Those of us that have been independent for a while sort of instinctively know there's a nice economic advantage to being independent. However, if you're not there yet, I want to go through each category that you need to have a sense of, both in your current situation and in an independent model, and how to account for each one. You can then do a hypothetical profit and loss statement. How would it look if you had your own practice? It is hard to nail down the numbers (especially on the "what if you go independent?" side), but you can certainly get a pretty good estimate of what the numbers look like, and that will help you decide if it's worthwhile to you. I will touch on some of the reasons or situations where it might not make sense to go independent.
First, on the EMPLOYEE side, at your current firm, there's about six or seven things I would consider and would want to add up to look at my total compensation. Again, the goal here is to get an estimate of what my net payout is - after all things are considered; everything I get from my employee firm. What is my net compensation as a percentage of my gross revenue that I generate for the firm? Let’s go over four areas to consider:
The first is the most obvious, that's just your grid payout. You know, for a lot of us that was (or is) 40% or so. It may be a little lower in the bank channel, or for newer, or smaller producers, and can certainly get a lot higher. It could be higher if you have a fairly large business, or if you've been somewhere a long time, or work for certain regional firms that might be a little more generous on the straight payout. What is your cash compensation every paycheck? 40% is sort of a good middle of the road estimate for average across the board. So what is that number?
The next consideration would be any deferred compensation that you're getting. Whether that's in the form of profit-sharing or just a straight deferred comp. That's going to be a percentage of your production. Typically single digits, somewhere between 3% and 8% is common from what I've seen. I was in a wirehouse for four years, and we had that compensation structure at Edward Jones when I was there, and I believe that's still the case. There's a profit sharing element.
Basically, it's some sort of compensation that is not cash today. It's deferred either as qualified money, like a profit-sharing plan, or as a nonqualified deferred comp. that might have a vesting schedule. So, I'm not going to get into the details of how to account for vesting, because when I do these analyses, I like to be sort of conservative, and not try to tilt the numbers to my vantage point, which is “independence is good.” So, deferred compensation (if you stay a long time) can be very valuable. Not just because of the amount you get, but obviously the deferral of taxes does have some value. However, it does restrict flexibility. So that's an interesting dilemma on how to account for it.
The next things I would consider are any retirement benefits. The two main ones being if you have a traditional pension or a 401(k) match on your contributions. 401(k) match is pretty straightforward. If you're getting any kind of match on your 401(k) contributions, I would count the match as a form of a payout because that's money that you're getting added into the bottom line that I would consider in the calculation of my net payout. So, if I'm putting in $10,000 a year, my firm is matching $10,000, and I'm doing $250,000 in production, that $10,000 might as well be another 4% payout because it's adding to my personal net worth. Again, it's deferred so you don't have the flexibility of cash, but you also have the benefit of tax deferral.
Parallel to that would be if you have a traditional pension. Not quite as straightforward to calculate, but the mechanism I used (for myself) when Morgan Stanley did have a traditional pension that I believe I would have qualified for if I'd stayed longer - they might not have it now, as most companies are not getting more pensions, they're getting less - what I did was estimate the benefit using a formula: you know, dig into your pension documents, and let's figure out whatever your benefit might be (you’ll have to make some projections on what you're going to earn), but let's say you come up with $3000 a month pension benefit at a certain age.
I think in my case, let's say I was looking out age 65, what I would do was take that $36,000 a year annual benefit, use some sort discount rate, and give it a present value. So, divide by whatever you want to use as your discount rate, 6%, 7%. I was, again, fairly conservative, so a higher discount rate is going to give you a smaller number. So, in that example, let's say you use a discount rate of 7%, which means you're multiplying by about 14. So whatever the number is, let's say in that case it's...I'll use 15 to make the math easier. Let's say $540,000 is the lump sum value of that pension, and I just divided it by the number of years it took me to earn that benefit. So, in that case $540,000 divided by 35 years and you get…whatever that works out to. I don't have my calculator open, but let's say that's $15,000 a year. So I just take that $15,000 a year, divide by my production. If it's $300,000, that's an extra 5% payout that I can sort of attribute to the value of that pension.
So, that's a very back of the envelope calculation, but I think you can assign a value to it. It's not going to be precise, the pension terms might change. Typically though, those are not retroactive, so if you have certain terms in a pension…I'm not so doom and gloom as to say that Merrill Lynch isn't going to pay their obligations, although I guess they did have some challenges for example, but Bank of America was there to take care of things. So, that's sort of how I would account for 401(k) and pension. Again, deferred compensation but still compensation.
The fourth item to look at is what I would categorize as “other free stuff.” Depending on your production level, you may have things covered by your firm. You don't have to really account for the value of the assistant because I think that's already...I would just call it netted out in your compensation that's why your payout is lower (that and the office). So, that does simplify that calculation. If there are trips that you earn, or an expense account, add it to the calculation (especially if it's valuable to you - in fact, I would argue if it's not valuable to you, don't count it).
So, if you get free basketball, or baseball, or football tickets, and you have no interest in going to those games, then that's not valuable to you, so I would assign a value of zero. That's the kind of thing that you have to think through, and deferred compensation, and pension 401(k) income is not exactly the same as cash, but there’s no doubt each has value and assists you in building for your future. So, some benefits and perks may not really be beneficial to you, and I think you can you leave those out of the calculation. Those are the main things that I would account for in your current firm to get a sense of “what's my total payout?”
If you're at a firm that has some sort of partnership structure, you're going to need to come up with a mechanism on how to account for that. Again, I would generally only value the income. Just because you never know if that equity will ever turn into anything different. In other words, I wouldn't ascribe a certain appreciation to it. Edward Jones in particular, if you have, for example, $100,000 of limited partnership equity, and even if it generates you 20% a year that you think is going to last forever - that $20,000 is nice, but if you're producing $500,000 dollars of revenue, that’s 4%. In other words, $20,000 of income divided by $500,000 of production, that's like an extra 4% payout. None of us are going to turn our nose up at $20,000 a year because it feels free to some people if they're not really thinking through how to analyze that. But if you get an extra 4% payout, that doesn't sound as exciting.
So, I think that's partially how some of these firms build compensation systems. They're giving you the facts, but they're positioning them in a way that's most beneficial psychologically to them. Because that $100,000, for example, of equity doesn't really do you any particular good unless the firm goes public, or there's a buyout above book value - there are triggers that could make it more valuable, but by and large, it's the income that is the benefit. And again, 4% payout extra is great, but it's not earth-shattering, especially when you look at the numbers on the other side as we'll get to. So, those are the things I would add in to get sort of one number or what's my payout as an employee.
Now, to go to the INDEPENDENT side, there can be a lot more moving parts, so I'm going to keep these categories pretty broad, and for once try to keep this episode fairly compact and a little shorter than usual.
First, you'll have a top line payout, and you'll get that as an independent advisor. 80% to 90% is probably a good estimate, but a lot bigger than you get as an employee because you have to pay your own expenses. So you get all your revenue in - obviously that top line number is something you need to be very aware of, and get a sense of what's included, what's not. Are there other charges? Are there things that come off the top before you get that payout? I've been surprised at our large broker-dealer, when we made the conversion to our own RIA, how many of the advisors that had the same compensation system I did were not aware of a basis points charge on our asset-based programs.
We always had the 90% stuck in our head and people seem to forget about…this was relatively small amount, but still it was coming off the top before the 90% was applied. So, that's something that I think we all need to be somewhat vigilant about and paying attention to how the numbers work. Even if they're fair, it still makes sense to be very aware of how they work. So, basically, what's the top line revenue? And then, are there any charges and fees that come out before that's applied to your revenue.
I’ve lumped the next two categories together because they are by far the biggest expenses for most advisors (if they have them). Some people will have zero in both of these categories. They may not be in “growth mode,” however, if you listen to the Ashley Hodge’s interview episode, he has zeros for these and he's done quite well. Those two biggest expenses are your employees (if you have any), and an office. Typically, my feeling is that it's always better to spend money, invest in people, because give you leverage more than an office does. I would tend to tilt towards people first, then office space, or invest in higher quality people if you have to make a decision early on. Keep your office space simple, or don't have it if you don't need it, but certainly those are personal decisions. Again, I think good people is a better investment to make first than good office space. Those are pretty straightforward to figure out. You might need to add some employment taxes depending on how you employ people, and again, that's another criteria, another discussion I can get into in a separate episode. Those are the two big ones.
Other office expenses
Most of the other expenses are easy to identify and decide what you need, and then you can look at the cost and you can experiment. It's a lot harder to get out of hiring an employee once you have one, or if you have an office lease, that's harder to change. So, not only are those the biggest expenses, they have usually the biggest commitments. Office supplies usually don't add up to much – paper, unless you're extremely paper-heavy with a large practice - it may be a larger dollar amount in that case, but it's going to be a small percentage of your total revenue. You're going to have to pay for your own equipment - computers and maybe office furniture. So there might be some upfront investment, but I'm talking about more the ongoing operations in those...any investments you make in office equipment, or any expense is tax deductible. So, it does have an impact. Certainly that's cash out the door, but then it reduces your taxable income.
You might have software for financial planning, or customer relationship management, CRM. Most software, if you're thinking about how you use it, and you're not going overboard, it's not going to add up to a large percentage of your revenue. Especially these days, the cost and the the power that you can get for the dollar you spend continues to improve.
Self employment taxes
One last issue that is good to keep in mind because I think people don't always think about it in the way I try to, and that is being self-employed means you do pay both sides of the self-employment tax, social security and Medicare. So as an employee, you pay - obviously your side comes out of your paycheck, your 1.45% for Medicare, and 6.2% for Social Security, and then your employer pays the other side. So you don't really see that. But that's money out of pocket for the company. So one of the "downsides" of being self-employed is now you're going to incur both sides of that. So you're going to pay 12.4% for Social Security, and 2.9% for Medicare.
A couple things though that are kind of very important to keep in mind. One is, I think some of us will get hung up on the total number, which is understandable, because that's what comes out of your pocket, and when you're self-employed, it's not withheld from your paycheck. It's more in your face, just like your federal taxes are. A lot of things we pay for, our office space, our assistant - we see the money go out the door, so we're much more aware of the cost. I think that's a wonderful thing because it makes sure you don't have money coming out of your paycheck, either through your payout, or through deductions that you're not really wanting to spend. Or at least if you do, it's your own fault. It just puts it in the forefront, which I think is a good thing. It makes us more efficient. But in the self-employment arena, we already pay half of it.
So, I think it's illogical to treat the whole number as an issue. You're going to pay half of it regardless if you're working somewhere. So, I only treat the marginal half, the second half, as an issue. So, that's one big point. The second major point is the Social Security part of that tax, which is the biggest part of that obviously (it's 6.2% versus 1.45% for Medicare), has a dollar cap on it. So in 2016/2017, that is less than $8,000 a year. The majority of that issue is capped - it's a known dollar amount. So, if you have a successful practice, even if it's modest by a wirehouse standards, or other employee-firm standards, if you're doing $400,000 a year in production, that's a 2% payout issue, 2%. I don't want to minimize $8,000, but if you're doing $800,000, it’s 1%. So, it just doesn't move the needle.
Now, the Medicare tax, again at 1.45, yes that can add up. But that's on your net as well, not on your gross. So, call it one and a half rounding. If you're making $300,000 a year net, that's $4,500 a year. Again, it's real money, but it's just not a large percentage number. I want to mention that because there's no way around it. That's an extra expense you're going to have if you're on your own, but I want to put it in context, because if someone were trying to spend that as a terribly expensive thing, they could factually say you're going to pay 15.4% of your income in self-employment taxes - which is true. You know, 6.2 times 2 is 12.4, plus 1.45 times 2, which is 2.9. You're up to 15.3%. It's a big number, but again, keep in mind that what that really means is, as an extra amount compared to what you're doing now - it's $8000 a year, plus 1.45% of your net. So, just something to keep in mind when you hear numbers floating around.
If you're really serious about considering independence, make sure you're questioning, first of all, the source, and then you're digging in and asking, is that really accurate, and what else might I be missing? There are people out there that, you know, may be independent, and don't think this through because they don't care. I'm in the business of educating and recruiting, so it pays for me to understand these numbers, and be able to articulate these differences. I think that's something that we need to get clear - let's not use that as some scare tactic. If you don't want to go independent, that's fine, and if that $8,000 plus 1.45% is the reason, that's fine, but just be aware of the actual numbers. All right, I'll let that go. I think I've beaten that one to death.
On the independent side, I would also have an “other” category for other things that you just have to have that your firm paid for, or that because you're independent you're going to have now. Whether that's you lease a car, and deduct it (which I think is a terrible financial planning idea, but some people like cars more than I do). If there are other things you're going to spend money on, then you want to consider those. Again, if you're trying to compare apples to apples, some of that I think you need to consider as an extra, and you have to decide if that's worth factoring in. A lot of things you can do, and invest in, and spend money on as an independent that you cannot as an employee, and that's more of a qualitative benefit of independence versus quantitative. So, those are, again, the key things for an independent advisor or your top line payout. How much it would cost to have employees, and an office, if you have them, plus any benefits for the employees, if you have them.
The final expense item to touch on is health insurance. I've done a separate episode early on in the podcast about that. You do want to compare, what you are paying as an employee versus what you pay on your own. I find that those are very...the differences are usually not very significant, but that's something to consider. Because you may be paying a little bit more, or you may have the same premium, but have a bigger deductible. So, health insurance planning is an issue. I would put that also on the independent side as an item that you need to consider, and compare what's coming out of your pocket as an employee for a premium versus what would your premiums be on your own, and then how do those policies compare? I think the high deductible plan for many people works well, especially because they're going to have a higher net income. The run of the mill doctor visits, and even some of the less expensive prescriptions, those won't make a major dent in your out of pocket costs. Certainly, if there's major surgeries, or worse, the high deductible needs to be considered because that's a real cost. Again for insurance, I tend to prefer you let me keep most of my money month-to-month, and then be prepared for catastrophes. That's what health insurance is there for in my opinion, is the things that are extremely expensive, the kinds of things where money is sort of the least of your concerns.
Certainly, a $5,000 or $10,000 deductible is expensive and painful financially, but again, if it's needed, it's usually the least important issue in someone's life at the time. So, the other things as an independent would be the self- employment taxes that I touched on at length, supply, and software that don't add up too much. Again, if there are any special things that you really want to have because you can as an independent advisor, that may be tax deductible, but I would argue they're not critical for doing business - like a leased high-end vehicle. That's something that certainly you can deduct from taxes, and you would want to do that if you're going to do it and use it for business, but comparing apples to apples, I don't think that's a legitimate comparison because it's not necessary to run the business. At least that's my opinion, and I'd be hard-pressed to change it.
There you have it - a simple framework to help you compare your current payout to your potential net payout as an independent advisor. As always, shoot me a note to firstname.lastname@example.org if you have any questions or thoughts.