Should RIAs Change Their Business Model?

There is nothing like solid returns in the financial markets to boost revenues and profits at registered investment adviser (RIA) firms using the assets under management (AUM) model. But will the good times continue? Industry observers cite several emerging trends and results from recent surveys of RIAs that could portend problems. These potential roadblocks include a lack of organic growth for advisory firms, pricing pressures driven by a changing clientele and emerging competitors, and cost pressures as compensation costs grow faster than revenues.

Stagnant Underlying Growth

Gabriel Garcia, managing director of BNY Mellon’s Pershing Advisor Solutions in Jersey City, New Jersey, notes that 2017 was a “stupendous” year in the financial markets. Nonetheless, he is concerned about the longer-term trend of advisers’ slowing revenue growth. He cites the “2017 InvestmentNews Adviser Compensation & Staffing Study,” which found only 5% median revenue growth in 2016 among respondents. That result represents a steady drop since 2013, when the reported figure was 16%. Although the financial markets’ performance for 2017 certainly will improve advisers’ profits, the respite might be short-lived. “My fear is that this tailwind from the market is going to mask and distract advisers from what’s happening beneath,” Garcia says. “And what’s happening beneath is . . . true organic growth has stagnated.”

Garcia cites several reasons for the growth slowdown. The average client age for advisory firms is around 62, and older clients are more likely to be in the wealth decumulation phase of their lives. These clients’ focus has shifted from increasing wealth to living off their assets and distributing them, which eventually leads to fewer assets supporting the AUM model. “They’re gifting their money, they’re funding college for their grandkids, they’re buying second homes, they’re traveling,” says Garcia. “There are no more corporate stock options to cash in, no more businesses to sell off, no more incomes to save.”

Mathias Hitchcock, vice president of practice management and consulting at Fidelity Clearing and Custody Solutions in Boston, says Fidelity’s research also has identified the lack of organic growth as a problem. The firm’s 2016 Fidelity RIA Benchmarking Study, which surveys a wide spectrum of advisers, found that organic growth, defined as total AUM growth less any growth driven by investment performance or merger and acquisition activity, was only 6.7% in 2015 (the study’s most recently published result). That figure represented a decline of 2.9 percentage points from 2014 and was the lowest level in the past five years. The components contributing to the decline included new assets from new clients (–1.3%), assets withdrawn by departing clients (–0.8%), new assets from existing clients (–0.5%), and assets withdrawn from existing clients (–0.3%).

Pressures on Pricing?

As baby boomers age, advisory firms need to attract younger clients to ensure the firms’ sustainability, but that’s easier said than done. One problem is that younger generations have different pricing preferences for advisory services. “Generally, we see those other generations being a bit more price sensitive, so they want lower fees,” Hitchcock notes. “They’re relatively less interested in paying one bundled basis-point fee, so they’re interested in more transparency, oftentimes linked to unbundling.”

The AUM model also can be a hurdle for younger clients, particularly when firms impose significant minimum asset amounts for new clients. This younger cohort (the so-called HENRYs, or “high earners not rich yet”) — often qualifies as RIA clients on the basis of income but not on the basis of investable assets. “They don’t have the assets, but certainly many of them value advice and are more than willing to pay for it,” says Hitchcock. One possible solution is for RIAs to move away from imposing asset minimums and move toward fee minimums, he suggests.

Hitchcock’s suggestion makes sense, but asset-based pricing is a cornerstone of the RIA business model. The 2016 Fidelity RIA Benchmarking Study found that 98% of respondents used an overall basis-point fee based on AUM, with 48% of firms bundling all services into that fee. The use of retainers or fees, which could increase pricing flexibility for younger clients, was much less prevalent:

• Overall annual retainer for multiple services: 8% (of firms).
• Annual retainer specific to individual services: 8%.
• One-time flat fee specific to individual services: 15%.
• Hourly fee: 21%.

The 2016 Fidelity study noted that the overall basis-point fee on AUM model is likely to “come under pressure and trend lower as investment management becomes more commoditized.” Part of that commoditization is driven by the emergence of the lower-cost robo advisers, according to Hitchcock, but it’s also driven by clients’ increased focus on financial planning and other elements of what he calls the “value stack.”

“As that planning piece of things becomes a bigger need and then at the same time you’ve got kind of the direct attack, if you will, on pricing for investment management coming from a lot of those robo advisers, in general that’s putting a kind of pressure on pricing models,” says Hitchcock.

Asset-based pricing, however, is likely to remain the primary model for the foreseeable future. Participants in the 2016 Fidelity study ranked “changing fees or pricing structure” as one of their least important business initiatives. Forty-four percent were not concerned about the challenges of changing their pricing models because they believed the current models were effective. Apparently, the market isn’t clamoring for change yet either. Only 7% of RIAs reported “receiving increasing pressure from our clients to justify our fees”; the number was 10% for pressure from prospects.

Garcia says that although product and service providers to the RIA market face increased competition and pricing pressure, he doesn’t see that happening with advisers. Pershing’s RIA research shows that prices, as measured by yield on assets under management, have consistently remained in the range of 75–80 bps since the early 2000s. When surveyed in 2016, about one-third of advisory firms reported changing their prices, but two-thirds of those respondents raised their fees. Instead of lowering fees, advisers are working to add value under their current structures, Garcia says. “What we’re seeing is an expansion of service and a wealth management offering both in technical specialty and array of services and solutions, and pricing is pretty consistent, if not increasing.”

Rising Compensation Costs

Compensation expenses are another potential pressure on RIA profitability. The 2017 InvestmentNews study found that between 2015 and 2017, RIAs’ staff salary increases outpaced inflation. At the low end of the increases, salaries for client service advisers rose 11%; lead advisers saw the greatest growth for the period at 23%.

Garcia believes several systemic causes are pushing wages higher. The first is an “acute need for professionals.” He cites estimates from Cerulli Associates that the annual attrition rate among US financial advisers is in the 6,000–10,000 range. A second factor is RIAs’ growing emphasis on offering clients specialized advice to help differentiate their service offerings from robos. “There’s a need for talent, which creates competitive marketplace practices, and there’s a need for specialization,” Garcia says. “And whenever you have somebody who specializes, that requires obviously an attention to compensation to attract the best talent.”

Fidelity’s research also found salary growth above the US national average for half the firms that participated in Fidelity’s “Insights on 2017 Advisor and Staff Compensation at Large RIAs and MFOs” (multifamily offices) survey. Since about 2013, however, human capital expense, including both RIA owners and nonowners, has remained around 60% of revenue, according to Anand Sekhar, vice president of practice management at Fidelity in Boston.

Still, Sekhar points to tight job markets, such as Boston and San Francisco, where it’s easier for front-line staff to find new jobs — a condition that pushes compensation higher. The employee-retention challenge is compounded by the different generations’ desires for what they want from their career, according to Sekhar. Salary and bonuses are important, but they’re only part of the overall package. Millennials and Generation X employees value a flexible workplace and want their work to inspire them, so they consider factors beyond financial compensation in determining job satisfaction.

More formal compensation planning is one method firms are adopting to manage costs more effectively. Garcia’s experience has been that when RIA firms were generally smaller, owners typically paid salaries and perhaps a year-end bonus when business was good. There was no compensation plan; It was more a question of the owner’s benevolence. That’s changing, he says: “What we’re seeing now is a more formal approach with job descriptions, goals, results-based goals especially, that attach to their performance. That then is connected to a very specific incentive plan, and that incentive plan is obviously relative to the position.”

Ideally, a compensation package rewards key employees and gives them incentives to remain on the job. Wealth managers understand this: Sekhar reports that his team is discussing long-term incentive plans more frequently with advisers. According to the large RIA and MFO survey, 65% offer one or more long-term incentives, but firms’ adoption of the different methods varies. Forty-eight percent used operating company equity, and 21% used phantom equity. None of the survey participants reported using nonqualified deferred compensation, and just over half (52%) offered formal profit-sharing programs.

Looking Ahead

RIAs might not experience a significant impact from these trends and developments for several years, but ignoring them could result in unanticipated problems, particularly if the investment markets reverse course. Garcia believes that wealth advisory firms should avoid dismissing the trends and plan strategically. “The challenge of increases in compensation is not that it’s getting more expensive; the challenge is that revenues are not growing fast enough to offset the increase in compensation,” he says. “That’s what people need to focus on: How do we grow organically, how do we focus on the next generation of clients, how do we manage our costs, and how do we invest for the future?”

This article originally ran in the April 2018 issue of CFA Institute Magazine.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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