An Alternative to Traditional Succession Planning

A lack of succession process readiness, along with valuation issues, makes selling an independent advisory practice unfavorable for many advisers, says a new CLS Investments analysis.

For many financial professionals who own their own advisory practice, selling that practice in the wrong environment may not provide the financial means necessary to adequately fund their own retirement. In addition, selling may not be in the adviser’s best interest, the analysis suggests, depending on market factors or the current client lineup. And besides, selling off the business may not be what the adviser truly wants to do after spending years—likely decades—building a successful independent firm (see “Outlook Study Warns of Succession Challenges”).

According to recent market research conducted by CLS, of 117 advisers surveyed, 61% expect to need $1.5 million or more to be able to retire comfortably, with 42% expecting to need more than $2 million. However, when asked how prepared they are to reach their goals, only 11% said they have already achieved their savings goal, and a little more than 18% said their retirement savings goals are more than 75% funded. Forty-eight percent said that they were less than halfway there.

At the same time, according to research cited by CLS from Pershing Advisor Solutions and Moss Adams, only 28.7% of advisers have defined or implemented a succession plan. This is quickly becoming a pressing issue due to the fact that 43% of financial advisers are either approaching or at retirement age, per recent research from Cerulli Associates. In that study, Cerulli finds that the average age of financial advisers is about 51, with 43% of advisers being over the age of 55 and nearly one-third of all advisers falling into the 55 to 64 age range.

In the face of all these challenges, CLS researchers suggest advisers “owe it to themselves and their clients to take action now to position themselves with the most choices, flexibility and options for enjoying their later years, while still ensuring that their clients are well cared for.”

Despite a preponderance of “sell-your-practice” messaging being promoted by industry experts, roll-up firms, and consultants, CLS says there are many alternative approaches advisers can pursue—such as “reinventing” themselves and their practices in order to continue working with the clients they enjoy, while streamlining their operations and daily work requirements. The reinvention option can empower advisers, in their later years, to continue doing the things they enjoy, lessen their workload, and continue to generate income to fund their retirement years, CLS says.

Partnering with third-party asset managers and other long-time service providers will be critical in establishing a streamlined practice, CLS explains. As an adviser ages and approaches retirement, he should be mindful of what tools, resources, and service outsourcing is available from either new or current service providers. Such tools may not be needed today, CLS explains, and they may be more expensive to utilize—but they can be powerful in helping to cut down on workloads as an adviser looks to retire while maintaining firm ownership.

Advisers should consider whether they could outsource many or all of the day-to-day aspects of running a firm. They could even bring in junior advisers and additional staff to continue growing the firm, CLS suggest, so long as they’re willing to keep an eye on the business during retirement. Under this approach, advisers can slow down their involvement with the daily function of the firm over time, and thus, they may not need a traditional succession plan.

CLS suggests this approach may not just be another option for some advisers—it may be an outright requirement for meeting retirement income goals. According to CLS market research, over half of advisers (55%) are planning on the proceeds from the sale of their practice to fund at least half of their retirement needs. Thus, over half of owners in the independent advisory industry are banking on the idea that their practices will fetch anywhere from $750,000 to $1 million when they retire, CLS explains.

But due to industry valuation models, the vast majority of advisers’ businesses are often worth far less than what they expect. This leaves a large gap that advisers will need to fill when they retire. CLS points to the hypothetical example of an advisory practice that has $400,000 in annual revenues—a figure that is “slightly higher than the average veteran adviser,” CLS says. According to industry benchmarks, roughly 40% of revenue goes to adviser salaries and 40% of revenue goes to overhead, leaving a profitability, or “free cash flow” of 20% revenue for the typical advisory firm.

In this case, the practice is generating $80,000 in free cash flow (20% of $400,000), CLS explains. According to common industry valuation practices, cash flow multiples for smaller practices range from two to five times. Using an optimistic multiple of five, this business would be valued at $400,000. And while a $400,000 payday may seem substantial, due to the earn-out provisions that are standard industry practices, the amount received will be spread out over time, typically from three to five years.

Thus, after a typical 40% down payment of $160,000, the adviser would receive only $48,000 per year for the following five years, an annual income stream that pales in comparison to the $160,000 annual income the adviser would have received if they stayed in the practice and did not sell. This is then compounded by the fact that after the earn-out period, the adviser is left with no assets.

As an alternative to selling, advisers have the very real option of continuing in the business by putting in place a few business planning steps, CLS says. This enables the adviser to work with the clients they have strong relationships with, off-load operational tasks, work fewer hours, take more vacations, and generally slow down.

“In essence, it gives [advisers] the option of changing focus and taking on outside activities they enjoy, while still having a foot in the business,” CLS explains. In order to accomplish this, there are several options that offer a broad spectrum of choices, allowing advisers to reinvent their practice to suit their personal goals, objectives, and interests. For example, advisers can:

  • Slowly wind down the practice by limiting the addition of new clients and referring current clients to partners or successors.
  • Identify an adviser within their community and develop a buy-sell agreement to ensure business continuity in case of death or disability.
  • Partner with another advisory firm to merge operations and transition the bulk of clients, while keeping the core set of clients they have strong relationships with.
  • Continue in the practice and outsource the day-to-day operations by working with third-party money managers or a fully outsourced “turnkey” asset manager program (TAMP).
  • Bring in junior advisers and staff in order to transition operational and client duties, which will provide additional infrastructure to continue growing the firm. According to industry research firm FA Insight, firms that employ junior advisers report 44% greater income and 15% asset greater growth versus firms that do not.
  • Use any combination of the above.

A full copy of the CLS analysis is available for download here.