Two subjects tend to surface around this time every year: compensation and valuation. These interrelated topics confuse firm leaders. While the numbers in play differ, both issues come down to the same key question: "Am I getting what I paid for?"
Business leaders find compensation particularly vexing because we have been taught to believe that if we pay somebody enough, they will perform exactly as we hoped. Having looked at literally thousands of financial firms, I conclude that the opposite result often comes to pass.
Take, for example, incentives paid for generating business. In the most recent InvestmentNews "Financial Performance Study of Advisory Firms" sponsored by Pershing, we found that while the average Ensemble Practice grew assets by about 18% in 2013, less than half of that growth came from new clients. The rest came from market appreciation or additional assets from existing clients. For firms with a high variable component tied to new business development, this should be a disappointing outcome. Why? Because they paid to get new business when, in reality, much of their growth came from great service and market momentum. Why would you pay somebody for something to which they didn't contribute?
The captive brokerage world has long experienced this phenomenon. Once a registered rep completes the training period, compensation then shifts to a variable model that rewards financial credits for the sale of certain products like financial plans, annuities and managed account programs. Some of these products now are referred to as "fee-based" solutions that, when sold to a client, pay the rep a perpetual income stream. Once these reps establish a repeatable, predictable cash flow, most of their income comes from existing relationships rather than new ones. In other words, sales drop off and they become advisors or service agents to their clients.
Fiduciary advisors (RIAs) may find it tempting to be self-righteous on this topic because they claim not to be incented to sell. In truth, many advisory firms retain vestiges of the brokerage compensation grid, often paying their people a percentage of the revenue they generate or manage. So while a firm may claim to base their model on client advocacy, their compensation structure often contradicts this philosophy. I mention this to generate awareness that compensation sometimes rewards the wrong behavior.
In theory, the more an advisor is involved in selling, the more his or her compensation should be variable and tied to individual production. Rewards follow sales closely, either in the form of commissions based on revenues or quarterly bonuses tied to growth. The more an employee is involved in service or management, the more his or her income should be fixed, with the variable component tied to exceeding expectations in her primary job. The bonus component is funded out of profits and based on team success. When a person is paid to "produce," but behaves more as a service agent, one could argue that the compensation model is not generating the desired outcome. I call the above strategy "compensation theory" because the same business people who pay more for production often are surprised when the outcome doesn't change.
My belief, albeit controversial in the financial services industry, is that compensation is not in itself a motivation factor but rather a means to recognize motivated people who do their jobs well. Clayton Christensen, a business professor at Harvard who wrote the terrific book "The Innovator's Dilemma," identifies compensation as a hygiene factor along with status, job security and work conditions. In other words, a fair compensation plan is necessary to keep people engaged and on task, but by itself does not drive positive behavior. He identifies motivation factors such as challenging work, recognition, responsibility and opportunities for personal growth.
