Ask Brad: What Are “Compensable Revenues?”
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.
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Next time you walk into a car dealership to buy a car, consider the ways the dealership generates revenue from you.
It’s not the sale price of the car alone.
As anyone moved along to the “finance manager” knows, there are upsells galore: extended warranties, service packages, lending originations, ding and dent repair, key replacement insurance, fabric protection, and undercoating, to name a few.
As for the “undercoating,” remember the Seinfeld reference: David Puddy declaring, “We don’t even know what it is.”
I’m not suggesting it’s unfair for a dealership to generate such revenues. Well, maybe not the undercoating, but you get my point.
Now compare this to the scenario of a financial advisor under a traditional broker/dealer affiliation, whether W2 employee or 1099.
As I have lamented in this column before, think of your “payout” not as the portion you get to retain but the portion you pay your firm.
Assume you are receiving a “payout” of 40%. Put differently, you are receiving 100% of the fees and commissions you generate, but in return for the value that your broker/dealer provides to support your ability to generate that revenue, you pay them 60%.
Depending on the firm you are at and the value they provide you, that might be a reasonable arrangement – other times, not the case.
“Payout” is nonetheless what many advisors initially think of when considering how much revenue their firm is generating from them.
Like a car dealership, your broker/dealer is generating revenue in several additional ways.
Interest rate spreads on cash sweeps, mutual fund omnibus fees, payment for order flow, margin and/or non-purpose lending, banking products, and TAMP platforms are a few examples.
Particularly in a post-Regulation-Best-Interest world, you, the advisor, are not compensated on any of these additional revenue sources.
Once upon a time, an advisor was compensated on cash balances and lending originations. Even higher compensation was paid on the sale of proprietary investment products. In most instances, those days are numbered.
This is where “compensable revenues” come into play.
You generally won’t see this term in a firm’s quarterly earnings report, as it is not a required GAAP accounting disclosure. Where you might see or hear it discussed, though, is on an analyst conference call corresponding to such an earnings report.
Compensable revenues are what a firm must compensate the advisor on.
The firm might have to pay the advisor whatever their payout is for every dollar in advisory fees and commissions.
With the noted additional revenue sources, though, the firm generally retains 100% of those revenues. They are non-compensable.
Listen to the analysts’ calls and guess where analysts and management generally indicate they want to see those figures trending towards.
Whether shared externally or not, many firms set internal benchmarks for what portion of overall revenues they want compensable revenues to account for. The lower the % of the latter, the more revenue (and ultimately, profit margin) stays with the firm.
With that metric in mind, consider how it can guide decision-making on comp plan changes, cross-selling banking products, etc.
If the target for the percent of revenues that is compensable is not being met, there are only two ways to move towards it: either increase overall revenues or decrease compensable revenues. Either approach is arguably not led with the advisor’s interests in mind as the guiding light.
In the RIA model (full disclosure: I help advisors explore it), some of these same auxiliary revenue sources still exist. Cash and lending is the largest revenue driver for a custodian. And as with the broker/dealer model, the RIA advisor doesn’t share in any of that revenue.
There are two important takeaways regarding compensable revenues for any advisor in a broker/dealer affiliation.
If your broker/dealer (or prospective broker/dealer) talks about how they are rewarding you with a “high” payout, never lose sight of the fact that this is not the only way they are generating revenue from you and your clients. Perhaps it is a fair payout for the value they supply you with. But make no mistake, they are taking more bites of the apple than payouts alone.
Second, remember that there are pressures to decrease the portion of compensable revenues and that inevitably drives managerial decision making. This is acute at publicly traded firms, where those pesky analysts/shareholders keep asking about it.
This exercise is a reminder of why it is important to understand the blocking and tackling of how broker/dealers and RIAs are run, and how different affiliation paths might benefit you.
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.