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How To Make Up For Lost Deferred Comp When Transitioning To The RIA Model?
A financial hurdle, which is in turn often a mental hurdle as well, from leaving a wirehouse or similar W2 type model, to go into the RIA model, is the potential of losing outstanding deferred comp you have accrued at your current firm. This arbitrary hurdle is the reason firms implement such programs to begin with, to make it harder for you to leave. There are though ways to mitigate the effects, where it is still worthwhile to make a transition, even if it means losing your existing deferred comp in the process.
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Full Transcript:
How to make up for lost deferred comp when transitioning to the RIA model? That is today’s question on the Transition To RIA question and answer series. It is episode #119.
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 also have articles, I have whitepapers. All kinds of things to help you better understand the model.
Again, TransitionToRIA.com.
Today’s episode is part rant, part solution discussion.
If you are at a wirehouse firm or any other sort of W-2 broker-dealer type firm, you usually must deal with deferred comp. Your firm is essentially taking income from you and deferring into the future.
The question is, if you take an RIA path with your practice, and likewise leave your firm, aren’t you going to lose that deferred comp? How can you manage that situation?
I’m going to discuss a couple items on deferred comp in general, and then some ways you can try to manage through the situation if you were to transition your practice to the RIA model.
I’ll start with a bit of a rant on deferred comp. This won’t apply to some of you. If you’re at, for example an independent broker-dealer firm, typically you don’t have deferred comp. But wirehouse, W2, regional type broker-dealer firms typically do.
Something that drives me crazy, and again this is a rant, is how executives at these firms, whether it’s a branch manager, or the head of the private client group, or the head of the whole firm, and they attempt to describe deferred comp as if it’s some sort of wonderful thing between the firm and the advisor.
They speak about how deferred comp creates “alignment” between us and our advisors. Or how deferred comp is somehow an “investment” in our advisors future. All this nonsense word salad garbage with how they attempt to spin deferred comp.
The reality is, deferred comp is compensation, income, you as the advisor have worked to earn in a particular year and they are arbitrarily, there’s no requirement that they do this, they are choosing to do this, they’re arbitrarily deferring some of that compensation into future years. Often way down the line, multiple years later before you receive the money.
The money you have earned this year, you might not receive for possibly five, six, seven years down the line. They are deferring it. And yet they are trying to spin this as if this is all in the name of alignment or, “rewarding” our advisors for their tenure and their loyalty.
No, you’ve earned it. They are deferring some of it into the future. We’ll get why they are doing this in a second, but that is absolutely what’s happening.
I would have a lot more respect for executives if they at least acknowledged what it is. At least say… “yes, we are taking some of this money out. We are not paying it to you for years later, and that’s to try to keep you at the firm.”
At least say it! We all know what it is. Don’t come up with these crap excuses or word salad corporate speak nonsense.
You can tell it really annoys me.
Sometimes you hear them talk about how they reward loyalty and longevity and tenure at the firm. When you truly reward someone, it’s fair to maybe have a vest period on that. Just like you might give an employee a stock award that usually has a vest period on it.
But with that, you wouldn’t necessarily do it every single year. I could understand if it’s, for example, on the 10-year anniversary an advisor has been with a firm, to reward them they are given a one-time additional – not a reduction from their income – bonus of $X. Here’s how that works if you would like to accept that bonus, it is tied up for a couple more years, or it has a vest period on it.
I can understand that, that is truly a reward, that is truly a bonus. But taking someone’s income they’re earning today and arbitrarily holding it and not giving it to them for multiple years is not “alignment” at all.
Executives, stop talking that way. Just say what it is. It’s a retention play and that’s why you’re doing it. But don’t come up with this nonsense.
Basically, the reason they’re doing this is to create what I call a never-ending treadmill, that you can’t get off. Typically the way these plans work is in a given year you earn income, they take part of that income and defer it, and in typical arrangement it might be with a cliff vest, say five years out.
It’s a cliff vest, so you’ve earned that income, but they are going to defer it, and you don’t get it for five years from now. And then next year, we’re going to take your income from next year, we’re going to take part of that, and we’re going to put that for five years out.
And all of a sudden you have these never-ending hurdles. As time goes by you’ll have tranches that reach their vest point and you’ll receive that money, but they’ll always be additional tranches just out of reach.
And the only way, typically with these plans, that you can fully receive all of the vested tranches – which reminder, is your income, the income you earned – is to stay at that firm until you retire and fully exit the business and usually sell your practice there at the firm.
It’s a retention play, I get it, that’s why they’re doing it. But again, they should just call it what it is. They’re creating these never-ending hurdles and so you can never leave without losing some of your money, unless you stay at the firm to retirement and then typically sell your practice at the firm. It’s absolutely a retention play. You can’t get off.
Now, one final thing I’ll rant about, because I realize this is not just a rant episode, I want to discuss solutions as well.
As I was compiling my notes for this episode, I was going to call this next topic “criminal.” Now, it’s not criminal in the true sense of the word, but in the spirit of it, I think it’s criminal.
It’s an interesting concept that they can take your money and defer it, and during that period of deferment, whether it’s five years, six years, seven years, whatever it is, before you can even receive money you’ve already earned, they can change policies at the firm that you have no say in.
Maybe they change, and this does happen, the payout that you will receive over those five years. Maybe the support level that you obtain over those years. Maybe they change the office to something you’re not as happy about.
There are potentially negative consequences you could have and you just have to ride them out (while waiting for your vest.) They could basically do whatever they want. Now, they are constrained because they don’t want to lose all their advisors so there is some kind of barrier mechanism there. But to get the income you’ve already earned, you have to play ball with whatever they want to do.
They could lower your payout and you still have to stick around just to get the money you’ve already earned because it’s been deferred.
I think you understand why I’m not a fan of deferred comp. I think it’s unfair to the advisors, and at a minimum firms should at least call it what it is. Be honest with your advisors. It’s a retention play. It is what it is. Be straightforward.
If you’re in that boat, I’m sure you’re frustrated by a deferred comp as well.
So the question is, what can you do about it if you want to move into the RIA model? What are your options to manage it, deal with it, hopefully long term be better off even if you lose it?
I have a couple tips to share.
First, you will lose it.
It doesn’t matter how unfair this arrangement is, everything I’ve just been ranting about. It is what it is. You’ve signed something, buried somewhere in an agreement or your annual attestation or something, and you are agreeing to their compensation plan. And that compensation plan involves this deferment of some of that compensation. For better or worse, you’ve agreed to it, almost assuredly in writing.
You can’t leave the firm, lose the deferred comp, and then say, it’s not fair, I want it back.
There are cases where advisors have sued over this, there’s a couple live examples right now, where some attorneys are trying to take some interesting angles on it. But they don’t seem to be getting too much traction on it, because again, fair or not, firms have put this in place, have disclosed it, have had you sign off on it.
Don’t think you can leave and somehow you’re going to be successful suing to get it back. I’m sure there’s been some crazy esoteric scenarios that have happened that have worked somehow for an advisor or a team, but that’s not the norm.
So, don’t put that in your toolbox as something that is realistically available to you to recoup the money. If you leave, you will lose it.
If you’re going to lose money, well, that’s painful. That’s losing your income. For some of you, that could be a substantial amount of money.
Part of the exercise as you explore the RIA model is there are a lot of variables to compare from whatever you have now to the RIA model. As I often talk about on these episodes, the economics, flexibility, all those sorts of things.
On the economic front, particularly if you’re at a W2 environment now, the economics are generally far better than what you have now at your firm. And so part of the exercise is to understand how those economics work.
I talk about that a lot in these episodes. I’m happy to talk one-on-one with you about it and how it looks for your situation. But the idea is you want to run that math and you want to say… “If I were to make a move to the RIA model, what would my future economics be and how does that compare to what I have now?”
You would want to do that regardless if you have deferred comp.
There’s usually a delta. Which for some of you, it could be a very meaningful delta of what you’re achieving at a wirehouse and what you could achieve in an RIA model.
You want to look at what is a realistic expectation of a transition, and realistically how much would my income go up, and then also over the balance of my career? You then take that increased income and ask…. “what is the break-even point?”
Using simple math. Let’s say you have $600,000 in deferred comp built up – and again, it’s this never-ending treadmill, you can’t get off of it – and you’re like “gosh, I will lose $600,000.”
Well, if in your new path – again, using simple numbers – let’s say you will make an extra $200,000 per year over what you get from your wirehouse model now. Yes, there are additional responsibilities to be aware of, but that is beyond the scope of this episode.
But the idea being, let’s say it’s $200,000. It will take three years to break even from the $600,000 you will lose (in deferred comp.) So based on these calculations, it’ll take three years to get back to level from where the new additional income will offset the deferred income lost.
And over the balance of your career, you will still be making that extra $200,000 and over time, in theory, it will continue to grow as your practice grows.
It’s no longer as good of an analogy because of where interest rates are, but this is like refinancing a mortgage.
Back in the day when interest rates were lower and you might refinance a mortgage, there are closing costs involved. You would do this same break-even calculation.
You’d say… “How much am I going to save in interest every year after I refinance this mortgage to a lower interest rate, what are my closing costs (to do the refinance) and then how long is it going to take me in annual saved interest to recoup that closing cost?”
If you’re going to sell your house within maybe one or two years, you might not reach that break-even point. But if you’re going to be in the house for five, 10, 15, 20 years, it’s worth digging a little hole for those two years, digging back out of that hole, and then you’re better off for the balance of your time in the house.
Same thing with while you’re at a firm. You might have to essentially dig a little hole, and then that new income digs you out of it. But unless you’re within that one, two, three years of retirement, and you still have five, 10, 15, 20 years in your career, it’s worth taking one step back to go two steps, three steps forward.
So, keep in mind the need to calculate your break-even point.
The next tip, and I want to say this lightly, because I don’t want to get hopes up, but if you were to join an RIA – I’ve done several episodes and why you might start an RIA versus join an RIA – there are some scenarios were joining an RIA that they’re could be some upfront transition assistance involved that they would pay you.
The reason I want to say it lightly is first, not all RIAs pay it. And second, the ones that do, we are talking much more modest figures than if you were to go to another wirehouse.
Now the reason for that is because the economics for you are so much better in the RIA model. The reason a wirehouse can give you this enormous check upfront is because they are going to take an enormous amount of your payout for 7, 8, 9, 10, 11 years going forward.
That’s not how it works in the RIA space. The economics simply don’t allow them to pay you a big amount upfront because they’re giving you better economics the whole time going forward.
But some do pay a modest amount. Again, I just want to acknowledge that it’s out there, but it’s not going to massively move the needle for you. But that could help contribute towards some of what you might be losing when you leave your current firm.
The next thing to keep in mind, not only do you want to think about the break-even point, not only do you want to think about your income annually going forward, but also at the end of your career you want to get the most value out of the practice that you’ve built for years, if not decades.
As I’ve talked about in other episodes, the enterprise value of a practice in the RIA model is almost always better than what you could get for your practice in the W2 wirehouse type world. Oftentimes, significantly better. Not only in the value that would be placed on your practice in the marketplace, but also and often overlooked, is how that money is taxed. It’s usually significantly more advantageous in the RIA model.
If you don’t get off the deferred comp treadmill because you don’t want to lose money – which again, you could potentially recoup in just a relatively short period of time – the reason they have deferred comp is to keep you there to the end of your career and they usually require that you go through their so-called “sunset plan” or their retirement plan for your practice.
Compare that to going to the RIA model. Maybe take a step back for one, two, three years, recoup that money, get higher income over the balance of your career, and then at the end – I don’t want to oversell it – but possibly get a meaningfully better valuation and after-tax funds in your pocket.
For some of you, retirement is a long ways off, and it’s painful to lose that $600,000 deferred comp today, but you might well more than make it up just on the enterprise valuation and taxation at the end of your career.
So again, play the long game. Don’t consider just income, but also the end valuation of your practice.
Next, be aware, unless you are selling your practice to an RIA, or going into an RIA model that is W2 – there’s generally not as many of those, or at least ones that don’t require that you sell your practice – but if you go into a more traditional 1099 model – that’s what most of my audience aspires to, they want to be a business owner, own their own practice – in those cases, deferred comp is not a thing. I don’t recall ever coming across an RIA that was a 1099 model that did any sort of this deferred comp nonsense.
If you sell your practice to a firm, and they want to incentivize you to stay around, who knows how they structure that. But as far as you retaining ownership and being in a more independent path, I don’t recall ever coming across one that has deferred comp. It’s likely there’s something out there that does that but just know that is not the norm. There is not another treadmill generally waiting for you on the RIA side.
The next tip, is to work to understand now what your deferred comp situation is.
Perhaps today you’re not ready to begin exploring an RIA path, but maybe you know you want to or need to at some point. And when that time comes, there’s going to be a lot of things you’re working through. And of course, this all needs to be done – this is just how the industry operates, it’s nothing shady – on the down low.
As you work through these steps, there’s going to be a lot of variables that you’re going to need to work through. If you can avoid it, you don’t want to be waiting till the eighth inning of that process to realize you don’t know what your deferred comp situation is.
Figure that out now, so there’s no concerns about your asking about it being a red flag that you might be exploring something else. Go figure it out and make sure you understand it. Make sure you know where to get that information. Make sure you know what your situation would be if you left three months from now, a year from now, two years from now, whatever your maybe rough target timeline is, how would that look, how would that play out?
Take the time now, particularly if you haven’t even begun exploring the RIA model, to figure all that out and get a head start on it.
Then the last tip is, a lot of this is just a mental exercise.
With a lot of advisors or teams I hear how they don’t want to “lose” their deferred comp. And I get where that’s frustrating because it’s, again, it’s your money. You earned it. For some of you, this is a substantial amount of money. To use my example from earlier, there’s nothing enjoyable about seemingly losing $600,000, particularly of your own money that you’ve already earned.
But you must mentally think long term. Do the math and say… “They don’t deserve to keep my $600,000, this sucks that I lose the $600,000, but if I’m going to be better off long term over the balance of my career, I can’t let that mental hurdle hold me back.”
It does for a lot of folks. There are a lot of advisors, a lot of advisor teams that – and this is again why the firms put these in place – that can’t overcome the mental part of it, even though the math says long-term it will map out. You will be better off, you will make that money up.
I don’t want to make a blanket statement, as every advisor, every team’s situation is unique, different. We must go through that one-on-one and look at what your situation would be.
But for most advisors, if you have enough time left in your career, the math is going to work out better for you. You need to put pencil to paper and confirm all that and figure that out.
But there are a lot of advisors and teams that either don’t even want to do that math because they know they still won’t be able to mentally get themselves off the treadmill. If that is the case, then stay on your treadmill.
But once you do the math and you realize how it might look, it becomes increasingly easier to get off the treadmill. But you still mentally must accept the fact you’re “losing” perhaps that amount of money. So try to overcome that mental hurdle.
The final takeaway, which circles back to the ranting I was doing at the top, is a geopolitical analogy. It considers how countries are governed, which you’ll see how this applies to what we’re talking about here.
All countries need to protect their borders. If you’re a sovereign country, you need to protect your border. It can’t just be free flowing.
There are two kinds of countries – this is not to mistake this with what is a hot political topic right now. But one set of countries in the world builds a wall to protect their people from outsiders trying to come in. This is the case with most countries.
There are also, though, countries that build walls to keep their citizens in the country. You typically see this with communist countries, where they have a fortified border that prevents their citizens from leaving.
Well, which country would you rather live in?
A country that believes in keeping the bad folks out and protecting their own people? Or the country that builds a wall to keep you from ever leaving?
I know it’s harsh analogy to compare wirehouse firms to communist countries, but why if wirehouse firms or W-2 firms or whoever’s doing this deferred comp stuff, if they are providing you as the advisor and your clients with such good value, and they are the best option for you and your clients, why do they have to put up a wall, in the form of deferred comp, to keep you from leaving?
Shouldn’t the value prop and the satisfaction they provide for their advisors be enough to keep you happy? Wouldn’t they provide a much better experience for you if that was their guiding light where they said… “We don’t need to build walls to arbitrarily do this. Let’s just do everything we can to keep our advisors happy and to reinvest in the platform and keep their clients happy”
Wouldn’t that be a more effective way to govern? It seems crazy, but that’s not how it’s at least entirely done. They are building these walls to keep you in. Think about that. Why does your firm have to arbitrarily build a wall to keep you in via deferred comp when there are solutions out there that don’t do that?
So just a little takeaway for you.
As I said at the top, my name is Brad Wales with Transition To RIA. This is the type of thing I help advisors with all day long is to look at what’s your current situation, how does the RIA model work, how does it look for your practice, what might a transition process look like, and then get into these details.
If you have deferred common, how would that work if you made a move. Working through those variables is part of this process. I’m happy to have that conversation with you as well.
As a starting point, 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.
And at the top of every page is a Contact link. Click on that and 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 RIA related. I’m happy to have that conversation with you.
Again, TransitionToRIA.com.
With that, I hope you found value on today’s episode, and I’ll see you on the next one.
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