. Even those who in the long run hope to transition to advisory fees may still do some commission-based business to fill the income gap in the early years.

Nonetheless, at some point when the adviser is established and there’s a steady stream of prospective new clients and referrals, it becomes far easier to transition to a fee-based business model — even for those who started out more commission-based and transactionally oriented.

To make the fee-based transition, the starting point is to become eligible to do fee-based business, which means either becoming an Investment Adviser Representative (IAR) of your corporate RIA (known as being “dual-registered”), or forming your own outside RIA (known as being a “hybrid”). The appeal of each depends on the capabilities of your broker-dealer’s corporate RIA solution, and whether they’ll [Office1] even permit you to have an outside RIA as an Outside Business Activity (OBA).

In order to begin doing advisory business — whether under the broker-dealer’s corporate RIA or your own — it’s necessary to have the Series 65 license. Those who originally did their Series 66 along with their Series 7 are already covered, as technically the Series 66 is a combination of the Series 63 and Series 65. For those who originally just did their Series 6 and Series 63 exams though, it’s necessary to register and sit for the Series 65 exam. Fortunately, there are a lot of Series 65 exam prep solutions available to help.

A key issue in converting your business to fee-based advisory accounts is that clients expect that you’ll actually do something on an ongoing basis to earn that advisory fee. And if the clients don’t hold you accountable, regulators will, as both the SEC and FINRA have raised growing concerns about how advisers are deciding when/whether to steer clients to commission-based or advisory accounts, and in particular whether otherwise low-maintenance clients are being subjected to reverse churning — where a client is placed in an advisory account but the adviser does nothing to earn the ongoing fee.

It’s hard to build a business earning just 1/16 of the upfront revenue when a new client comes on board.

This doesn’t necessarily mean that you have to actively manage the accounts yourself, though clearly that’s one option. You could decide to use third-party managers or separately managed accounts, or have discretion to manage the account directly and hold predominantly passive investments. But at a minimum, regulators will expect that you can demonstrate a process of ongoing monitoring of client investments — including both reviewing the accounts themselves and periodically meeting with the clients — to substantiate the ongoing fee.

However, the process of monitoring and having more regular client meetings can become very challenging when every client holds different investments. In a transactional world, it was/is sufficient to simply sell an investment, and when the client happens to meet with you again, pull some fresh Morningstar reports and see if there’s anything that is worth changing or replacing. In the context of a fee-based advisory account though, the process should be more systematized.

This means adopting a consistent set of investment solutions — or perhaps a series of models with varying degrees of equity exposure — so that the process of monitoring the investments means you just have to monitor a common set of investments once, and not re-research every holding of every client leading up to every meeting. Otherwise, as the number of advisory clients grows, the busy work leading up to each client meeting becomes unbearable.

In today’s environment, a process of ongoing investment management — or at least, ongoing investment monitoring — is effectively a minimum standard for charging an advisory fee. The challenge, however, is that robo-advisers are already capable of doing the same thing, while charging far less than the typical adviser.

This means that adding enough value to charge an advisory fee is increasingly about doing more than just creating a diversified asset-allocated portfolio and monitoring it, because that service is becoming commoditized. Instead, to help bolster their value proposition and justify their fees, advisory firms are now faced with providing more and more personal planning advice.

For an adviser who has historically been primarily focused on commissions, this means it will likely be necessary to pursue your CFP certification — or if you already have it, consider a post-CFP designation — and expand your advice knowledge beyond your current product set. Or alternatively, and at a minimum, it means going out to hire paraplanner support, or even full CFP professionals to be service advisers, to provide that additional advice value-add.

In turn, those deeper planning capabilities must then be packaged into a planning solution for clients. That could be a commitment to do annual plans or updated retirement projections for every client, being available throughout the year to answer their ongoing planning questions, or even the development of an entire annual client service calendar of planning value-adds.

Simply put, if you’re going to transition to fee-based advisory accounts, be prepared to demonstrate what value you will provide beyond what a robo-adviser — or a solution like Vanguard Personal Advisor Services or Schwab Intelligent Advisory — can already do for 28-30bps.

One of the biggest challenges in making the transition to fee-based advisory business is that, even as a relatively established adviser, it will likely feel like taking one step backward in order to take two steps forward. After all, the reality remains that ongoing advisory fees generate less income in the first year, and far less income in the next quarter, than commission-based business, even if there’s a favorable crossover a few years down the line.

As a result, the transition from commission-based to fee-based business is often done gradually over a span of several years.

The starting point is to more carefully consider each new client that comes on board, and whether they’re a good fit for the fee-based model. The key determinant should be whether it’s a client who wants and needs ongoing portfolio management and ongoing advice, and has the potential to be a long-term fit for the firm. If some new clients go fee-based and others are still commission-based, the income transition is not as traumatic as switching all new business at once.

Similarly, transitioning existing clients to fee-based accounts is also something that should be done gradually. The starting point is simply to make a list of clients and identify the ones for whom an ongoing advisory account might be a good fit. Then, aim to raise the issue at their next review meeting.

When transitioning clients, it’s usually not enough to simply state that you’re now switching them to a new type of investment account/solution that has an ongoing fee. Clients who are not used to paying an ongoing fee will rightly ask what the benefit is to making the shift now. As a result, the easiest way to make the transition is to position it as an entirely new service solution, for which you’re making a new sale to an existing client who happens to be a very warm prospect — given they’ve already done business with you. For instance, you might say:

[Mr. and Mrs. Client],
We’ve been working together for several years now, and I’m excited to share with you that we’re rolling out an entirely new service that I think will be a great fit for you.

With a new Managed Account solution through our [broker-dealer] platform, we now have access to new, high-quality investment solutions to meet your retirement goals, and I’d like to transition you into one that I think is a particularly good fit for you. [Share some additional information about their investment process.]

Making the shift will have no upfront commission cost to you. Instead, we’ll simply be paid a small ongoing advisory fee in the future for our role in helping you to manage and monitor the investment portfolio. In addition, for clients who choose our new advisory solution, we’ll also be providing ongoing annual planning updates to ensure that your portfolio is on track to meet your goals, at no additional cost. And we’re hiring a new CFP professional to add to the team, just to help answer any additional financial planning questions you may have.

To move forward, we’ve already done a review of your existing account for the potential tax consequences of making this transition, and would like to go over those details with you now.

Of course, the reality is that not every client will want to shift to an ongoing advisory service, nor would it be right to shift every client.

As noted earlier, regulators are increasingly scrutinizing whether advisers are appropriately steering clients to commission- versus fee-based accounts, and clients who don’t have ongoing investment or advice needs shouldn’t be in an ongoing advisory account. In the long run, you’ll have to decide whether it’s worth continuing to support those clients at all though, if they don’t fit your service model in the future — or if it’s more appealing to simply transition them to another adviser, or even engage in a partial sale of the business for that portion of your client base.

Even with a gradual transition though, it will still be necessary to prepare for the revenue impact of transitioning clients to fee-based advisory accounts. While it may lead to a more stable and profitable business in the long run, it can still take three to five years of ongoing advisory fees to make up the lack of upfront commission revenue. That means being certain not to transition too quickly and cause a cash-flow crunch for yourself.

Nonetheless, in the long run, the rapid growth of the RIA channel makes it clear that fee-based advisory relationships can actually produce a much larger and more stable advisory business — not to mention one that gets far better valuation multiples — thanks to the nature of a recurring revenue business that allows for a more stable staff infrastructure to give clients more and deeper ongoing service.

In practice, transitioning to advisory accounts also better aligns the business to where the winds of regulatory change are already blowing. After all, investment commissions have been banned in the U.K. and Australia in recent years, and while the DoL fiduciary rules didn’t outright ban commissions, the streamlined compliance rules for operating as a Level Fee Fiduciary using advisory accounts means most of the industry here in the U.S. may end up there in the coming decade.

This all means that the sooner you transition, the more prepared you’ll be for the regulatory environment to come.

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