Price Waterfall and the Financial Advisor Business Model

In class this past week we looked at a McKinsey study describing the concept of a price waterfall.  This concept describes the net price that the company would sell a product for after all expenses were paid.  Furthermore, the concept also described the number of customers and the amount of their "pocket margin" or percentage of target price.  Since I am targeting the investment management business as a career after graduation, I thought about what this means to clients within this industry.  In my view, there are two sides to applying a price waterfall approach - one viewpoint from the product side that investors utilize to accomplish their retirement, savings, and investing needs.  The second is from the advisor side, as they try to serve their most profitable clients.

From the product side, advisers have many options when putting their clients in different investments.  Take an investor that has $10,000 to invest.  If an advisor uses a load fund with a 5.75% front end load the net balance an investor will have as their cost basis will be $9,425.  On top of this initial investment, the average mutual fund carries an annual 1.0% expense ratio that is imputed in the fund return.  If a typical fund returned 10% gross, 9% net the investment would have $10,273 left after one year or 2.73% return on a $10,000 investment.  A different way an advisor can set up his practice would be to use no load funds that have comparable returns as load funds, however no upfront sales charge and lower expense ratios.  These advisers charge 1% of net assets annually in order to earn their compensation.  If this same investor made a $10,000 investment, achieved a 10% return, no up front load charge, and the expense ratio was 0.20% then the net balance at the end of year 1 would be (10k*(1.1)*(.99)*(.998) = $10,868.  The net return for this investment would be 8.68%, substantially higher than for the previous example.  I think its important for clients to understand the fees that are involved when investing with a financial advisor.  If the fees are not described in detail up front, the cost to an investor can be substantial.

From the advisers perspective this pocket margin can be applied to their clients.  Assuming the advisor uses the fee based form of compensation like the second example above.  Using this method, the advisor will soon realize that his most profitable clients are the largest ones that provide the highest amount of fees.  One way of analyzing this total fee revenue stream would be to categorize the accounts in increments of $250,000 and show how much fees are generated from each category.  Because fee based financial advisers typically scale down their fees as the size of assets grow higher, advisers may find that the more lucrative clients are the ones with lower assets.  It would be an interesting study to analyze how much revenue is  generated from each "asset under management" category and divide that by the time spent on that client.  If an advisor doesn't spend a lot of time on small accounts but still generates 1% of fee revenue from them, they could end up being the most profitable accounts to collect.  In addition, analyzing this pattern in a bar graph form would provide further insight into which clients an advisor should aim to collect.