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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One of the largest expenses of running an advisory practice is office space.
This is true whether you have your own independent practice and pay for it directly or whether you are a W2 employee advisor and are paying for it via your payout. The latter approach is particularly painful.
For you, that is, not the firm you’re employed by.
Let’s start with the inconvenient truth for W2 advisors.
As a W2 employee advisor, you “pay” your firm for the resources and services they provide for you via the inverse of your payout. If your “payout” is 40%, you are paying 60% to your firm.
While you never receive an itemized bill explaining the breakdown, a portion of the 60% payment covers the cost of providing you an office, access to a conference room, etc.
What happens as you increase your production?
Assume you generate $1 million in annual production and have a payout of 40%. Part of the $600k your firm retains (60%) goes to providing you with an office. If you increase your production to $2 million, you’ll now pay $1.2 million to the house. Does your firm now provide you with an office twice as big as before? Do you now have access to a conference room twice as big?
Of course not!
But Brad, larger producers get a higher payout percentage.
Let’s consider that.
A $250,000-producing advisor might have a payout of 30%. They’re paying $175,000 (70%) to their firm. From part of that, they are provided an office.
A $4 million advisor in the same branch might have a payout of 50%. (After deferred-comp holdbacks and other payout gimmicks, it is assuredly not 50%, but we will assume it is for argument's sake.) That advisor is paying their firm $2 million (50%). They, too, are provided an office.
The $4 million advisor pays over 10X more to their firm than the $250,000 advisor. The $4 million advisor is likely provided a larger office, but 10X the size? Or access to a conference room 10X larger?
Again, of course not!
The dirty little secret of office expenses is you should never pay for it as a variable expense. When paying for office space as part of your payout, the more you grow your practice, the more you pay – even though your office space likely won’t change.
But this is a great arrangement for your firm. Whether they lease or own the branch, it is a fixed expense. Once the annual revenues of the branch exceed the fixed annual cost of the real estate for the branch, every additional dollar in revenue is incrementally more profitable for them.
Someone gets to benefit from this “operating leverage.” Would you rather it be you or your firm?
Independent advisors cover the expense of their own office directly and thus pay for it on a fixed basis.
Once the annual revenue of an independent advisory firm exceeds its annual fixed real estate cost, every incremental dollar of revenue is more profitable. That increased profitability flows directly to their bottom line. They are the ones benefiting.
How do W2 firms counter this argument?
I have heard executives at such firms espouse in a down market (as we’re in now), “Aren’t you glad we (the firm) are responsible for this fixed lease expense we have? You’re not the one stuck with a fixed office expense as your production goes down.”
That logic reminds me of the analogy of a baseball outfielder who horribly misjudges a fly ball hit their way. The fielder dramatically corrects course and makes a spectacular diving catch. The crowd goes wild!
Had the fielder not misjudged the play, the spectacular play would not be necessary.
It’s the equivalent of a branch manager patting themselves on the back for slightly improving an enormously unfavorable arrangement for the advisor. Compared to a fixed expense, the difference between a variable expense for office space narrows during a declining market. But the gap is still wide for most advisors.
Step one in reducing your office expense is to pay for it on a fixed basis, not a variable one. Independent advisors managing their own “local expenses” take advantage of this operating leverage.
In Part 2 to follow, I discuss how to reduce your fixed office expense even further.
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.