"There's no free lunch" is a proverb that has stood the test of time. In a capitalistic system, market inefficiencies are quickly arbitraged out of existence and anything of value ultimately costs its end users something. Even the chips at Mexican restaurants eventually stop coming without an order from the menu or the bar.

The marketing function in the financial advisory business, however, has long been a curious exception to this rule. Accountants, insurance agents and lawyers have referred potential clients to advisory firms for years. For free. No strings attached. These gifts have inflated the profitability of advisory firms and have fostered a false sense of entitlement-one that has made some advisors delusional when discussing the future cost of client acquisition.

This "silver spoon syndrome" has become particularly apparent as a result of recent changes in the Schwab Advisor Source Program. Specifically, for each client referred, advisors now will be required to rebate 15% of their ongoing revenue across the life of the relationship, regardless of source. Schwab will serve as custodian for the clients' assets, and shifting to another custodian will trigger an onerously large termination fee, all borne by the advisor. Hence, for all practical purposes, the client referred by Schwab will remain a Schwab client so long as it is a client of the advisor.

Many advisors have described this new structure as highway robbery and an attack on their sovereignty. Those who are not outraged by the referral fee are incensed by the termination fee. In reality, over the long term, 15% will likely turn out to be cheap compared with what referrals will ultimately cost. And the terms will likely be even more restrictive to protect the referring party's interest. What Schwab is doing is simply part of the normal rationalization of markets.

To be clear, we are not advocating doing business with anybody, including Schwab. Every advisory firm has to figure out what is in its best interest, and a wide variety of factors beyond just referral costs should be considered. However, free referrals from any source will soon be a thing of the past.

Waiting For The Call

Disdain for the new Advisor Source fee structure stems from the fact that, to date, advisors have paid next to nothing to acquire clients. The supply of potential semi-affluent clients grew so rapidly over the last decade that, despite a dramatic increase in the number of advisors, there were plenty of millionaires to go around. Advisors have not needed separate marketing staffs. Most do not advertise. And few spend large amounts of time recruiting clients. One prominent advisor has even described his marketing strategy as "watching the phone until it rings."

The ease of capturing new clients has lulled advisors into believing their true business is giving financial advice. But it isn't. Their true business is getting clients to pay for advice-much like a five-star hotel's true business is getting people to pay to stay there, rather than providing outstanding service. From an economic perspective, marketing is the true business of advisory firms-a business on which they currently spend little or nothing.

Marketing Is About To Get A Lot More Costly

The experience of other industries suggests that this is not sustainable. Distribution is a dominant factor in most businesses. The economics of industries such as consumer goods, publishing and even movies all are driven by the costs of distribution.

This is particularly so in financial services. In the insurance segment and variable annuities in particular, the cost of providing the life insurance embedded in the product is often trivial-two or three basis points by one calculation. However, the wrapper can cost up to 125 basis points per year. Why? The immense sales charges that must be paid to the agent. Nearly all of the cost of the product is in its distribution.

Similarly, in the money management business, although fees on mutual funds have dropped only slightly over the past decade, the economics of the industry have been changed completely by distribution costs. For example, selling product through wirehouses and regional dealers has become so expensive-the cost for shelf space combined with the marketing and service cost in selling to brokers-that some firms believe that they now lose money on a marginal net present-value basis every time they make a sale.

The advisory business will likely go through similar changes as it becomes more competitive, a change that is coming soon. Nearly all financial services firms, including accountants, wirehouses and insurance companies, are reinventing themselves as financial advisors. (A good example are the most recent Morgan Stanley ads-you would think the firm was a NAPFA member.) While they recognize that they may never be able to provide the same quality of independent advice, they also realize that their success will not necessarily be related to the quality of their service. As with business marketing, it's not what you do, it's what the client thinks that you do.

Demanding Fees Is Rational

The current client turnover of most advisory businesses is fairly low, usually less than 3% per year. (Compare that with the mutual fund industry, which averaged 18% redemptions per year from 1989 through 1998 and more than 30% per year over the last two years.) Hence, typical advisory clients will be clients for the next 15 to 20 years, and the present value of the future fees they will pay is very large. As competition for clients increases, providers of referrals rationally will demand a larger share of this potential revenue.

Some anecdotal examples of where this has already occurred involve advisory firms in two smaller markets-one on the East Coast and the other in Texas-and their local accounting firms. In both cases, the advisors had longstanding relationships with the accounting firms and even had referred numerous clients to these organizations. The advisory firms woke up one day to find that the cost of referrals from the accounting firms had jumped from nothing to 50% of revenue from the client relationships. Why? Several brokerages and other advisory firms had offered to pay for referrals, and the accounting firms were simply reflecting the highest bid.

Proprietary Marketing Forces

An alternative to paying for referrals will be creating a proprietary marketing force. But this option may prove to be impractical for many advisory firms.

Consider an advisory firm with $100 million under management. The firm has two principals and charges a blended fee of 80 basis points on assets, yielding annual revenues of $800,000. According to a recent study done by Moss Adams, a highly efficient fee-based advisor operates at 40% margins, resulting in this firm's principals each earning $160,000 annually.

Adding a dedicated marketing person dramatically changes these economics. While the cost varies depending on location and on a fully loaded (including travel, seminars, entertainment and benefits) basis, good marketers typically cost $150,000 to $175,000 annually. Incurring $150,000 in additional expense immediately reduces the principals' compensation by nearly 50%, to $85,000 annually. To return to its previous level of profitability, the firm needs to increase its asset base by nearly 20%.

Hiring a marketer, however, also offers no guarantee of growth. And typically it can take even successful marketers at least a year before they start landing large numbers of new clients. Given this reality of cost and risk, paying for third-party referrals as a key source of new clients may be the most practical alternative for many firms.


Regardless of its merits or weaknesses, we believe that Schwab's new structure for its referral program will be fairly typical of changes coming to the advisory business. New clients are worth a lot of money, and as the industry becomes more competitive, referral providers are going to want part of this value. And despite the hullabaloo over the changes to Advisor Source, Schwab has had no shortage of advisors interested in participating.

Mark Hurley is chairman and CEO of Undiscovered Managers, an investment company based in Dallas, Texas.