Q55 – How Much Revenue Does A Broker-Dealer Generate From Their Advisors?

Also available as podcast (Episode #55)

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How Much Revenue Does A Broker-Dealer Generate From Their Advisors?

While financial advisor “payouts” are the most referenced source of revenue for a broker-dealer (i.e. the portion of the fees and commissions generated by the advisor that the broker-dealer retains for itself), there are a multitude of “non-compensable” revenue sources that broker-dealers benefit from as well.  It is important for advisors affiliated with broker-dealers to understand these various revenue sources.  Having this knowledge will give you perspective on whether you are getting your fair share of value from your current firm for the revenue you are generating for them, as well as will give you a foundational understanding so you can compare it to alternative affiliation models you have available to you (e.g. RIA model.)

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Full Transcript:

How much revenue does a broker-dealer generate from their advisors? That is today’s question on the Transition To RIA Question & Answer series. It is question #55.

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 to the RIA model.

If you’re not already there, head on over to TransitionToRIA.com where you’ll be able to find the show notes from this episode, as well as all the other resources I have to help advisors understand and explore the RIA model. Again, TransitionToRIA.com.

On today’s episode, we’re going to be talking about how a broker-dealer generates revenue from their advisors.

If you are currently at a broker-dealer, the question is, “How much revenue is my firm making from me?” I’m going to explain why I think this is important for you to understand. But it also begs the question, why is an RIA guy like me talking about how broker-dealers generate revenue?

One of the biggest factors of why advisors leave the broker-dealer world, leave the wirehouse world, leave the independent broker-dealer world, and move into the RIA model is for the economics of it. And so, it’s important to understand how those economics work.

That is something that I routinely help advisors with on a one-on-one basis. I’ve made other episodes on the topic as well, including how a custodian generates revenue.

On this episode we’re going to talk about how a broker-dealer generates revenue. So, for those of you that are at a broker-dealer you want to understand what your current situation is now. Part of that is what revenue do you generate? What do you earn? And then, and what does your firm make?

As you potentially consider and explore the RIA model, this will give you a better appreciation for what your base situation is right now.

First, a couple quick reasons why I think this is important for you as an advisor, if you’re in that broker-dealer environment, to understand these topics.

What prompted me to make this video now is it’s that time of year when the large broker-dealers are updating their annual compensation plans for advisors. Which is another conversation about the how silly it is that they do this on an annual basis, and they’re constantly tweaking it. I could rant and rave about that process on an entirely separate episode just by itself.

But the reality is that’s what’s occurring right now. Here’s the comp plan for next year and here’s what we’ve changed, things like that. You will want to appreciate – if you are one of the advisors in that situation – the objective behind the broker-dealer, when they are making those changes to comp plans.

I always say don’t blame the executives that are making those decisions behind the scenes. Your broker-dealer is a company. One of the main objectives of a company, particularly a publicly traded company, is to maximize profitability. So, those executives are tasks with finding ways to maximize profitability.

One of the main ways they do that with the advisor comp plans is to say, “How much can we squeeze and squeeze and squeeze the advisor on their comp, but fall just short of the point where we’ve squeezed them so hard that it forces them to leave or it encourages them to end up leaving and going in a different direction?”

Make no mistake, they want to get as close to that line as possible. And they don’t do it all at once. It’s the proverbial death by a thousand cuts, that’s in part why they change these things every year. Every year they shave off another little piece and they’re just pushing you and pushing you, and squeezing you and squeezing you and hoping you don’t leave.

Part of understanding that is knowing the many different ways a broker-dealer makes money from you. That’s what we’re going to be talking about here.

I always encourage advisors to think of their payout differently than you most likely do by default. Imagine you’re a $1 million-producing advisor. And for that, we’re just going to use some simple numbers here, your payout at a large firm might be 40%. And so, you think, “I retain $400,000.”

I always encourage advisors, and I encourage you now, look at that differently. Don’t think of it as, “My portion is 40%.” Think of it as, “The firm is retaining 60%.” Put differently, “As the advisor, I’m generating $1 million in fees and commissions every year and I’m paying the broker-dealer,” again, if it was 60%, the inverse, “$600,000 a year for all the services they provide me in return.”

And to be fair, they do provide services. They might give you an office. They might give you staff, technology, things like that. They’re providing value. But part of the exercise when advisors are exploring the RIA model is to ask, “Am I getting enough value for the dollar amount I’m paying?”

And so, what I want you to be thinking about is that inverse. If you are that $1 million advisor getting a 40% payout, you are paying $600,000 to the firm. But don’t think that’s the only way they’re making revenue off you. It’s not just $600,000. That’s what we’re going to dive into on this episode. These firms do make quite a bit more off of you than just that.

And again, to be fair, they have expenses that they need to cover on their own. They are a for-profit business. They deserve to be able to make a profit margin and all those sorts of things. The question is, are you getting your fair value from all that?

Then the final point of why we’re doing this episode now is – this impacts custodians as well, which I covered in a separate episode – one of the big ways broker-dealer’s generate revenue is on interest rates spreads on cash deposits.  We are arguably on the verge of interest rates rising for the first time since the pandemic began, and will most likely continue to rise for years to follow.

The revenue broker-dealers generate from such interest rates is about to explode in a big way. Now, to be fair, the interest rates have to go up quite a bit just to get broker-dealers back to where they were a couple years ago. But make no mistake, the revenue they’re generating from interest rates now, it will arguably be much higher in the next couple of years – if and when interest rates do go up as the market seems to anticipate will happen.

As we now dive into the list of how broker-dealers generate revenue from their advisors, one of the variables to keep in mind – and I wrote an article on this, I’ll link to in the show notes – is a thing called compensable revenues. This is a term you may or may not have heard of before, but it’s certainly a term used inside broker-dealers. I worked at such a firm. I’ve sat through plenty of meetings where compensable revenues were being discussed.

What compensable revenues mean is of the revenues a broker-dealer generates, which part of that do they have to compensate the advisor on? Hence, compensable revenues. The inverse being non-compensable revenues.

An example of a compensable revenue is your fees and commissions, where you receive a payout of that.  Every dollar that comes in the broker-dealer is maybe going to pay you out 40 cents on the dollar – or whatever the case is. They are compensating you on that revenue.

There are then other revenue sources that they do not compensate you on. So there are incentives for firms to strategize…”How can we increase the non-compensable revenues we as a firm are generating, and how can we reduce the compensable revenues?”

One way to accomplish this is by squeezing you on your compensation plan, while also encouraging (or forcing) you to introduce banking products to your clients that you are not compensated on.

This is something to keep in mind as we go through this. I’ll try to remember to point out compensable versus non-compensable, but you would know anyways because you know what you’re getting paid on, or not.

The final takeaway on this relates to an example I observed early in my career. I was at a large independent broker-dealer firm and I remember they rolled out a new initiative – coincidentally, to then it roll-back a number of years later.

The idea was the firm would continue to pay a traditional (independent broker-dealer level) payout, but also pay an additional comp component as well.  It’s more complicated, but I’m going to use simple numbers here. They basically said, “We’re going to give our advisors a 90% payout” (at the highest production level). And then, depending on their production for the year, “We will also give them deferred comp on top of that.” I remember the highest level of deferred comp was 10%.

At that time I was early in my career, before I knew a lot of what we’re going to talk about on today’s episode, as I was left thinking, “If you’re paying out the advisor 90%, and then there’s a scenario where you might go and turn around and give them another 10%, 90 plus 10, obviously that’s 100%. That’s crazy. The firm’s not making any money!”

The reality is, as I came to eventually understand, they are making money from these non-compensable revenue sources that we’re going to dive into. Point being, don’t think of solely your payout as we go through this.

Going through the list, this is in no particular order except for maybe the first one, because that’s the most obvious one. And then after that, there’s no particular order. Not by size of revenue source or anything like that.

The first item on the list is payout, which everyone generally understands what that is. “Every dollar that comes in, I get (perhaps) 40 cents.” And again, I want you to think of it as the inverse. Think of the opposite, what you are paying. Regardless though, the firm does make money. Every dollar that you bring in, if they’re giving you 40% payout, they are retaining 60%.

To be fair, they are providing you value in return for that. They have to cover their own expenses and their costs, and they deserve to make a profit in there as well. The question is, would you rather share in more of that profit margin, via the RIA model? That’s why this comes up so often with folks exploring the model, or would you rather have the broker-dealer earning that full profit margin themselves?

Payout, the simplest example, that is a compensable revenue. The money comes in, they compensate you on it.  That is a major revenue source for a broker-dealer.

Next up, I alluded to this earlier, is how interest rates allow broker-dealers to generate a spread on the free cash in client accounts. Now, right now, because interest rates are so low, this is less of a revenue driver, but under more normal circumstances, it is very relevant.

In a typical scenario, your client’s cash is sweeping to some sort of interest earning vehicle. It’s typically an in-house bank for most larger broker-dealers. You typically don’t have a choice where it sweeps. There’s only one option. It’s usually to an affiliated bank of the broker-dealer.

When that cash sweeps over, your broker-dealer pays your clients interest on that cash. Right now, interest rates are low. But under normal circumstances, they’re going to have to pay a competitive rate. They take that cash and lend it back out at a significantly higher rate to borrowers. That’s Banking 101, there’s nothing wrong with that.

The broker-dealers have an incentive though to pay your clients as little as possible while still being competitive with the marketplace. They then make the spread from what they can loan it back out at. And it’s fair they are paid for this. They have risks in doing this. They have costs involved with loaning the money out. So, not a cakewalk, but that is very lucrative business for a broker-dealer.

Now you might think, “Well, I don’t really keep that much cash in my client’s accounts.” I’ve even heard some advisors say, “I don’t keep any cash.” The reality is, you always have some cash amount in accounts because there’s always dividends being paid, bond interest being paid, you have to have some cash to pull your fee from. So, there’s always some cash.

Some advisors can have even more in cash because they’re tactical investors, and they get defensive in the market and move positions into cash. But in aggregate, when you take you and perhaps 10,000 plus other advisors at your firm, and all of your clients, that is an enormous amount of cash that is sweeping. And again, they’re making that interest rate spread off of it.

There was a time, depending on the firm you were at, that you were perhaps paid on some degree of cash balances. Because of, among other things, Reg BI that for the most part has gone away. It certainly has gone away right now with interest rates how they are. But for the most part that’s non-compensable and is a very good revenue generator for a broker-dealer.

Next up is something you typically see in the independent broker-dealer model, but variations exist in the wirehouse models as well.

A typical conversation I have, especially with an advisor at an independent broker-dealer, is I ask what their payout is. They say, “I’m getting a high payout, I’m getting (for example) 90%.” Yet, almost 99% of the time when you start peeling back the onion the reality is that their payout in aggregate is actually something meaningfully less.

An example of how it can be meaningfully less is when there is also a “platform fee” or an “advisory fee” involved.  These are usually expressed in basis points. It might be the broker-dealer saying, “Advisor, you get a 90% payout, but we’re also charging your client a 25 basis point platform fee, of which for you advisor, is non-compensable, you don’t get any of that.”

The advisor might say, “Well, I charge my client 1% and I get 90% of that.” But if the client is being charged 1% for your services, and then in addition, another “platform” fee of 25 basis points on top of that, the client is really paying 125 basis points. They don’t care who is getting what behind the scenes. They just know they are paying 125 basis points.

You, the advisor, are only getting 90% of the 100 basis point part of the overall fee. So, you’re really getting 90 cents out of every 125 cents that comes in. When you do that math, that is definitely less than a 90% payout. Whereas in the RIA world, you could receive more of that spread yourself.

So, just know that platform fees is another, usually, non-compensable revenue source for broker-dealers.

Next item is lending. This is wonderful business for a broker-dealer.

What I mean by lending – and there are some other lending sources which I’m not referring to here, such as mortgages. Which you might be pressured into encouraging or forcing your clients to use in-house resources. And to be fair, maybe your firm has some great mortgage resources. I don’t want to disparage that.

What I’m referring to here though is things like margin loans and non-purpose loans. The latter sometimes is called securities-based lending. These are where your client has perhaps $1 million in their account. They want to borrow $100,000 to buy a boat, do a house remodel, maybe even reinvest it back into the market.

Margin and non-purpose loans is a wonderful revenue source for broker-dealers, and which has nothing to do with your fees and commissions. And typically, margin and non-purpose loans are non-compensable. Typically you would not receive any compensation as a result of putting your client into a margin loan or something along those lines.

It’s a wonderful revenue source, and generally fairly low-risk too for the broker-dealer. They protect themselves – as you know from taking your Series 7 – there’s only so much they can lend out even if they wanted to. And then sometimes they might even do less just to protect themselves further. So, generally, low-risk very lucrative business for a broker-dealer.

Next up is mutual funds, where you utilize such funds as part of your investment vehicles. The typical arrangement, and there’s nothing wrong with this as it’s a fairly widespread practice – it’s the same in the custodial world as well – the mutual funds typically have to pay the broker-dealer.

There’s different official and unofficial names for it…revenue share, pay-to-play, shelf-space payments to basically be available to the advisors of that broker-dealer. The broker-dealer says, “Mutual fund company, we will have a selling agreement with you. We will make your mutual funds available to our advisors. And for that, you have to pay us X basis points a year.”

And to be fair, the broker-dealers sometimes provide things like omnibus services. But make no mistake, it is a very good revenue source for the broker-dealers.

An example of where this can kind of go in the opposite direction is there are some, not many, mutual fund companies that refuse to pay any sort of revenue share back to a broker-dealer (or custodian). A typical example, usually the most thought of example is, Vanguard. Because their fees are so low, there’s not enough revenue in their expense ratio for them to share it with anyone. And regardless, they philosophically refuse to participate in revenue share or shelf space or anything like that back to a broker-dealer.

That’s why you often see a Vanguard fund – if there are transaction fees that you have to pay with a mutual fund purchase – significantly higher than other mutual funds.

Some firms have even gone so far as saying they won’t even allow their advisors to purchase Vanguard mutual funds. They spin it with some nonsense about, “We can only handle so many relationships and we want to provide the best mutual funds blah, blah, blah.”

No, the reality is it’s because Vanguard is not willing to pay revenue share back to them. One way you can force your advisors to more lucrative mutual funds for the broker-dealers is to simply not allow them to use Vanguard funds, regardless of the fact that maybe Vanguard funds are an excellent product for your clients.

So, just be aware, if you’re using mutual funds, it’s a good revenue source for broker-dealers. Generally non-compensable to the advisor.

Next up is payment for order-flow. Big topic this year in the news with the Robinhood app, as that’s their primary revenue source. Some broker-dealers charge it, some don’t. It’s not necessarily a massive revenue source for broker-dealers compared to some of these other sources of revenue, but it does exist for with some broker-dealers. It’s something to be aware of. And certainly, it’s non-compensable.

Next, transaction charges. I already alluded to this briefly. You don’t see this as often anymore with changes with Reg BI, and how some broker-dealers are instead introducing new platform fees that I talked about earlier.

But to the degree transaction charges still exist, and they do with some types of trades, that is a revenue source for broker-dealer. There was a time that those were kind of explained away by broker-dealers who would say, “That covers the cost of us transacting the trade, sending confirms to the client, things like that.” And that was, I think accurate at one point.

The reality is though the cost of facilitating a trade and the cost of sending an electronic confirmation – which is now how it’s generally done – is microscopic. And so, when transaction charges are involved, it is a revenue source for the broker-dealer.

With any of these, there’s nothing wrong by the way, with a broker-dealer generating revenue. I’m not suggesting it is wrong what they are doing. This is not to say they’re being shady. They deserve to generate revenue. They are a business. They have to generate revenue to reinvest into the company, to pay for all the support, all the value, all the resources. But the reality is, that revenue is coming in and you’re only getting paid on a portion of it.

And so, part of your calculus is to say, “Am I getting my fair portion, or maybe should I look at other options considering how much my firm is actually making off of me?” So that’s a quick sidebar in the middle of my list here, but I don’t want to make this sound like broker-dealers are horrible for generating revenue. There’s nothing wrong with that. They are a business, they should generate revenue, but it’s important you understand all of these variables.

For the last two quick items, there are things like investment banking that perhaps if you have a client that has a business for sale and you refer them to the investment banking group, while you might make some sort of referral fee – to a degree compensable – even if you got a referral fee, it’s dwarfed by the fee the investment bank itself could generate from that engagement. So, certainly, a great revenue source for broker-dealers as well.

The last item involves – which you’re well aware of – the random fees that are charged either to you or to your clients. Those could be annual IRA fees, those could be fees to send wires, that sort of thing. Those are always non-compensable to you. They are a revenue source for the broker-dealers.

You might think, “Okay, but those are pretty small fees.” But when you go across millions of accounts, that can add up to a not-insignificant amount of revenue for the broker-dealer.

I’m sure I’ve probably missed some, but those are the main ways a broker-dealer generates revenue from you and your clients.

The question you might ask is, “Brad, how much is the broker-dealer specifically making off me?”

Let’s go back to that example of an advisor producing $1 million in fees and commissions per year. We’re going to use simple math here. Let’s say that gives you a 40% payout. With the inverse, that means the firm is actually retaining $600,000 a year, so 60%. And so you say, “If on a payout level, the firm’s making 60%. When you factor all the rest of this in, what do they really make? Does it come to the equivalent of like 90% of my fees, maybe even 110% of my fees?”

As for how it could be over 100%, because of these non-compensable revenue sources, it could exceed in aggregate what was generated from fees and commissions alone.

And so, what is that number? The reality is it’s hard to calculate, I don’t have a confirmed answer. Most firms don’t have an answer. To explain why, consider two advisors each generating $1 million in production. One of the advisors, because of the products and services they use with their clients, could generate significantly more revenue for the firm than a seemingly identical $1 million advisor could.

Why is that? Imagine one of the advisors uses mostly mutual funds, which generates revenue share for the firm. And maybe they like to keep a good amount in cash, so the firm makes a good cash spread. They use account types that have involve an additional basis point platform fee. Those sorts of things.

And then the other advisor and their clients they don’t use any margin or any lending. They don’t use mutual funds. They don’t the advisory platforms. But still, they generate the million dollars in fees and commission. Point being, no two advisors are alike.

And so, it’s hard for a broker-dealer to even answer that question even if they were forced to – how much in aggregate are you making off these two advisors? You must attribute both the compensable, and non-compensable revenues. What is the answer?

I was on the finance team of a broker-dealer and then a custodian at one point in my career, and I would tell you it’s hard to run that math even if they wanted to. You have maybe the bank over here making their revenue with cash sweeps, and maybe they have a separate P&L that they run internally for the bank. Then a different department manages the mutual fund relationships, and they have a separate P&L. And so, the revenue share comes in there.

Trying to attribute that all back to a specific advisor is essentially impossible. In theory, I guess you could do it, but the resources needed to try to attribute it all back would well exceed the benefit from doing so.

But just know, if you are that $1 million advisor, you’re getting 40%, so they’re keeping 60%, they are indeed making well more than 60% off of you because of all these non-compensable revenues as well.

I’m not saying this in any sort of disparaging way for broker-dealers. It’s just important that if you’re going to start looking at what the RIA model might mean for you, it’s important to understand how broker-dealers generate revenue off you now. How does that impact your economics? What would that look like in the RIA space? I help advisors all day with understanding the differences and what the RIA space looks like.

This all is very timely right now, with broker-dealers rolling out updates to their comp plans. If you’re frustrated by the changes and how it’s being communicated – “We are investing in you and look how we’ve ticked your payout up a percent here or whatever.” And they’re trying to tell you how lucrative the payouts they pay you are, “We pay some of the highest payouts on the street. You should be thankful for that, our generosity.”

The reality is they are making a lot more money off of you and your clients than just that payout. Again, there’s nothing wrong with that, but don’t let them position it as them being generous, particularly with the constant squeezing going on. Make sure you’re not getting taken advantage of how things are being positioned to you.

This is a common thing that provokes advisors to say, “Let me learn more about the RIA model. Let me learn how the economics would be different for me.” At least have this baseline understanding though of how broker-dealers generate revenue for themselves.

With that, like I said, my name is Brad Wales with Transition To RIA. This is the exact sort of topic I help advisors with all day long. What is your current situation? How does that work. What would your practice look like in the RIA model?

Then to the degree it might be a good fit for you, what are the steps and options involved with transitioning to the RIA model? That’s a conversation I have every day with advisors. I would be happy to have that conversation with you as well.

If you’re not already there, head on over to TransitionToRIA.com, where you’ll find a lot of additional resources. I have all the episodes in this video series, or for those who prefer podcasts, you can digest them in that format as well. I also have whitepapers, all kinds of resources.

At the top of every page is a contact link. If you click on that, you can instantly and easily schedule time to have a direct one-on-one conversation with me to have this sort of conversation by saying, “Brad, here’s where I’m at now. Here’s my frustrations. I’ve heard certain things about the RIA model, but maybe I don’t know much about it, or I want to learn more about it. Help me understand everything I need to know, and whether I should even continue down the path of exploration. And then to the degree it does sound like a good fit for me, teach me what I need to know about my options and how to go about doing it.” I’m happy to have that conversation with you.

For now though, I hope you found value in today’s episode, and I’ll see you on the next one.

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