Why the economics of advisor independence should matter to investors

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There has been increasing attention among investors in recent years on the fees they pay for financial advice. What this singular focus misses is any discussion of how much of those fees end up in their financial advisors’ hands.

But if the amount of money clients pay their advisors influences how much time and attention those clients receive, then understanding advisors’ ‘cut’ of the fees matters.

Any advisor registered with either the Mutual Fund Dealers Association of Canada (MFDA) or the Investment Industry Regulatory Association of Canada (IIROC) must operate through an associated mutual fund or investment dealer, respectively. That dealer then retains a portion of the total revenue the advisor generates for services provided.

Each dealer maintains its own schedule, commonly known as a “grid,” which sets out the percentage of advisors’ revenue paid out to them. Depending on the dealer and the level of advisor production, these percentages can vary widely. Looking only at grid levels, we can group dealers into three categories: bank-owned brokerages, high-grid independents and low-grid independents.

Bank-owned brokerages provide the highest amount of support and brand recognition, but also take the largest cut of the advisor’s top-line revenue – from 49 per cent up to 72 per cent.

To make matters (for the advisor) worse, even though bank-owned brokerages provide the most support for advisors, that doesn’t come close to covering the costs associated with running an advisory practice.

The costs of staff, travel and promotion often fall on advisors. As a result, average advisor earnings before owner compensation (EBOC) at bank-owned brokerages range from about 20 per cent of top-line revenue for low-producing advisors to about 35 per cent for high-producing advisors.

At high-grid independents, the advisor grid tops out at about 60 per cent of revenue. While not all advisors’ costs are covered, the more generous grid structure at larger independent dealers means advisors’ EBOC is similar to bank-owned brokerage levels, if not slightly better.

In addition, due to these firms’ lower production thresholds, the top of the grid is easier to reach. That means lower-producing advisors can reach the top quicker than their peers at bank-owned brokerages.

Finally, low-grid independents provide only basic services to advisors, giving them the freedom to run their businesses as they see fit. Everything from office rent, to human resources, office management and various software decisions are left in advisors’ hands.

In exchange, advisors retain 75 per cent or more of total revenue, and higher payouts are available at much lower production levels. Some dealers provide grid “caps” while others now provide flat-fee services – effectively turning grid payments from a variable cost into a fixed cost that can equate to a low, single-digit percentage of total revenue.

In return for this higher payout, advisors must run virtually all aspects of their own practices. But the economics remain more favourable, with EBOC averaging closer to 50 per cent. The most efficient practices can push their EBOC levels to 70 per cent or more.

Why does all of this matter to investors?

Let's consider a client who has $500,000 to invest and is looking for a new advisor. She finds four advisors with similar service offerings who meet her needs. One is a rookie at a bank-owned brokerage; the other is a top producer at a different bank-owned brokerage; the next is a high-producing advisor at a high-grid independent; and the last is at a low-grid independent.

All four would charge the client 1 per cent of assets under management for a total of $5,000 in top-line advisor revenue per year. How do the numbers shake out (without considering operating costs)?

• The rookie advisor at the bank-owned brokerage will receive about $1,250 (25 per cent of the fees paid by the client).
• The top producer at the same brokerage will get $2,500 (50 per cent).
• The advisor at the high-grid independent dealer will get $3,000 (60 per cent).
• The advisor at the low-grid dealer will get between $3,750 and $5,000 (or 75 per cent to 100 per cent).

The differences are significant. The advisor at the independent dealer is likely to pocket between one-and-a-half and four times the amount the advisor at the bank-owned brokerage would get. (Keep in mind that the thresholds to hit the top payout on the independent side are lower, making it more likely that the compensation for the advisor at an independent low-grid dealer will be close to or at the top end of the range.)

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Now, if the reasonable expectation is that the more a client pays an advisor, the more of her time and attention the client commands, then grid levels impact client service. Put simply, time equals money – and more money should equal more of that advisor’s time.

From advisors’ perspective, payout grids impact the structure of their business. To achieve similar EBOC levels, advisors at high-grid dealers need to manage significantly more assets than advisors at low-grid dealers. That means significantly more clients. This dynamic then creates a client-servicing issue for advisors on a high grid: the more clients they have, the fewer hours they can spend on and with each client.

All advisors must balance the number of clients they serve, their overall service offering and time spent per client carefully. When one of these factors increases, the other two must decrease. Thus, advisors have focused on the number of clients they serve as that’s the only factor among the three that’s linked to compensation.

For investors, there’s plenty of guidance on how to pick an advisor. But compensation grids are noticeably absent from the lists of questions to ask their potential advisors. Yet, this factor plays an outsized role in determining how much of an advisor’s time and attention a client will get.

Jason Pereira is partner and senior financial consultant at Woodgate Financial Inc., a financial planning firm under the IPC Securities Corp. umbrella in Toronto.