The 1990s were a glorious time to be an advisor. Little or no direct competition, overwhelming demand for advice and a roaring bull market all combined to make success in this industry relatively easy.

So easy that most advisors have never bothered themselves with many of the more mundane management activities that other businesses must follow to survive. Detailed time sheets. Constant pressure to increase revenue. Cost control. In other services industries-such as accounting and legal-these measures are essential tools for ensuring long-term viability.

A big reason why advisory firms have not really had to act like other businesses is that, during the 1990s, they had a hidden subsidy that obscured inefficient operating structures and management practices. The advisory business grew up during the best possible economic environment, a bubble market that protected advisors not only from competition, but also from themselves.

Now that markets have returned to sanity, inefficiencies are coming to the fore. The market downturn is the latest catalyst for change among financial advisors. And it will only hasten the impact that competition and technological advancements have on the industry's future shape and structure.

Blissful Beginning

The math behind the myth of invincibility among many advisors is simple. Consider a typical portfolio - 80% equities and 20% bonds. During the 1990s, the S&P 500 Index returned more than 18% on an average annual basis, and the Lehman Corporate Bond Index returned slightly less than 8%. Clients with portfolios heavily weighted in equities thus had returns between 14% and 16% per year before fees.

Since advisory firms generally charged a percentage of assets for their services, their revenues likewise grew 12% to 14% per year. With revenues almost automatically expanding at such high rates with no client growth, advisors did not need to worry about controlling costs and operating efficiently. Costs expanded by 8% to 9% annually, and net income still rose.

The bubble market and its impact on company revenues also lessened the importance of attracting new clients. In the words of one advisor: "The market became our most important client."

As a result, advisors were able to spend disproportionate amounts of time on activities that didn't generate revenue. Many spent more time attending conferences than growing their businesses. Others were content to work less, increase their leisure time and improve the quality of their lives.

Cost accounting was almost nonexistent. Few advisors understood the profitability of individual clients. They priced their services without any consideration to the cost or time involved. They had no incentive to conduct capacity utilization analyses on their business.

A New, Harsher Environment

But the incentive exists now. If equity returns over the next five years are about equal to their 1960 to 1990 average of 7% annually-and many economists and money managers are predicting returns far lower than that-advisors will need to run their businesses much better if they want to remain profitable.

Consider the following math. If equities return 6% before fees and taxes and bonds return 3%, and advisors and their money managers charge an average total fee of 1.5%, portfolio returns will average only about 4% annually, net of all fees. If expenses continue to rise at about 9% annually-as they have done in many firms over the last decade-advisory firms will either need to start attracting a lot more clients or run the risk of seeing their margins decline by more than 5% every year.

While at first glance 5% may not seem very large, it is when you consider that most advisory firms are not extremely profitable. According to the latest Moss Adams/FPA study on the advisory industry, an owner of a typical fee-based advisory firm earns approximately $278,000 in total compensation. As margins compress 5% per year, owner compensation will decline by 16% per year ($44,000 in the first year). In about three years, the owner's compensation will be cut in half.

An obvious alternative to this scenario is to increase the number of clients advised by the firm. However, many advisory firms believe that they already are operating at near-capacity. Unless they can get a lot more efficient in running their businesses, they will be unable to grow and still retain their existing clients.

And as bad as these numbers may appear, they do not include the potential effect of other factors that are looming over the horizon. Increased competition for clients and employees, the need to do more for existing clients and potentially reduced fees will create a much harsher economic environment for advisory firms, regardless of the returns of the equity markets.

Large Firms Are Not

Immune To These Problems

A large advisory firm that we recently studied as part of our research is fairly typical of what we have found in the industry. Although it manages more than $400 million of client assets and recently revamped its structure to be more efficient, it had no cost-accounting systems. Consequently, it had neither any idea of how much it made on any one client, nor the marginal cost of servicing that client's account. And while all of its key professionals believed that they were fully occupied and were working at 85% to 90% capacity, it had no means of measuring productivity other than gross revenues.

A comprehensive cost-accounting analysis generated several startling findings. First, the firm lost money on a marginal cost basis on more than 85% of its clients. Second, its key professionals were working only at about 17% of capacity, assuming a goal of working on client-related issues for only 25 hours per week. Third, and most important, the firm's compensation structure rewarded employees for attracting unprofitable clients.

How could this happen? Like most advisory firms, this organization did not track its employees' use of time, did not tailor its pricing of services to different sized clients to reflect the cost of advising them and relied on a compensation system tied primarily to the total gross revenue generated by each professional.

Because the firm did not have a detailed cost-accounting system and structure, it made money only by no fault of its own. It largely operated by inertia, and it created an incentive structure that reduced profitability over time.

As surprising as these findings might be, we have heard similar results from several large organizations that have implemented cost-accounting mechanisms over the last few years. Each told us that they were astounded by what they learned and have rethought how they run their businesses. They now track the time of each employee; have created income statements for each unit within their organization; and have changed their pricing and compensation structures.

A Brave New World

Clearly, the advisory business only now is awakening from a peaceful sleep induced by the 1990s' tremendous equity returns. The best-managed firms have recognized, however, that they are now operating in a fundamentally different environment and need to change. Like all other businesses, operating efficiency, cost accounting and capacity utilization have become key tools they are using to better run their businesses. Other advisory firms would be wise to follow their example, or their viability-and not just their profitability-may be at risk.

Mark Hurley is chairman and CEO of Undiscovered Managers LLC. Tom Fuller is director of research.