Should Advisors Be Paid Like Brokers?

Editor's Note: Mark Tibergien is one of our 2014 IA 25 honorees. Read his profile from the May issue of Investment Advisor here, and look for his extended profile on ThinkAdvisor.com on May 7.

At a recent Barron's conference acknowledging the top 100 independent advisors, I became engaged in an interesting discussion with several firm leaders. The topic was compensation practices within advisory firms. One very accomplished broker-dealer executive expressed frustration that young people coming into the business today do not want to be "paid on the grid," with variable compensation based on their personal production.

This executive encourages his older advisors to bring in younger people to sell fee-based solutions to the bottom end of their books, the segment of the client base that has long been neglected but represents potential for more income. He said that because young professionals eschew the variable compensation model, they lack the incentive to "work the book," so it becomes too expensive for advisors to hire young people.

As I listened to this argument, several thoughts occurred to me:

Many broker-dealers confuse fee-based business with the advisory business. Just because the firm generates annuity-type income from product sales does not make it an advisory practice. "Working the book" to sell more products to clients represents the classic brokerage model, not the relationship fiduciary advisors strive for with their clients.
If a professional needs an incentive to serve clients well, they are in the wrong profession. While rewards and recognition are important, meaningful pay is a by-product of attracting the right clients and delivering value to them. Clearly pay should be competitive and relevant to the job that an employee is expected to perform—but not a motivator in itself. The key is to hire motivated people, then avoid distracting or discouraging them so that they focus on the right outcome. The challenge is to hire the right people and match them to the right job.
For centuries, the best model for people development has revolved around a master/apprentice philosophy. The older, wiser practitioner mentors and teaches, while the younger novice learns how to do things right. For generations, doctors, lawyers and accountants have proven this approach to be the most effective way to prepare their professionals to become masters in their own right. In contrast, the financial services industry was built on an "eat what you kill" model, in which unskilled and inexperienced people were forced to sell financial products to whomever they met, until they developed the wisdom and insight to act as advisors (or more commonly, to sell products to higher-net-worth clients).

For some time now, financial services has been at a crossroads between the traditional brokerage world and the growing, dynamic advisory business. The flight from transaction-based organizations to fee-for-service models continues—though the commission world still predominates. Of the roughly $12 trillion of investable assets in the United States, about a quarter is under the guidance of RIA firms. Outside the United States, the financial services industry is still substantially product-based (and therefore commission-based), but that is slowly changing, especially in the U.K., Australia, Singapore and certain countries in Latin America.

Broker or Advisor?

To keep their reps up to speed with the advisor competition, broker-dealers created "fee-based products," which they characterize as "advisory solutions," to generate consistent, predictable income. What they often miss is the fundamental difference in business models between a fee-based rep and a fiduciary advisor, or the difference between a BD business model and a custodian. Understanding this difference and adopting better solutions would help broker-dealers stem the tide of defections to the new world order. More significantly, it would help reposition their businesses to capture new opportunities, not just defend against outflows.

The dynamic between BDs and RIAs has existed since at least 1940, though it seems like a relatively new phenomenon to many. For years, banks, trust companies and discretionary money managers set up businesses as professional investors. They executed through institutional brokers in return for research and ideas, then either self-custodied the assets or held them in nominee name at a bank, sometimes in street name at the executing broker-dealer.

When Chuck Schwab introduced the RIA custody model 25 years ago, he effectively disintermediated institutional brokers by offering a cheaper way to do business for these discretionary managers as well as the emerging market for financial planners. The new offering included integrated technology and a mutual fund supermarket. (This followed Schwab's first disruptive act in the 1970s: the push for discounted commissions that disintermediated many full-service brokerage firms.) There are now at least a dozen other firms positioned as institutional brokers and custodians to RIAs, including some broker-dealers who have expanded their offering beyond retail brokerage.

While BD executives tend to view an RIA as an "unregistered rep," by definition (Rule 15a-6 of the Securities Exchange Act of 1934 and FINRA Rule 4512), an RIA is an institutional client that manages the assets of individuals, trusts, foundations and retirement plans. In other words, they are professional buyers conducting their business through professional sellers (brokers) and independent custodians. Because of this difference, RIA firms are regulated differently from FINRA-governed broker-dealers who face appropriate concerns about sales practices.

When one recognizes the fundamental differences in these business models, the approach to hiring, training and compensation takes on a different hue. It also provides a clue for broker-dealers. If they want to recapture the flow of assets to the advisory side, they should consider restructuring their businesses, including compensation models.

So, what is the human capital strategy for the most effective advisory firms? First and foremost, the mission of a fiduciary advisor is to position himself as a client advocate rather than a product advocate. There is still work to be done here, of course, as fees based purely on assets under management still constitute a form of contingent compensation with potential for conflict. Nonetheless, the notion of getting paid for managing the client's wealth instead of getting paid for the sale of a product is more in line with an advisor's role. To showcase this difference, bear in mind that RIAs get paid by clients even if their assets are all in cash because that is an asset class, whereas in many brokerage firms, cash is excluded from the grid.

Firms have always struggled with translating this revenue model to advisor compensation within their practices. Traditionally, the more a professional is involved in sales, the higher percentage of pay is variable and short term, while the more one is responsible for service or management, the higher percentage of pay is fixed and long term.

Advice, Not Products

Most elite advisory firms are delivering advice rather than making product sales. Thus most have changed their compensation plan to a base-plus-incentives structure. The incentives may be funded by profits or revenue growth, but the bonus is based on the behaviors they want to reinforce, such as client retention or growth, continuing education, internal collaboration, safe practice behaviors and people development.

The big change is not in how the firm pays advisors, but in how the practice is structured. The best advisory firms use a team approach in which a seasoned advisor leads a group of younger associates. This approach creates operating leverage, much like the doctor/nurse-practitioner model, and provides a valuable avenue for training staff to become full-fledged advisors who ultimately will be responsible for business development and leading their own teams. We refer to these types of practices as ensembles. Studies continue to demonstrate that ensembles reward their owners more, grow faster and develop their people more effectively.

When posed with the challenge of attracting young people to the business, first decide what role you want them to play. There is nothing wrong with hiring them as salespeople, but if they expect and desire to be an advisor, they will feel a disconnect between what you ask them to do and what they want to do. If your goal is to create operating leverage and sustainability for your practice, then you must craft a people-development strategy. The ensemble model will help you generate more income while serving your clients more effectively—and this is true even if the compensation model is more fixed than variable.