Here are some ways advisors can repair their profit margins.

It's no secret that global business profitability has undergone a wrenching adjustment across a broad range of industries in the last three years. This adjustment has not spared the financial advisor profession.

For American business at large, the development that has totally confounded and disturbed economists like Federal Reserve Board Chairman Alan Greenspan is how such a small decline in revenues could translate into such a big fall in profits. Like other small businesses, many financial advisory firms have experienced a dramatic change in the economics of their business.

The problem of financial advisors' profitability was the subject of a recent profitability guidebook prepared by Mark Tibergien of Moss Adams LLC for Fidelity Institutional Brokerage Group (FIBG). It shouldn't be a big surprise that the seeds of destruction, or at least wilting profits, were sown in the late '90s when the economy was growing at a rate that has proved impossible to sustain. Financial advisors who saw their top revenue lines levitate with the stock market bubble were, like other financial services firms, particularly vulnerable to the latest business disease, known as margin compression.

Yet while the bear market has spawned doubts about financial advisors' ability to run their practices, it has confirmed the viability and staying power of the services they offer. Contrast advisory practices to other segments of the financial services business like IPO underwriting, online trading and merger and acquisition activity. All of these business lines have suffered top-line declines of 50% or more over the last three years, while advisors' practices have suffered modest shortfalls.

Moreover, recent consumer research underscores the new level of respect accorded financial advisors and their services. A study conducted late last year by OppenheimerFunds revealed 84% of investors who use advisors believe that they are worth the cost. "Ten years ago there were all sorts of arguments about whether advisors could justify what they charge clients," notes Rob Denson, senior vice president at OppenheimerFunds. "Today, there isn't any argument. No one questions their value any more."

Financial advisors may be delivering value to clients, but they are finding it more and more difficult to create value for themselves. Advisors experienced 25% annual growth for much of the 1990s and, as the business took off, attracting assets was Job One, according to Jay Lanigan, executive vice president of FIBG's RIA services group, Like many other segments of the financial services business, making a transition to an era of slower growth has proved very challenging to advisors, he adds.

What this means is that advisors must rethink their business models in order to position themselves for growth in the next decade, Tibergien says. The most glaring problem at many advisory firms is their inability to control their gross margins, he explains. A firm's gross margin involves dividing all direct expenses (including its salaries, the owner's base compensation, and all commissions paid out) by its revenue. To determine a firm's operating margin, add all other overhead expenses to direct expenses and divide by revenue.

Tibergien identifies four factors that are causing financial advisors to experience gross margin erosion. The first is poor pricing. Many advisors have long underestimated the value of their services and continue to spend free time with prospects, viewing it as their marketing budget. Others are adding new services for existing clients and bundling them into the same old fee structure. Advisors need to focus more on making sure that expenses are attached to revenue streams. "Margin compression is caused by adding services for the same old fee," he explains.

This problem partially explains the second factor, poor productivity. "The staff often is not spending enough time serving the right clients," Tibergien says.

The third factor hamstringing advisors' gross margins is an inappropriate client mix. "I'm amazed at how many people accept the 80-20 rule as a natural condition of their business," Tibergien continues, referring to the tendency for many clients to rely on 20% of their clients for 80% of their business. "What it says is that a firm is content having 80% of their clients who are not within their sweet spot."

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