A number of product providers have recently implied that initial commission for products with low charges will disappear and a number of announcements confirming this will be made in the coming months. The plan is to only pay commission where the product charges will justify it. Where they do not a fund-based commission model may be applied.
This is a positive move by the product providers that will, in the long term, benefit the industry. It should precipitate the long-overdue realisation that historic levels of initial commission are unsustainable.
The supply chain’s restructure is being fuelled by legislation, technology and consumer needs. Life and pensions providers are no longer in competition with themselves, but also fund management groups, platform providers and banks.
For this reason product providers are finding it increasingly difficult to maintain and grow profits and are now placing greater emphasis on profitable and efficient business relationships. As far as shareholders and policyholders are concerned they have a duty to do so.
Positive measures to encourage firms to move towards a trail-based commission model will ultimately benefit not only these individuals or organisations but also IFAs and their clients.
A trail-based model benefits an advisory firm and its clients in a number of ways. Trail-based commission allows for a mutually beneficial commercial relationship between the client and IFA. If the trail commission is also fund-based then when the fund is performing well the IFA will receive more commission. If the performance of the fund goes down then the client will pay less commission.
It can also create a business culture in which the focus is on close, long-term client relationships underpinned by a commitment to service. To encourage the right behaviour within the firm, remuneration should be structured to encourage advisers to service their clients and engage in long-term dialogue and communication.
This will also remove the constant pressure to sell more products whether they are right for the client or not. Instead, the firm should focus its energy on the internal mechanisms that can help it generate more profit, such as assessing the efficiency of the providers it is dealing with and productivity and profitability of individual advisers.
But there is another benefit which could provide the greatest financial reward. An advisory firm operating with a trail-based commission model possibly mixed with fees will create long-term value in the business and make it more attractive to a potential investor or acquirer. The reason for this is as follows.
When a business is valued both quantitative and qualitative factors are assessed. These can include historical profits, assets, cashflow, liabilities and income and cashflow projections. Different methods can be applied but the one that normally produces the highest valuation is discounted cashflow. This is where an analyst capitalises an anticipated income stream or cashflow in the future and is achieved by discounting a company’s future income or cashflow at an assumed opportunity cost of capital. This is called bringing future anticipated income to present value.
IFAs that derive a high percentage of income from trail commission are in a better position to anticipate future income and cashflow. For this reason any buyer will have a much higher degree of confidence in the future of the business and will subsequently apply a much higher multiple to its value.
For example, an IFA whose income is largely derived from initial commission may only have a multiple of 2 to 4 points applied, but one that operates a trail or trail/fee model will find that the multiple be somewhere between 10 and 20 points.
By moving to a trail-based model the IFA will also be in a better position to raise capital against forecast earnings to invest in or expand the business. It will also create a more solid financial platform from which to focus more on the delivery of a long-term financial advisory service to clients and consequently increase product-per-client ratios that will feed directly back through to improvements in the cost-to-income ratio.
The challenge is funding change. The move to wraps and fund-based commission models will make this easier, but capital investment may also be required to make the transition, which could take up to three years.
Financial advisory firms are fortunate in that regular long-term client contact is necessary. Other industries don’t have this advantage but continually strive to achieve it. Advisory firms must take advantage of this and create long-term value for not only them but their employees, clients and ultimately the IFA sector.
Innes Miller is a director of Cydonia