Commission Business Spikes

Over the past few years, some of our most basic assumptions about investing and the investment profession, ranging from modern portfolio theory to the repeal of Glass-Steagall have been shaken to the core. Now, the conventional thinking about fees versus commissions can be added to the list.

For at least a decade, wirehouses have been promoting the benefits of fee business, chipping away at the traditional commission-based compensation model embraced by old school stockbrokers who rely on transactions to earn their paychecks. Because the revenue stream generated by a transactional approach to the business is so unpredictable and fluctuates so wildly, brokerage firms have dedicated an enormous amount of time and energy encouraging their advisors to abandon their old commission/transaction approach and transition over to more of a consulting model (e.g. SMAs and mutual fund wrap accounts), typically charging 1% to 2% for every dollar they manage.

Encouraged by the promise that a fee approach would align the advisor’s objectives with the objectives of his or her clients, financial advisors have responded enthusiastically to the call for fee conversions. Data from the Securities Industry and Financial Markets Association (SIFMA) shows that compensation from fees has increased dramatically from 1999 through 2007, representing larger and larger portions of an advisor’s overall income. While compensation from fee business represented just 19% of all advisor compensation in 1999, it soared to reach more than 50% by 1998 (see exhibit 2-1) and spiked to a record-high 55.1% in June of 2008.
A sudden, tectonic shift

But when the stock market crashed in late 2008, everything changed. Fee-based compensation fell from 55.1% in the middle of the year to just 50.3% of all earnings by the end of 2008, slightly above the level reported at the end of 2007. And in 2009, for the first time in at least a decade, fees represented a smaller portion of registered rep income than they did the previous year, falling abruptly to 45.4%. If we assume that financial advisor compensation has remained relatively flat during the past several years, as reported by Registered Rep magazine in its 2010 compensation survey, then we can assume that advisors are conducting more and more transactional business to make up for declining fees.

As Exhibit 2-2 shows, research from FRC’s Advisor Insight series indicates that commission business for all different types of financial advisors (wirehouse, regional, RIA, etc.) has increased steadily, representing a weighted average of roughly 41% or 42% of assets in 2006, 2007, and 2008; then reaching 49% in 2009. This uptick was fueled by variable annuities, which have become especially attractive for their income guarantees. VAs represented 11% of advisor assets in 2006 and jumped to 15% in 2009. One exception to the rule was individual stocks and bonds, which bucked the upward trend in transaction business and fell from 17% in 2006 and 2007 to 15% in 2008 and 2009. Conversely, as shown in Exhibit 2-3, fee business is slipping. Fees represented 59% of financial advisor assets in 2006 and 2007, fell to 57% in 2008, and then dropped sharply to just 51% in 2009. Mutual funds dropped most dramatically, from 40% of advisor assets in 2006 to 33% in 2009. SMAs fell from 11% in 2008 to 8% in 2009.

Why the sudden shift from fees to commissions?
 Understandably, investors are turned off by the thought of paying a percentage of their assets to lose money. So, they may be acting on their own volition and driving this shift.
 In a depressed market, investors are attracted to benefits and features typically associated with some commission-based investment products, such as the lifetime income guarantees offered by VAs.
 Moving money onto the sidelines (money market funds) generates commissions, not fees. Notice the increase in “cash and equivalents” business from 5% to 8% of assets shown in Exhibit 2-2.
 Finally, financial professionals who have seen their asset-based paychecks evaporate over the past two years may view commission business as a way to buoy their compensation levels and recoup some of the losses in 2010. So, it is within the realm of possibility that financial advisors are steering clients more toward commissioned products. Of course, wirehouses now have safeguards in place that raise a red flag when a transaction-focused client is spending money on commissions and would be better off paying an asset-based fee.

SEC filings from wirehouses seem to reinforce our findings that commission business is up. Merrill Lynch Global Wealth Management reported “increased transactional activity” in 10Q, and Wells Fargo said revenues were up 10% versus 4Q09 on asset-based fees and “increased brokerage transaction activity.”

Implications for manufacturers

Clearly, several influences have converged to create an environment that makes commissioned products more attractive than asset-based fees for more investors and financial professionals. Although the effects of this shift will be felt most significantly by brokerage firms, mutual fund manufacturers should take careful note of the movement toward Variable Annuities and insurance products, and consider developing Sales Ideas or value-added marketing materials (possibly branded with the VA manufacturer’s logo) that help FAs better understand VAs, incorporate them into their business models, and clearly communicate their benefits to clients.

Finally, asset management professionals should remember that the pendulum of consumer and advisor tastes swings back and forth. Like the markets, preferences are cyclical. FRC believes this shift toward commissioned products is a temporary aberration on the trendline, since advisors continue to predict that fees will constitute larger and larger percentages of their books. So, while this shift has just started to take hold, the most savvy asset management firms should already be anticipating its abatement. When markets stabilize and the current frenzy over commissioned products subsides, investors will start moving back toward fee-based products such as SMAs and wraps.