How to Avoid the Coming Crunch on Advisor Compensation

Those are norms. Advisors in the top quartile or decile of production do much better. At most wirehouses, a successful advisor (but not a superstar) would have AUM of $100-150 million after 10 years, grossing roughly $750,000 to $1.2 million and taking home $300,000-500,000.

When looking at what’s reasonable in terms of advisor compensation, there are no exact parallels. To get some perspective on market levels of compensation, I looked at five professions:

• Senior financial executives in public companies
• Senior managers and directors of accounting firms
• Private bankers
• Pharmaceutical sales representatives
• Dentists practicing in the best-paid specialties

The American Institute of CPAs has a 2014 salary guide that shows norms between $93,000 and

$260,000 for the first two positions on the list:

Source: Robert Half Salary Survey

All of these individuals have meaningful roles and substantial responsibility. A reasonable observer looking at these salary ranges as a guide would conclude that typical financial advisors should earn $150,000 to $200,000 – perhaps half of what they make now.

Let me preempt questions about chief financial officers of public companies or managing partners of accounting firms who earn millions of dollars in incentive compensation. Focusing on median compensation (whether it be for advisors or comparison occupations) lets us ignore outliers and concentrate on the norm. I’m not examining compensation among top earners, but rather the typical compensation for advisors compared to norms for other occupations.

Here’s another way to think about reasonable compensation for advisors. In a conversation with a faculty member in the MBA program at the University of Toronto, where I’ve taught for many years, he asked what other people who provide financial advice make. Here’s what the Robert Half compensation survey shows that experienced private bankers earn.

Source: Robert Half Salary Survey

My colleague’s quick conclusion: Any advisor compensation above $115,000 is attributable to additional value on top of the advice that‘s being provided – which raises the question of what makes the market value of advisors so much higher than that of private bankers. (Note that this salary range almost certainly excludes the high-end private bankers at elite firms who bring in business and are paid more as top-performing independent financial advisors are.)

The factors that drive up compensation

There are four good reasons that advisors earn significantly more than is justified by the training they’ve received or the advice they provide:

Skill premium: If building a successful practice were easy, many more people would enter the business, resulting in a price war that would quickly push down compensation. The key to success as an advisor requires a rare skill that has little to do with providing advice – and that’s the ability to attract clients. The reason that private bankers are paid much less than financial advisors is that bankers are fed clients, making them an interchangeable commodity and their salaries subject to the forces of supply and demand.Advisors benefit from a “persistence premium,” as those who can’t attract clients leave the business (in some cases adding to the supply of private bankers or financial planners available to work in bank branches, depressing compensation).

The skill premium, when it comes to business development, isn’t unique to financial advisors. Look at the partners in any large accounting or law firm: The big earners are the rainmakers, those with the ability to bring in business. The scarcest commodity in almost any business is the ability to bring in clients – and that commands a premium. The question is how big that premium should be.

Uncertainty premium: The traditional rule of thumb in the financial industry is that fewer than one in four new salespeople make it to year three. When someone chooses to become a financial advisor, he or she is taking a big risk relative to a safe and stable job with a predictable salary. For example, pharmaceutical sales reps are similar to advisors in that they require in-depth knowledge and strong selling skills. In 2013, the median compensation for pharma reps was $125,000, and it was $155,000 for the pharmaceutical industry’s hottest sector, biotechnology.

Source: Medreps.com

Part of the reason for the excess compensation for advisors, like the excess return in an equity portfolio, is a reward for the risk they took in entering the business. Economists would argue that to enter any business, people need an expected value of future compensation (both financial income and non-financial income that comes from autonomy and doing something you love) that fully compensates them for the uncertainty they are facing. The data show that assertion is valid.

Effort premium: On top of risk of failure, being a financial advisor in the early and middle stages of building a business is exceptionally hard work. (And of course, many successful advisors continue to work hard after they’ve become successful.) Part of the compensation premium for financial advisors reflects how hard they work to build their business.

Risk premium: Anyone who runs his or her own business faces a greater risk of failure than someone who has chosen to be an employee. Even recognizing that job security as employees is not what it was, financial advisors who run their businesses still face uncertainties and liabilities that an employee doesn’t have. And again, this uncertainty needs to be reflected in the compensation that financial advisors earn.

I talked earlier about the shift in how dentists operate. Dentists complete many years of education, work long hours and face greater financial pressure and uncertainty than ever before. In a striking parallel to financial advisors, the struggles of many new dentists mean that banks no longer routinely grant loans for dental-school graduates to set up their own offices. Many dentists have no choice but to work on salary as associates for established practitioners, in some cases staying in this role for many years before striking out on their own or becoming permanent associates.

What was the return for this training, risk and effort? In 2012, the median dentist earned just under $150,000, with median compensation for even the best-paid specialties such as orthodontics under $190,000. Reasonable observers looking at median financial advisors making almost twice the highest paid dental specialists would scratch their heads in puzzlement.

Source: Bureau of Labor Statistics

Prognosis for future compensation

Those four reasons partly explain why advisors deserve to make more than a sales rep for a pharmaceutical company or a private banker. But these reasons don’t account for the compensation premium that advisors have above senior financial executives or orthodontists, who spend six years in university after their undergraduate degree. Using these benchmarks as a guide, median compensation for financial advisors should be in the range of $150,000-200,000.

Three final factors that widen the compensation gap will come under pressure.

Business model: The perceived value that advisors create and their ability to capture part of that value elevate compensation. The research on whether investors who work with financial advisors are better off as a result is mixed – both sides in this debate can present data to make their cases. When it comes to the fees investors pay, however, what’s important is whether they think they’re better off and are willing to share part of their gains as a result.

Historically, clients have been willing to pay advisors a portion of the excess returns they believe they’ll earn as a result of the advice they get. Perceived value is the same reason that clients pay for tax or legal advice. However, the advisor business model is typically not based on an hourly fee that caps upside. The typical approach is driven by client asset levels, permitting higher returns than would be the case if advisors were paid by the hour. In essence, advisors are able to charge based on how much better off clients think they are as a result of working with them, rather than by the training the advisors have received and the effort they expend.

Oligopolistic competition: A key factor that has historically elevated compensation for advisors relates to the nature of the competition in this industry. In an oligopoly, a small number of firms control the market and set prices. Oligopolistic pricing is why gas stations across the street from each other charge the identical amount and why cell phone users pay more in the U.S. than in Hong Kong, India and Sweden. In classic economic theory, oligopolistic pricing is a gentleman’s agreement that sets prices above the efficient-market level and allows competitors to earn excess returns as a result.

The major players in the advice business compete fiercely on everything except price, where there is recognition that cutting prices would lead to a downward spiral in which no one would benefit except customers.

Lack of transparency: Due to a lack of transparency and asymmetric information between buyers and sellers, advisors have a much better sense of how profitable clients are than clients do.

Last week’s column described a conversation between an advisor and a $5-million client, rationalizing the $200,000 fees that he’d charged over the past five years. Greater transparency on fees means that advisors will be having many more of these conversations, accelerated by growing demands from clients and regulators for advisors to unbundle the cost of advice and investment management. Combine that with lower cost alternatives and new competition from online robo-advice, and fees will inevitably come under growing pressure – no different than the pressure on prices in just about every industry.

This will be especially true of larger clients who tend to be more profitable and often represent windfall profits for advisors. Yes, $3-million clients pay lower fees as a percent of assets than clients with $300,000, but in most practices larger clients still subsidize smaller clients, because their absolute fees are out of proportion to the time they take to manage. Awareness of this issue is already rising among larger investors, fueled by media coverage from credible voices like Wall Street Journal columnist Jason Zweig in this recent interview. And this article points to attention from regulators to instances where arrangements conflict with clients’ best interests.

Insulating yourself from fee pressure

One group will be the least susceptible to downward pressure on compensation – the very best advisors who run the most efficient practices. As the market for advisors becomes more rational, there will be greater separation between compensation for average advisors and for the very best. This is a bit like the market for free agents in pro sports – what puzzles insiders isn’t the $20 million annually that superstars make; it’s the $2 million that run-of-the-mill journeymen are paid. As the market becomes more efficient, those middle-of-the-road athletes will be the most susceptible to downward pressure on compensation – and the same applies to advisors.

Just as some dentists have prospered by building large teams, compensation will hold or increase for trusted advisors who run large practices providing not just investment, tax, estate and retirement planning but also expert advice on real estate, charitable giving, business succession and multi-generational planning. In addition to serving clients well, this broader focus will lead to additional revenue opportunities as advisors meet the full range of clients’ financial needs.

Alternatively, specialist advisors will do well if they are the go-to resource and “safe choice” for a defined niche of attractive clients, whom they serve exceptionally well because they know and understand their specific needs.

As those exceptional advisors succeed, compensation will decline for everyone else. For new entrants to the industry, this will still be a good business in terms of compensation, because some of the factors that drive compensation higher will persist. It won’t, however, be the path to riches enjoyed by advisors who were fortunate enough to enter the industry 20, 25 or 30 years ago. Just as autoworkers who started working on GM assembly lines in the 1960s and 1970s enjoyed windfall compensation, most advisors who came into the industry years ago have grown accustomed to compensation that doesn’t jibe with the real world and isn’t sustainable.

I’m not the only one to predict pressure on advisor compensation – an ongoing series of articles by a successful RIA who merged his practice into a bigger firm points to impending fee pressure as one of the reasons for his decision. In the new world that we’re entering, the only way to be confident of earning exceptional compensation is to provide an outstanding client experience – a combination of professionalism, quality of advice, scale to operate efficiently and a clear, concrete value proposition that justifies premium pricing.

The way forward

My goal in the past three articles has been to get readers thinking about the important macro trends in the advisory industry. You may not agree with everything on my list – in which case, you can identify your own unsustainable realities that have to change.

Once you identify something as irrational, it will inevitably change. The reason that most companies fail is not that they don’t try to change, but rather that they take too long to adapt to a new reality, waiting until change is not an option – at which point it’s too late. The time to plan for change is now.

We all recognize that the things that led to success yesterday and success today won’t necessarily make us successful tomorrow. Remember, I’m not suggesting these developments will all happen over the next three or five years. Inertia is a remarkably powerful force in postponing change. That said, they will happen. Today, advisors have the luxury of time and are operating from a position of relative strength – exactly when they should be positioning their businesses for the future.

conducts programs to help advisors gain and retain clients and is an award winning faculty member in the MBA program at the University of Toronto. To see more of his written commentaries, go towww.danrichards.comor herefor his videos.

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