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."

An inappropriate client mix often results in a poor product or service mix, causing distractions and inefficiencies, which is the fourth factor hurting many advisors. As an example, Tibergien cites the case of a firm whose largest client, a successful business owner, asks the firm to run his company's 401(k) plan and the advisor goes for the bait, not realizing that the 401(k) is labor- and service-intensive.

Fidelity's Lanigan, who worked with Tibergien on the report, has seen that problem arise on a number of occasions. "It's important to define your business strategy and then align the way you manage your practice against that strategy," he comments. "And manage your human capital in ways that support your business strategy."

Unfortunately, advisors aren't managing their operating margins much better than their gross margins, Tibergien adds. The three primary factors causing problems in this part of their income statement are mismanaging overhead, not generating enough volume to support their infrastructure and a lack of cost-control discipline.

Compounding these problems is the solution that many advisors have devised, blind cost-cutting. "Don't think you can simply cut your way to profitability," Tibergien says. "Many advisors are making the market their excuse. It's the declining staff productivity and poor client selection that is causing so much stress."

There is simply no substitute for shrewd management of a firm's human resources to which Lanigan alluded. "View people as assets on which you need a return, not as an expense," Tibergien says. "The more you are willing to invest in and develop people, the more you can see revenues per client, income per owner and revenue per staff employee all go up."

That means channeling a firm's personnel into areas where they are most productive and most passionate. "Look at their ability, motivation and interest," Tibergien counsels. "Many people have jobs they are qualified to do but they hate that kind of work."

Many advisors have a proclivity to add overhead, or service people, rather than professionals who can help develop their business. The reasons are two-fold. First, as small-business owners they understandably are concerned about how their level of service stacks up against larger, better-capitalized rivals. Second, most advisors are passionate about serving their clients and, since this is what they do best, tend to monopolize this function.

When the partners and staff learn to share clients, amazing things can happen to a firm's growth rate and bottom line. A decade ago, Sullivan Bruyette Speros & Blayney was a tiny Mclean, Va.-based firm with only a few million in assets. Today, it has about $800 million in assets and has surpassed firms that are larger or of similar size. The partners say the decision to share clients and let personnel focus on their areas of strength was the overriding factor behind their remarkable growth.

"If every client relationship has to go through you, you will die on the vine," Tibergien warns. "Sustainable profitability is a function of a sphere, or a span of control. Recognize that when you have a death grip on the business, you can destroy it."

Indeed, an advisor who is that much of a control freak might want to consider becoming a solo practitioner with just an administrative assistant. The problem is that many advisory practices occupy a no man's land, or as Tibergien puts it, they are either too large or too small.

Smaller advisors may not want to hear it, but larger firms have several built-in advantages. Once a firm reaches $1 million in revenues, it can create a net profit (which Tibergien says can be as much as 18% to 25% of total revenues) after the owner's fair-market compensation. While many owners will opt to pay themselves most of the net profits as a distribution, this line item can serve as a cushion in bad times and a source of capital to reinvest in new services during good times.

Larger organizations also enjoy much flexibility in managing their human capital and making the staff more productive. "Bigger firms can justify hiring people in both the business development and technical areas," Tibergien explains.