Fees net more revenue

Large independent broker-dealers that rely heavily on revenue from commissions struggled in 2012 to match the performance of broker-dealers that generate the lion's share of their revenue from fees charged against clients' assets. Overall, 2012 was a weak year for the independent-broker-dealer channel. Collectively, the largest 25 firms managed to eke out only a 3.8% year-over-year increase in revenue, reporting $16.3 billion in sales, versus $15.7 billion in 2011, according to an InvestmentNews survey. That poor performance came after two years of strong revenue growth for the top 25: 16.9% in 2010 and 12.3% in 2011. Nine of the 25 largest independent B-Ds reported declining revenue in 2012, despite a rising stock market that saw a 16% gain in the S&P 500. In all, 2012 proved the securities industry maxim of the past five to 10 years: Revenue from charging fees on clients' assets is the sweetest type of revenue there is. It can insulate a firm from choppy and turbulent markets, as well as spooked investors, the argument goes. “The higher the percentage of broker-dealer commission revenue, the lower the growth rate,” said John Rooney, managing principal with Commonwealth Financial Network, which relies heavily on fee revenue and which posted 10.1% growth in total revenue last year. “Broker-dealers that are fee-based companies benefit from the rise in assets under management.”

VAs LESS PROFITABLE

What particularly hindered independent B-Ds that derive a greater amount of revenue from commissions was anemic sales of variable annuities, industry executives and analysts said. Insurance company underwriters have pulled or restructured high-commission VAs — making them less attractive to investors — because record-low interest rates have eroded their profitability. “Firms that relied more prominently on commission revenue saw a tough year for variable annuities sales,” Mr. Rooney said. “Carriers are pricing VAs more and more aggressively.” According to Morningstar Inc., net flows of new investor money into variable annuities reached a 10-year low in 2012, with only $14.7 billion in sales. That compares with $27.7 billion in 2011 and $21.6 billion in 2010. MetLife Inc.'s decision last year to reduce its overall sales of variable annuities had a ripple effect across the industry, said John McCarthy, product manager of annuity solutions for Morningstar. “Whenever a "big three' player makes such a decision, it impacts the overall industry,” he said. “Some smaller players picked up the slack, but not to the extent of the drop.” Broker-dealer executives have acknowledged the deterioration of firms' profit margins as a result of record-low interest rates, which have eradicated once-lucrative areas such as margin lending and the spreads on money market accounts. Interest rates have eroded variable annuities sales, Mr. McCarthy said. “It's been a long, slow, painful period of low interest rates,” he said. “I don't see a rebound of sales and [1035] exchanges” until rates rise, he said. The independent B-D industry's largest player, LPL Financial LLC, which saw total revenue growth of 7.3% last year, recently acknowledged the weakness of variable annuity sales. “The combination of low interest rates and market uncertainty impacted sales commissions for variable annuities due to its impact on product design, which lowered demand for these products,” the company noted in March in its annual report. “In addition, insurers have lowered the amount of risk they are willing to retain on variable annuity products by reducing certain insurance benefits, thereby making the products less attractive to investors.” Of the 25 largest independent broker-dealers, nine reported that 50% or more of their revenue comes from fees. All but one of those firms reported an increase in revenue when compared with a year earlier. Meanwhile, the 16 remaining firms that reported 50% or more of their revenue coming from commissions fared much more poorly than their fee-based brethren. Of those, eight reported a decline in revenue, ranging from a decrease of 0.3% to a decline of 5%.

LOOKING FOR THE EXIT

All of the firms reporting declining revenue are owned by large insurance carriers or brokers, many of which have been exiting the independent-broker-dealer business due to weakening product sales. The firms reporting declining revenue are Lincoln Financial Network, MetLife Securities Inc., Royal Alliance Associates Inc., NFP Advisor Services Group, MML Investors Services LLC, FSC Securities Corp., New England Securities Inc. and Woodbury Financial Services. One insurance-company-owned broker-dealer, Axa Advisors LLC, bucked the trend. A high percentage of its revenue, $508.6 million, or 81.4%, comes from sales commissions. Unlike other broker-dealers with such a high level of revenue from commissions, Axa increased its total revenue by 9.1%. The firm recently introduced a new type of variable annuity, which features a structured product linked to an equity or commodities index. Its popularity offset tepid sales of standard variable annuities, said Frank Massa, president and chief operating officer.

INVESTORS WARY

Declining variable annuity sales aren't the only problem facing independent B-Ds. Retail investors remained wary of the broad market, executives said. “Overall trading activity, with retail investors moving out of risk, was very subdued,” said Robert Moore, president of LPL Financial. “That's why revenue levels didn't track to S&P 500 levels. Remember, low interest rates create margin and earnings pressure. Coupled with higher operating expenses, that creates a challenging operating environment.” Brokerage executives are philosophical about the past year. “2012 was a tough year, but after "08 and "09, if you eked out an increase [in revenue], people weren't feeling great, but they weren't feeling bad,” said Scott Curtis, president of Raymond James Financial Services Inc. Raymond James' revenue increased 4% last year.