The DOL rule kicks in. Will independent broker-dealers survive?

A year ago I wrote about the impacts of the Department of Labor’s fiduciary standard being applied to our industry and the immense implications. Now we have two important news events with ripple effects that impact every financial adviser in the U.S.
On Oct. 6, Merrill Lynch announced they would no longer allow retirement investors to pay a commission for trades when the rule becomes effective next April. A few days later, InvestmentNews reported that LPL, the nation’s largest independent broker-dealer, was seeking “strategic alternatives.” These two events are not coincidentally so close together. They reflect the harsh economic realities that differentiate full-service broker-dealers and the independent broker-dealers that have been thriving for the past few decades.
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MUSCLE OF THE THUNDERING HERD
I haven’t been a huge fan of how big banks operate. However, Merrill Lynch, a subsidiary of Bank of America, and the other full-service brokerage firms have four advantages that very few of the independent brokerage firms possess:
1. A more profitable and adaptable payout model. Advisers at the full-service firms often complain about how their payouts can change and production targets can be adjusted. However, that flexibility allows their firms to weather transitions in a rapidly evolving landscape. LPL and their ilk, with their 90% payouts and independent contractors, simply cannot pivot rapidly enough. If advisers’ revenue drops because of the loss of commissions, one firm can change payout structure, the other takes a direct hit to their bottom line.
2. Less dependency on sponsorship fees. Both full-service and independent firms rely on sponsorship fees from the product providers like mutual funds, investment firms and insurance companies, but their implementation is different. The independent broker-dealers receive direct fees from vendors and that provides a large portion of the cash flow needed to operate. The full-service firms receive payments, but they also use their size to drive down what their providers charge, and then mark-up that cost as a platform fee. When sponsors are no longer willing to pay as much in sponsorship fees, it is a direct hit to the profitability and the sustainability of the independent broker-dealer model. It is a much less impactful to the full-service firm.
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3. More diversified revenue streams. All of the large full-service firms are now aligned with a bank and that means they can work with the client’s liabilities and their assets. A client might no longer pay commissions, but they could have a loan, a credit card and a mortgage provided by their adviser. That diversified revenue stream makes the full-service firm less reliant on commissions. If the independent broker-dealer has half of their revenues tied to commissions and half of their assets in retirement accounts, they might lose as much as 25% of their revenues. Thanks to razor thin margins, their profitability can disappear overnight — not including the impact from the decline in sponsor fees.
4. Stronger balance sheets and better profit margins. After the crisis, most of the banks have incredibly stout balance sheets and better margins that allow them to withstand a temporary drop in profitability. They can also invest billions in their platforms and systems to become more competitive in the future. More importantly, when the slew of legal challenges begin in earnest in the spring of 2017, Merrill will have mitigated their risk immensely by making their proactive move, and they have the balance sheet to withstand the legal quagmire that follows. You can’t be as optimistic about the independent firms that are dragging their feet on implementation. The less they do now, the higher the future litigation risk becomes. How many of the independent firms can withstand the onslaught?
A YEAR FROM NOW
I suspect a year from now Merrill, and the other full-service firms that follow their lead, will have shed a large portion of their existing advisers due to changing economics. Perhaps as many as 15% of their advisers will no longer be sustainable in the new world. However, these firms will still be immensely profitable and relatively protected from future legal recourse because of their advance action. The viability of many of the independent broker-dealers is less certain, especially if their larger advisers decide to become RIAs and go directly to a custodian.
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When the United Kingdom implemented similar legislation a few years ago, about 40% of advisers simply left the business; so too did the firms that serviced them. It might not be quite as extreme in the U.S., but our world is going to change abruptly. The future will belong to the full-service brokerage firms, the few independent broker-dealers that can successfully pivot and the RIAs that already live under the fiduciary standard.
Joe Duran is chief executive of United Capital. Follow him @DuranMoney.