Ask Brad: The Inconvenient Math of the W2 Model
This is the latest installment of a regular column to answer questions from advisors who are considering transitioning to an RIA model. To see Brad’s previous articles, click here. To submit your question, please email Brad here.
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Should every financial advisor “go independent” with their practice?
But Brad, aren’t you in the business of helping advisors transition their practice to the “independent” RIA model?
But from experience, I know that an independent model is not for everyone. I have spoken to plenty of advisors who have neither the desire nor the wherewithal to run their own business.
I respect this. There are advisors who love being practitioners of their craft and don’t want the additional responsibilities of business ownership, no matter the economic upside and additional flexibility of doing so.
So, do not let the title of this article fool you into thinking I’m blinded to anything short of a fully independent model. However, there is inconvenient math that comes with a W2 approach at one of the large traditional broker/dealers.
Consider an analogy relating to air travel.
We pay for airfare on a per seat, per flight basis. The more flights we take, the more the cumulative variable cost of doing so increases.
Imagine if your favorite airline offered a pass for unlimited travel within a calendar year for $10,000.
Would you buy it?
You’d inevitably consider how many flights you might plan to take in the coming year, how much each flight might individually cost, etc. You would then add the cost of all of those individual flights up to calculate the break-even point on the $10,000 price.
If you anticipate spending less than $10,000 per year, you’d stick to the variable cost of paying for flights. Anticipate spending more than $10,000, you’d take the fixed-rate deal.
What if, though, you anticipated spending $50,000 per year in cumulative flight costs? It would be a no-brainer to take the $10,000 deal!
Now let’s consider the economics of the W2 payout model.
One benefit of the model is that certain things are provided for you: office space, technology, perhaps a sales assistant, compliance support, health benefits, to name a few.
Your payout is how you are paying for these services. But don’t think of your payout as the portion of your production you retain; think of it (using the inverse) as the portion you pay for the services you are receiving.
Consider if your firm offered you a choice of one of these two options:
- 50% payout on your production (and thus you are paying 50% to the firm); or
- You keep 100% of your production, but pay $500,000 per year.
(I purposely chose the 50% payout level to reflect the highest payout levels typically found at traditional W2 broker/dealers.)
Which of these two options would you take?
This presents an easy break-even analysis.
If you generate $1,000,000 per year in production, it makes no difference whether you pay 50% of your production or $500,000. It’s the same thing.
If you’re only generating $600,00 per year in production, paying 50% ($300,000) is a better deal than paying $500,000.
But, if you’re generating $2,000,000 per year in production, you would never take the 50% option ($1,000,000) when the $500,000 option exists.
Run this math at higher production levels and the disparity grows larger.
Here is where things get inconvenient with the math.
A $1,000,000 producer doesn’t care which of the two options they choose. It’s the same $500,000 per year.
A $2,000,000 producer would want option 2, the flat $500,000 per year.
However, this isn’t how it works at the traditional W2 broker/dealers.
At the traditional W2 broker/dealers, the only option is to take the 50% payout. The $2,000,000 producer will pay their firm $1,000,000 per year for the services they receive, double the $500,000 the $1,000,000 producer pays.
Surely, the $2,000,000 producer is receiving double the value from their firm as the $1,000,000 producer receives?
Double the office size?
Double the health insurance benefits?
Double the technology?
Nope, that’s not how it works!
What about a $3,000,000 producer? Or a $5,000,000 producer?
Yes, at some point, the larger producer/team might receive additional sales assistant support, marketing reimbursement support, etc., but that increased value does not remotely keep pace with the increased cost the larger producer is paying for it.
The inconvenient reality is that the cost of the benefits that a W2 broker/dealer firm provides to you is fixed. Office sizes only get so big. Health insurance only gets so generous. Everyone uses the same technology, etc.
Yet, the way advisors pay for these services is variable, not fixed.
The larger you grow, the more you pay, with no cap regardless of how significant your production becomes.
Consider instead how it works in the independent model. Most of the fixed costs of running a firm are paid by you. Once your revenue exceeds those costs, every incremental dollar you bring in is profit.
There are still variable costs associated with running your own firm. But, under an independent shingle, you are the one who benefits from the meaningful fixed side of the cost structure.
Ever wonder why airlines don’t offer the fixed annual flight passes I mentioned previously? They know everyone will game the system and only those that would benefit from it would buy it.
In the advisory profession, gaming the system is there for the taking.
Brad Wales is the founder of Transition To RIA, a consulting firm uniquely focused on helping established financial advisors understand everything there is to know about WHY and HOW to transition their practice to the RIA model. Brad utilizes his nearly 20 years of industry experience, including direct RIA related roles in compliance, finance and business development to provide independent advice regarding how advisors can benefit from the advantages of the RIA model.