Independent broker-dealer business model is an endangered species

The current business model of many independent broker-dealers, which depends on selling high-commission products, such as variable annuities and nontraded real estate investment trusts, is an endangered species. That's the blunt assessment of Sanjiv Mirchandani, president of Fidelity Clearing and Custody. “If you think 10 to 15 years ahead, that traditional model of a broker-dealer and its dependence on commission-based products needs to change,” Mr. Mirchandani said in a recent interview. “Firms need to move their businesses more toward fees, and many have done that,” he said, pointing to two Fidelity clearing clients, Commonwealth Financial Network and Securities America Inc., that have embraced that approach. “The question for firms is, do they have the right level of scale to be successful?” As head of Fidelity's clearing business, Mr. Mirchandani enjoys a unique perspective on the fast-changing landscape of financial advice. He has hundreds of broker-dealer clients, and their problems become his. His success depends on his clients' success. The relationship between a clearing firm and a broker-dealer is close and intense. Mr. Mirchandani's gaze into the crystal ball is well worth heeding. As regular readers of InvestmentNews know, we have been chronicling the impact of the Labor Department's new regulation that will raise investment advice standards for retirement accounts. Industry executives have pointed to the specter of the DOL's fiduciary regulation hanging over the independent broker-dealer industry in 2015 as a key reason for the slowdown in business.

WORST YEAR SINCE CRASH

Indeed, as we reported last month, the IBD industry suffered its worst year since the credit crisis, with the top 25 firms collectively reporting $21.03 billion in revenue, an annual increase of just 3.2%, according to the latest InvestmentNews survey. By that measure, it was the weakest year for the industry since 2009, when the S&P 500 fell to a low of 683.4 before rebounding. The top 25 firms recorded a meager 2.6% year-over-year growth in revenue that year. Of all the negative contributing factors, the decline in commission revenue did the most damage. The top 25 firms reported $9.85 billion in commission revenue last year, compared with $10 billion in 2014, a drop of 1.6%. A stunning 33 of the top 50 firms reported some decline in commission revenue. So it's obvious that Mr. Mirchandani is on to something. Broker-dealers need to become acutely focused, get big or give up the ghost.

COSTS RISING

“The Department of Labor is a huge factor, but there are others,” Mr. Mirchandani noted. “Business is migrating to fee-based accounts — some firms made that change well and others have not. Those that have not, better get on with it. The cost of technology and recruiting reps is growing. Firms need to get specialized or, if not, get scale. “Profit margins of small broker-dealers are in trouble,” he said. “If a firm is doing $50 million or less [in annual revenue], the average margin is 5% or less now. It has dropped precipitously. But some firms could thrive if smaller firms get squeezed.” (Related: DOL fiduciary's impact on small broker-dealers) The independent broker-dealer industry will widely act as a fiduciary in the next decade, he said. “The broker-dealer model and the registered investment adviser [model] will converge. If firms don't manage that convergence, they will become a lifestyle business for their owners, go out of business or be acquired. “Customer-centric firms with organic growth will be the winners,” Mr. Mirchandani predicted, pointing to several key factors. With baby boomers retiring, Generation Xers are coming into their wealth-accumulating years, he said. How will firms and advisers handle that switch?

CHOPPED TO PIECES

Service will become unbundled, with the 1% standard fee to advisers being chopped into pieces. In one case, planners could get 50 basis points and investment managers the other 50. “Pricing faces downward pressure,” he said. Next, humans and machines — in other words robo-advisers — merge, bringing the trusted financial adviser and the digital world closer together, he said. Mr. Mirchandani makes a compelling argument about the future of the IBD industry. Broker-dealer executives and advisers would be wise to listen to his appraisal.