Skating in Boiling Water
Written by John Lefferts, CFP,CLU,ChFC
"I skate to where the puck is going, not where it is"
This often used quote seems to have new meaning to those of us in the retail financial services business as the unprecedented volatility and market declines have shaken what we know as "where the puck is" to wonder "where the puck is going." For years, it has been thought that the current retail financial services models whether they be wirehouse, insurance agency, banks or independents would have to inevitably change as a result of evolving economics and convergence. But there were never any major lasting events to force this to happen. Yes, 9/11 did shake America's psyche and the markets roiled afterwards for a while, but we rebounded shortly after. The depth and spread of this financial crisis is unlike anything we've seen in modern history, yet the retail financial services industry seems to be doing little to respond. It's like the crude, but true description of placing a frog in a boiling vat of water. (please don't try this at home). It's feels the heat and jumps right out. But if you place a frog in a vat of lukewarm water, it swims around like everything is okay. When the heat is turned up, it happily stays. Then, when the heat brings the water to a boil, it continues to stay and boils to death. Frankly, this example, as repulsive as it is, can be applied to the retail financial services industry models we have been operating under for the past several decades where there has been no material structural change. Yes, there has been a drift towards the independent advisory model, but there is no bona fide evidence that this is a panacea either. And the economics of this meltdown and eminent re-regulation of financial services have changed the game for everyone.
So, I pose the questions, will the retail financial services distribution models continue in their present forms while the environment around them is essentially boiling?... Are they adept enough to see that if they stay in their current structures, they will potentially die a slow and agonizing death?... Or will they figure out that now, unlike ever before, it is time and perhaps even a unique opportunity to make long overdue structural changes for future survival? Answering these questions are not as simple as saying, "just get out of the boiling water!" We know that the current environment is forcing a change, but then, what to? Where is the puck going? In this paper, I'll explore what I see evolving from my vantage point.
For the longest time, the careers of financial advisor and financial planner have been ranked as the leading professions to enter based upon a growing need for quality financial advice given the complexities of products and the economy. But more so, it is the "pig in a python" baby boomer demographic that is evolving and aging needing help like never before. In their early years, it was easy... Get a job, buy a house, save for college education and hopefully have enough left for retirement. So for this huge segment of the population, financial planning was relatively easy...just save money. The focus was on accumulation of assets which is how the mutual fund industry exploded over the past several decades. But now the kids are out of the home and educated, the house can no longer be viewed as the nest egg it once was and the 401(k), once joked to be a 201(k) is now more like the 101(k)...not very funny. Folks need advice more on how to protect what they have, how not to outlive their assets and if they're lucky enough to have anything left over, how to efficiently transfer it to the next generation. It's a sad irony that now and for the next decade, there has never been a greater need for quality financial advice and advisors at a time when the industry is least prepared to provide it.
The rules for retail financial services distribution models have been re-written as a result of the confluence of events ignited by the bursting of the real estate bubble and resulting fallout, the aging boomer demographic and an actual decline in the supply of advisors to meet the increasing need for advice. Add to that an expectation of widespread financial regulatory overhauls, a shrinking universe of players (Where's Bear, AIG, Lehman, etc?), tax law changes and the expectation of convergence/consolidation in financial services gaining momentum, it can be a "head hurter" to try to figure it all out. But in change there is always opportunity for those adroit at reading the tea leaves, or being able to "skate where the puck is going." And if the size of this economic crisis is any indicator, the opportunity has never been greater.
The Current State of Affairs
To decode this coming opportunity, it seems logical to me to lay out what we know so far. The best way I can break it down is identifying and sorting out the two key components of the business; supply (financial services providers) and demand (the financial services consumer). With their faith in the financial system rocked by Madoff, Stanford and their account statements at values less than over a decade ago, the average consumer is paralyzed with their financial matters. They're highly dissatisfied with where they are, but are confused and afraid about where else to go. And there really are few places to go. But time heals, and when the smoke begins to clear in the financial markets and with customer loyalty being at all time lows, you can bet there will be more money in motion than ever before. It will take some time, but it will happen. Every piece of research tells us that with the exception of a small segment of "do it your-selfers", most consumers don't have the time, desire or aptitude to shop for financial products. They simply want to look a competent, reputable and honest financial advisor in the eye to tell them what to do. And further, they don't want the inconvenience of having multiple financial services providers, multiple account statements and multiple tax reports. They want one place where they can confidently trust that it's all taken care of. And it's been estimated that at least 50% of the financial services clientele is up for grabs. Big change-big opportunity.
How about the supply to meet this coming demand? That is a great deal more complex. With the deregulation and modernization of what was formerly Glass-Steagall in the late 90's, it was thought that the walls between banks, insurance and investment companies would come down and a new model of a financial services supermarket would evolve. Citigroup was thought to be the model of the future with the banking entity coming together with Travelers Insurance and Smith Barney Investments. But the horizontal integration didn't ever materialize as planned since the cultures between each entity never blended together. The brokers remained transaction driven, the insurers process driven and the banks service driven. Today, the Citi model appears to be going down in flames. Despite the politicians trying to blame deregulation for the current economic crisis, it wasn't the removal of the outdated separation of banks, insurers and investment firms enabling this mess so much as it was the continued misaligned web of regulation that missed the oversight of complex leveraged financial products...products that Warren Buffet described as "financial weapons of mass destruction". How can an insurance company regulated by a state insurance department, issue complex investment products like Credit Default Swaps and get away with it? ...misaligned regulation. Between state insurance departments, state securities departments, FINRA, SEC, FDIC and virtually no regulation of the mortgage business, the rocket scientists of the financial services product development business found an opening that fell between the cracks of the outdated and over-politicized regulatory bodies. Repeal of Glass-Steagall changed the game for financial intermediaries to enter a modern era in financial services, but regulations remained unchanged and stuck in the past. It's unfortunate that we needed a crisis to realize it's time to align the business models with the proper regulations.
Let's take a closer look at where each silo'd model within retail financial services is currently positioned...
As the water continues to boil, the insurance companies will be forced to stick to their knitting and manufacture insurance products. For those with their own sales force, they will have to reach a decision on the sustainability of maintaining their owned distribution that makes its profits only if it sells the products it manufactures, something that flies in the face of today's market reality. If an insurer can find a way to make profit margins from non-proprietary lines of business, it has a shot at sustainability with its owned distribution. But the dynamics of the marketplace today appear to be dictating that insurance manufacturing needs to be separate and distinct from insurance distribution much like the commercial insurance brokerage distribution firms have done. Additionally, the high-low commission structure of the insurance business will undoubtedly come under scrutiny as regulations force disclosure of compensation. If the economics of the products force a flattening of the insurance product commission structure, it will have dramatic implications for the Insurance based B/D. Mutual insurance companies can temporarily hide under their dated "black box" structures but will be challenged to compete in a consolidating and converging marketplace lacking the currency of equity to participate once the games begin.
The wirehouses, having lost the consumer trust and throwing good money after bad by giving huge upfront signing bonuses to has-been brokers, will potentially fade away over time since they've stemmed the recruiting of new blood and the vets retire or leave after their deals are up. Top producers will no longer be willing to stay with the wires giving up compensation and payouts for the privilege of using a tarnished brand. Much like the proprietary insurance distribution models, the stockbroker who once peddled proprietary stocks from its parent company market-making investment banking arm no longer exists with the recent demise of investment banks as we know them. And with their compensation models publically exposed and the shift of power from Wall Street to main street, we may have just witnessed the end of an era. Greed, as it turns out, was not so good.
As prior mentioned, Independent B/D's have been steadily increasing in size over the past decade at the expense of the wirehouse and Insurance B/D models. But a shift occurred last year that hadn't happened before...more were leaving the Indy model than entering. It comes down to 3 things, or the 3 "C"'s. Compliance: Indy's have a need to increase their expenses to prepare for the coming increase in regulation, something that will place a strain on their already thin profit margins. Cost: With increased need for technology platforms and the general cost of doing business on the rise, Indy's lack the scale to spread these fixed expenses around. Camaraderie: Many advisors who left the larger firms with their traditions and culture find themselves lonely, particularly in this economic crisis. The increasing trend in teaming has placed a strain on the lone independent producer model. However, the greatest threat to the independent B/D model is the classification of their advisors as independent contractors. It is believed that the Obama administration favors a tightening of the classification of independent contractor towards employees. If this happens, it would be the death knell to the Indy's as the costs of maintaining employees would be too great to survive. Bills have already been submitted on this and it will be interesting to see how it plays out.
Then commercial retail banks, who have neither the depth of talent (paying for performance is counter to the culture) nor the know-how of insurance and investment products, have "missed the ball since the kick-off". They have had the greatest opportunity of all, but lack the leadership to execute on a fully integrated financial services strategy favoring a passive self-service strategy. Unlike famed bank robber Willie Sutton who figured out that banks are the place to go because "that's where all the money is", bankers haven't realized they're sitting on a financial services goldmine seemingly because they're unwilling to pay for the skill that knows how to get it. As the more exotic lines of business become regulated away, perhaps banks will wake up to their tremendous opportunity held within their existing clientele...stay tuned.
De-Reg to Re-Reg
Needless to say, re-regulation is coming, and it will serve as a primary driver in the evolution of the retail financial services industry... where the puck is going. The need for a super-regulator that oversees all financial intermediaries, including the mortgage business, has never been greater and all indications are that this will happen soon. And the angle for FINRA brokers to give up their licenses to enter the more thinly regulated financial advisory business,...the end to that strategy will be coming as well...thanks, Bernie!
The politicians and several regulators would love to go back to silo's as banks separate from insurance companies separate from investment companies turning the clock back to the era of Glass-Steagall. It's what they know, understand and frankly can point at to assign blame for the crisis. However, we cannot effectively undo what has already been done without creating more calamity in the markets. The best option is to have a single regulator that cuts across all financial intermediaries aligned in the modern era of a global economy. This would eliminate the inefficiencies, redundancies and holes in the current web of overlapping and misaligned regulations that let credit default swaps happen and Bernie Madoff exist. For those who are currently overregulated such as insurance companies with state insurance and multiple securities regulators to answer to in every state in which they do business, updated regulation will be welcome. But for those who have been flying under the radar, such as investment advisory firms, or hedge funds, you are now in the cross hairs of the feds and their coffers are being filled to launch warfare. This regulatory leveling of the playing field is something to pay attention to as we try to anticipate the future.
Suitability versus Fiduciary Responsibility
Once the regulators have financial products distributors "on the same page" the next question is, what page will that be? With what seems like a new Ponzi scheme uncovered each day, the government will be focused more than ever on protecting the consumer. And the consumer has no idea what regulations their advisor/planner/agent/broker/financial professional, etc are being held to. To the general public, they all look the same, but nothing could be further from the truth. There appears to be momentum in correcting this confusion with former FINRA head Mary Shapiro now leading the SEC. Her view that all financial product distributors should be held to the higher standard of fiduciary responsibility could drive towards uniform regulations for all providers. Just as the definition change of independent contractor to employee would be devastating to the Independent model, a move towards fiduciary standards could likewise impact the product driven distribution models that are economically built on selling "proprietary" products and services.
In addition to sweeping new regulations, another factor influencing the future of retail financial services are the economics of the current business models. With a cost of around $200,000 per trainee only to lose 80% of them after 4 years, it's no wonder most financial firms have dropped their recruiting of new blood for in favor of essentially buying veteran talent. Add to that the likelihood that the 20% who do survive will likely be recruited away for the "greener pasture" someday, and it doesn't take a brain surgeon to figure out that the model of grow your own is seriously fractured in its current form. I personally believe that under a new and updated model, a grow your own strategy can be successful, but changes in training, compensation and recognition are a pre-requisite. Additionally, eliminating new advisor recruiting in favor of experienced producers can be a suckers bet. Seldom do they meet the requirements that their "signing bonuses" were predicated upon and in the net, they simply roll existing customers from firm to firm rather than create new ones which creates a huge compliance liability. So, if the large national firms are flawed, one might surmise that the independent model would be the natural wave of the future. But with the coming increase in regulation, the increasing costs of doing business, their lack of scale combined with increasingly thin margins are the greatest challenges to the survival of the independent producer. And as prior mentioned, the classification of independent contractor to employee is looming out there over the head of the Indy's.
Will anyone survive?
So here we are. Trying to anticipate the inevitable re-regulation of the financial services business while lacking a current business model that appears to be economically sustainable. Where is future for retail financial services and who will be successful? When I ask myself that question, the raspy voice of my linebacker coach comes to mind as he yelled "shoot the gap!" In a environment where silo's no longer need to exist between banks, insurance and investment, combined with rationalized and broad regulatory oversight, cutting a new path down the middle, a space currently open for the taking, screams out to me as a potential solution. By evolving and improving on the poorly executed concept of CitiGroup, but integrating it into a single culture with scale, absent the product driven underpinnings of insurers or wirehouses, there is a light at the end of the tunnel. That is by taking the best aspects from independents, investment, insurance and banking models into a fully integrated, scalable organization. I think Citi had the concept right, but was simply too large and silo'd to pull it off. The chassis of this evolved model could have its roots in the wirehouse, bank, insurance or independent models. It will be the entity that can organize in anticipation of the coming regulatory, legal and tax law changes while meeting the greater share of a customers' needs that will have an opportunity to become the breakaway model for the future. Most leaders in the business I've spoken to generally acknowledge that change has been forced upon the industry and there is no turning back to an era gone past. With the forces of the economics and sweeping new regulation, now may be the opportune time.
It is still somewhat unclear as to how all the change will shakeout the retail financial services industry. New broad based regulations, new tax law, employee status changes, and the continuing erosion in the economics of the business will be key factors in shaping the future. While certain retail financial services models will die in the boiling water environment because they are either paralyzed and don't know what to do or simply choose not to make any changes because change is uncomfortable, there is an opportunity like never before for a new model to emerge in the direction of where the "puck is going". And whoever gets this right, will be the victor to the riches of the coming economic recovery and demographic evolution of the baby boom generation. It will take vision, leadership and the ability to execute on a plan to make it happen, something that at the moment is difficult to find in the financial services industry. It will be interesting to watch this evolve and witness who survives and thrives as the new realities of the marketplace create the opportunity for better, more evolved retail financial services models as we "skate to where the puck is going" and out of this boiling water market. e to make changes rather than have changes forced upon us.
If you have any comments on this article, please send them to John Lefferts at his e-mail address: firstname.lastname@example.org