Q107 – Are The Economics Better In The RIA Model?

Also available as podcast (Episode #107)

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Are the economics better in the RIA model?

While articulated in different ways, the two main motivators for why advisors transition to the RIA model are for increased flexibility with how they can run their practice, and to achieve better economics.  There are several variables that go into the latter including higher top line revenue to begin with, ability to control expenses, tax advantages, higher enterprise value, just to name a few.  When comparing the RIA model to what your current affiliation model is, it is important to understand how the economics differ and how they would look for your own practice in the RIA model.

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Full Transcript:

Are the economics better in the RIA model? That is today’s question on the Transition To RIA question and answer series. It is question #107.

Hi, I’m Brad Wales with Transition To RIA where I help you understand everything there is to know about why and how to transition your practice to the RIA model.

If you’re not already there, head to TransitionToRIA.com where you’ll find all the resources I make available from this entire series in video format, podcast format. I have articles, I have whitepapers. All kinds of things to help you better understand the model.

Again TransitionToRIA.com.

On today’s episode, we’re going to talk about why the economics are better in the RIA model.

The precursor to where economics comes into the equation is there are two main reasons, two main motivations for why advisors transition their practice to the RIA model.

No matter how it’s articulated, how it’s described, it typically falls into one of two buckets. First, increased flexibility with how they can run their practice and the services and investment solutions they can provide their clients. And second, better economics.

On today’s episode, we’re going to talk about what exactly goes into making the economics better in the RIA model. I’m going to go through a couple items. As always, it’s not an exhaustive list, but these are things that will start to help you understand why you hear in the marketplace, why you hear me talking on episodes, about the better economics.

The first advantage applies to if you start your own RIA. It’s a little different if you join an RIA, but it can still be just as advantageous.

As an RIA you get a 100% payout.

I used that terminology, that framing, because that’s something I hear advisors often refer to it as, a 100% payout. The reality is, if you have your own RIA, there’s no payout at all. That term technically doesn’t even apply.

The reason it’s often expressed as a 100% payout is because that’s the easiest way to compare to the payouts that other affiliation models offer. But the reality is, it’s not a payout. The custodian that holds your assets is not giving you some sort of payout. When they process your client fees for you, all they are doing is remitting them out of the client’s accounts, per your instructions, and sending the funds in aggregate to you as the RIA at 100%. They are not taking a payout on that along the way. That is not recorded as revenue for the custodian.

Point being, don’t think of it as a payout. 100% of the client fees that you generate in your practice with your clients, that comes to you. Now, as we’ll get into, obviously you have expenses to cover, but to be clear, that top line comes to you at 100%.

Next, and related to that, one of the big benefits of the RIA model, and this applies whether to you start your own RIA or you join an RIA that has a 1099 model, is the ability for you to manage and control your so-called “local expenses.”

That are things like an office, staff, paying for compliance, paying for technology, etc. Because you control that, you decide how extravagant you want to spend on something or not.

So examples, two of the biggest expenses of running a standalone RIA are the office that you choose to be in, and the size of your staff that you choose to have.

Some advisors like a very fancy office and likewise have a higher cost structure when it comes to the office. Others have a large team and they feel that makes them more efficient, they can grow the practice faster and that makes more sense. That’s great, but that comes at a higher cost.

Others outsource a lot of things. I’ve done an episode on how to have a very lean RIA. And likewise, their local footprint, their team member footprint is fairly light compared to others. The point is, you get to control that.

When you’re at (for example) a wirehouse firm, someone else makes the decisions of how extravagant or not something should be, how extensive a resource should be that’s being provided. You don’t have any control over that.

In the RIA space, you get to control your local expenses and only pay for things that you’ll actually use, and you can go to the marketplace and decide which vendors, which solution providers you’re going to use to do that. And in many cases even negotiate what that price is going to be. It’s a big economic advantage to have control over your local expenses.

Another big benefit of the RIA model when it comes to the expense bucket is that several of the expenses you incur running a practice can be fixed expenses.

An example of that is your office. I just recently did an episode of why it’s so important to perhaps even consider owning the office that you’re in.

Consider the fixed cost of having your own office. Yes, there might be some marginal costs that go up each year, the property taxes if you own it, the insurance you’re paying on the building, etc. But the bulk of the cost is static.

Now yes, as you grow your firm at some point you might grow so large that you must expand that office footprint. But the idea is that your office expense does not go in lockstep with your growth.

Whereas if you’re at, for example, a wirehouse W2 model, you’re paying for that office as part of your payout (the inverse of your payout.) As you continue to increase your revenues, your production, every additional dollar in production you bring in, that’s more money you’re paying for an office. It’s linear, it goes up right alongside your production.

In the RIA model, you have operating leverage on some of these costs where you get to experience the operating leverage growth.

Compliance is another example. If you have your own RIA and you’re paying a compliance consulting firm, which is the typical path – I’ve done several episodes on how to manage the compliance responsibility.

The cost of the compliance consulting firm will depend on the size of your practice. But you can grow your practice 20%, 40%, 60% perhaps before you necessarily need to increase the cost of that compliance.

Now, if you grow your firm large enough and you add enough team members, at some point, maybe you’ll need to step up to a higher tiered level of service from that compliance consulting firm. But for the most part, as you grow your firm, that cost is not going up in lockstep. It’s more of a fixed cost that you can manage on your own.

Again, that’s operating leverage. That’s something you absolutely cannot benefit from if you are in a W2 model where the (cost of the) resources being provided to you, office, compliance, technology, whatever, goes in lockstep alongside your payout. The more revenue, the more production you produce, the more you’re paying for those things. Not the case in the RIA model.

The next example that makes the economics better is the tax advantages of the RIA model.

I didn’t come up with this, but if you study the tax code and learn about all the different ways you can use it, there’s a saying that the two best ways to maximize the tax code to your advantage are to own real estate and to be a business owner. The way you can write things off, depreciate things, etc. it is very advantageous.

The first example, whether you have your own RIA, or are a 1099 with another RIA, is how you pay yourself.

A portion of your compensation is paid as salary, and goes through normal payroll taxes. The other part can be taken out as a distribution from the company, which you don’t pay payroll taxes on. You still have income tax to pay, and of course, this is not accounting advice, work with your CPA, but it’s a benefit to be able to manage how you are receiving that income, and likewise, what the tax treatment of it will be. You have no ability to manage that as a W2 employee at a broker/dealer or wirehouse type firm.

Another tax advantage is the ability to write off business expenses of running the practice, things you might not be able to write off now. Whether it’s things you’re doing for marketing, business development reasons, you’re meeting with prospects, there’s costs associated with that. Your firm may or may not let you deduct some of that or get expense reimbursement for that now.

If it’s a valid business expense that you can justify, you write it off as an expense and that lowers the taxable income of the business. It is what it is. You have much more flexibility to do that under the business ownership / 1099 world than you do as a W2 employee.

The final example on tax advantages, which this is by no means an exhaustive list, is if you own the building you’re in.

I did a recent episode on this. The fact you can depreciate the building and offset that against some of the income of the practice, the way you set it up and how you perhaps pay rent to the ownership of the building, there’s all kinds of tax benefits of doing that.

This is not accounting or tax advice, but there are opportunities that do not exist in the W2 employee model that exist over here in the RIA model. It’s something to be aware of, something you’d want to talk to your CPA about. If you were to do this, be in an independent model, what would you have available from a tax perspective that you don’t have available from a W2 perspective? You will be quite surprised if you’ve never dug into it how advantageous it can be.

The next example of how the economics can be better in the RIA space is – I’ll give you two examples – the ability to drive top line revenue higher.

We’ve talked about how you can reduce or manage the expenses of the firm to your advantage. We’ve talked about the tax advantages. But don’t forget, what drives better economics is higher revenue as well.

The first example is having more flexibility with how you charge for your services. If you are at a large broker-dealer firm, W2 firm, wirehouse, whatever the case is, you’re probably fairly constrained with how you’re allowed to charge.

You’re likely allowed to do an AUM fee, which probably has specific fee guardrails you must stay within no matter what the circumstances. And you might not at all be able to charge things like flat fees, hourly fees, retainer fees, project fees, whatever you want to do.

Maybe with your client base, there’s not a lot of opportunity for that. But maybe there is. Maybe there are smaller clients or clients that haven’t built up a net worth yet that still want your advice and have the means to pay for your advice but don’t have the AUM yet where an AUM fee would justify the relationship.

In the RIA space, you have much more flexibility with how you can price your services. You might say, we primarily have an AUM fee, but we also have these other two options, a flat fee, a project fee, or maybe an hourly fee.

Anytime you have more flexibility with how you can set your price to match the value proposition you offer your clients, that’s going to give you a better ability to drive your top line revenue. Which hence increases your economics as well.

Be thinking about, if I was not restrained by some preset guidelines of how I can charge my clients, are there pricing approaches I would like to introduce into my practice? I might be able to generate additional revenue as a result.

The other revenue item I want to point out, and this circles back to what I said at the top, is there are two main motivators for why advisors move into the RIA model. The flexibility bucket and the better economics bucket.

Keep in mind how the flexibility bucket spills over into the economic bucket. The more flexibility you have with how you run your practice, will lead to better economics for your practice.

If you have more flexibility with how to prospect for new clients, how you do your business development, how you position your offering in the marketplace, that is always going to provide a better path for potential growth than not being able to do those things.

Maybe you want to have a podcast, or make videos like I make. Maybe you want to write articles in local periodicals or industry periodicals. Maybe you want to create whitepapers and distribute them to potential clients.

In the RIA model, you have much more flexibility with the different techniques you can use to grow your practice than most captive advisors have in the W2 space, where you generally can’t do a podcast, or videos.

And if you can do videos, it’s here’s a script you have to read verbatim, and by the way, we’ll still check it afterwards, and it’s going to take us four weeks to check that, so don’t think you’re going to put the video out in any sort of timely fashion.

Compare that to the advisor that has the flexibility to make a video and release it the same day if they want to. They have their own process they need to put in place for their own compliance responsibilities, but it’s much more flexible.

Think about it, if you are in competition in the marketplace, you are one advisor and there’s another advisor down the street, and that advisor has way more flexibility with how they can go to the marketplace and position their firm, do their business development, choose the services and solutions to provide, how they price it out. If they can do that all in a more flexible manner than you, they are going to have an advantage attracting. It is going to drive better economics.

Then the last item I’ll point out for better economics for this episode, again, this is not an exhaustive list, is the higher enterprise value that the marketplace assigns to an independent practice, particularly in the RIA model.

I did an episode on why RIAs are attributed a higher valuation in the marketplace versus other models, so I won’t go into it too deep here. Check out that episode if you’re interested.

But it is what it is. The market values a practice at a higher valuation in the RIA model than you can get typically with the so-called sunset plans, for instance, at large warehouse firms.

Not to mention the taxation of sunset plans versus the taxation of what you can do when you’re in the open marketplace selling your firm in the RIA space. Very big difference from how that valuation occurs, very big difference in how the taxation of what you receive occurs. That’s going to drive the better economics as well.

Those were a couple items – again, not an exhaustive list – but a couple items to get you thinking about how when you hear that the economics are better in the RIA space, why is that. These are a couple things to be thinking about.

Two takeaways to sum this up and wrap up the episode.

You might say, that 100% coming in on the top level and then I have expenses, but when you factor all that in, what do you typically net at the end of the day? Because that’s what I, perhaps if I’m a W2 wirehouse advisor, need to compare against what I’m making now.

By the way, if you do this comparison and you’re that W2 wirehouse advisor, you can’t just look at what your “payout” is because among other things, there might be deferred comp that’s taken out of that before what you actually receive

If you want to do this comparison, be true to yourself and say….regardless of what my wirehouse firm describes it as, the payout of the comp plan, with all the little gotchas and all the ways they take money out, they don’t pay me on certain size accounts, or they don’t pay me on the first X dollars of the account size, or production for the month, or they take money out and defer my money that I’ve generated and defer it into the future of no choice of my own, you have to factor that all in and say what actually goes in your pocket?

And then to compare that to, in the RIA space, what can you typically expect?

As I noted prior, it depends in part on how you run your local P&L. If you want a very fancy office, if you want a very large team, that’s going to be a different bottom line experience for you than someone that does it on a much more lean or lower cost setup.

But typically, most reasonably run – again, how you manage your P&L – and reasonably sized – there are some scale advantages, the larger you get – but reasonably run, reasonably sized, most RIAs experience a bottom line of 60 to 70% of top line revenue, before you pay yourself as the advisor.

The top line comes in, you have all these expenses that you must cover, what then flows to you as the producing advisor is typically in the 60 to 70% range. Compare that to what your bottom line is now, and in almost all circumstances you’re better off in the RIA model from an economic standpoint.

The final takeaway relates to how I never want to be accused of overselling something or overselling an idea or anything like that. The RIA space comes with more responsibility than you have now if you’re at a wirehouse firm, a W2 firm, whatever the case is. There’s more responsibility that comes with that.

Maintaining your own office, maintaining your own staff, doing your compliance. There’s a way to manage and solve for all those pieces. That’s a big part of my value proposition. Helping my advisor clients understand what are the variables you need to solve for and how to solve for them. It’s entirely doable, but make no mistake, it’s more responsibility than you have as a W2 advisor, if that’s where you are now.

The question for you then is does the much better flexibility and the much better economics justify you as the advisor taking on the additional responsibilities?

There’s no black and white answers. It’s very specific to every advisor scenario. The profile of your practice, the vision you have for it going forward, that all must be thought through to conclude whether it’s going to be best for you. I don’t sit here and say – I’ve never said this – every advisor should go into the RIA space.

But when it makes sense and you’ve taken the time to learn how it works, how your practice would look in it, how the flexibility is different, how the economics are different, it can be very advantageous.

That is what I help advisors with. What’s your current situation? What’s your possible future situation? Does it make sense? And if it does, how do you go about making a transition to the model?

Like I said at the top, my name is Brad Wales with Transition To RIA. I’m happy to walk through this exact conversation with you. What does your current practice look like, what would it look like in the RIA space? Whether you want to talk about the economics of what that would look like, the flexibility, or any of the other variables involved in a potential transition of your practice to the RIA model, I’m happy to have that conversation with you.

First things first, head to TransitionToRIA.com. You’ll find all the resources I make available, from this entire series is available in video format, podcast format. I have articles, I have whitepapers.

At the top of every page is a Contact link. Click on that, you can instantly and easily schedule time to have a one-on-one conversation with me, whether you want to talk about today’s topic, or anything else related to the RIA model, I’m happy to have that conversation with you.

Again, TransitionToRIA.com.

With that, I hope you found value in today’s episode, and I’ll see you on the next one.

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