For larger (or even mid-sized) advisory firms, bringing on additional back-office and support staff is just a normal part of the ongoing growth process. But for the solo advisor who may be starting to approach (or has already hit) a capacity wall and needs some operational help, hiring that first employee is a huge decision. Because, in one fell swoop, that once-solitary practitioner has not only suddenly doubled their business’s headcount (from you to two!), but they’ve also just given themselves a whole slew of new responsibilities as an employer that, no matter how good they are at delivering great advice to their clients, they may have little to no experience in.
Because, once you have employees, you have to figure out the best way to keep them challenged and motivated, and how to financially reward them while keeping their interests aligned with those of the business.
For many firms, the easiest way to accomplish that goal is by doling out bonuses, and so in this week’s #OfficeHours with @MichaelKitces, my weekly broadcast via Periscope, we discuss the pros and cons of various employee bonus structures, why sometimes monetary/financial rewards are less than optimal, and why it’s important to remember that business owners and employees aren’t always challenged and motivated by the same things.
Because our industry has its roots in product sales and commissions, the most common bonus structure is to share in the “sales” to new clients by sharing a percentage of new client revenue… where any new revenue that’s generated is split amongst advisors and the support team in such a way that recognizes their various levels of participation in the process of generating that revenue in the first place.
However, as the advisory industry shifts from upfront commissions to ongoing recurring revenues (e.g., AUM fees), firms that are hiring often have even more recurring revenue than new revenue, and it’s equally important for employees to not just help get new clients and revenue but retain the existing clients and revenue as well. Consequently, another approach for bonuses is to base them on a percentage of the firm’s gross revenue instead of off new revenue from new clients. Which not only rewards team members when the firm grows by adding new clients, but motivates them to work hard and provide great service to retain existing clients, too.
The caveat, however, is that in a business model that aims to create and increase annual recurring revenues over time, percentage of revenue bonuses – whether tied to new or gross revenue – have the potential to become quite large after a number of years, and can even compound to the point where they end up hindering the firm’s ability to reinvest into the business itself. Which, in turn, has prompted some firms to adopt a fixed-dollar bonus based on measurable (but not always static) business goals that can be adjusted over time based on ongoing firm growth and staffing needs, and (importantly) structured in such a way that manages employee expectations and keeps them focused on supporting the ever-evolving goals of the business (which naturally change over time).
Of course, bonuses don’t have to be monetary at all, as financial rewards on top of base salaries may be motivating initially but can become less so over time once employees begin to expect them as just another (implicitly-guaranteed) piece of their compensation, especially for otherwise-successful firms that regularly hit their bonus targets anyway. Instead, firms can offer experiential rewards for the whole team (and even their families!), which can often be a better sustaining motivator for people whose work requires creativity and original thought anyway.
Perhaps most significantly, though, is simply that advisory firm business owners must remember that their motivators are often quite different from their employees, who might actually respond much better in an environment that offers stability in compensation and job security (rather than risk-based upside potential). Because, if they were interested in taking the types of business/career risks that offered big potential upside as well as the possibility of many sleepless nights, then they would likely have chosen a different path in the first place!
Ultimately, though, in a world where it’s hard enough to find reliable and trustworthy employees in the first place, it only makes sense that one of the most important tasks when hiring that first employee is to figure out a bonus structure that works for them (as well as the ongoing needs of the business)… rather than just the one that you personally might find appealing as an employer!
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Well, welcome, everyone. Welcome to Office Hours with Michael Kitces.
So for today's Office Hours, I want to talk about a topic that I'm hearing coming up a lot over the past couple of weeks as firms got into their end of year planning process and then employee review process, which is how to set proper bonus structures for employees in an advisory firm. And I'm not talking about the bonuses that get paid to advisors for managing client relationships, I'm talking about the bonuses that you set for the rest of your employees, the administrative and operation staff, the paraplanners and the associate planners who don't have business development or direct client relationship responsibilities but also may want and need bonuses and incentives tied to their compensation.
So a good case in point example, the situation came from a recent email I received from, we'll call him Adam, who asked, "Michael, I'm mulling over a pay structure for my new paraplanner that I'm hiring through New Planning Recruiting. I would appreciate some advice as this is my first full-time hire. I'm planning to start her out at a $60,000 base, but I'm concerned with how to set her bonus. I'm thinking of a percentage of revenue from every new client that comes on board after her hire. What do you think?"
Well, first of all, congratulations, Adam, on the new hire. Adding your first full-time staff member as an advisor is often the single hardest hire to make. You know, it's rather traumatic to the business when you literally double your headcount from you to two, and often feels like a really big step back financially that you have to carve out, you know, from your income to hire this full-time employee in the hopes that eventually you'll be able to grow beyond it. So again, congratulations to you on hitting a major milestone in the business to be able to hire.
But ironically, this question of what's a proper bonus structure for a paraplanner or any other kind of administrative or operational employee is a common challenge for advisory firms I find both large and small, with remarkably little data on what approach firms typically use to pay bonuses. But I do see a couple of fairly common structures. And so I just want to talk through them a little bit and kind of how to think about this in an advisory firm.
Paying A Bonus Based On A Percentage Of (New) Revenue Growth [02:09]
So the first option for paying a bonus that I still see very commonly in advisory firms is to pay a percentage of all the new business that comes in after the hire. This was essentially Adam's plan. This I think really actually goes back to our roots as advisors who sold products, where when multiple advisors work jointly on a client, they would carve up and split the commission. The overall thumb even that I first learned in the industry about 20 years ago was that you can basically split the process for getting a new client into four roles: the finder, the binder, the grinder, and the minder.
So the finder was the person who went and found the prospect and brought them in, the binder was the one who actually bound them, made the sale and converted the prospect to a client, the grinder was the one who did all the support work and analysis, and the minder was the one that was going to do the ongoing service and support work thereafter. And so, the classic commission split of all was that each role was one-fourth or worth 25% of compensation. So if you were a solo advisor, obviously you got all of it. But if you were the advisor and someone else was the finder who provided the lead, they got 25%, and then you kept the rest. And if you worked for an advisor and you did the grinding support work, you got 25% of their commission as the grinder.
And while advisory firms now are increasingly going to an AUM fee model and they're not necessarily on the upfront commission model anymore, old habits die hard, and I find a lot of firms are still engaged in these kinds of new business splits. So if we get a new client this year, my paraplanner does the grinding work to support that new client, then my paraplanner gets 25% of the revenue. Or it might be 10% if it's a client service administrator, or maybe it's as much as one-third or 33% for a paraplanner who also sits in and supports every client meeting along the way. But that essentially means if the firm brings in $10 million in new assets this year and generates $100,000 in new revenue, the client service administrator gets a $10,000 bonus, the paraplanner might get up to a $30,000 bonus. Now, the percentages here aren't necessarily set in stone, but conceptually, I still find this is a fairly common approach. All the new business is split between the advisor and the support team. And in some way, that recognizes their various roles.
Paying A Bonus Based On A Percentage Of (Gross) Revenue [04:19]
Now, the second approach that I see commonly to advisory firm bonuses to employees is the percentage of gross revenue approach. Now, this is a little different than the prior bonus because that's typically only paid on new revenue from new clients. So while the percentage of new revenue approach might pay something like 10% of all new revenue to a client service administrator or 25% to a paraplanner, the percentage of gross revenue approach typically pays a much smaller percentage. It might be 5% or 2% or 1% or less for a very large firm, but it's still meant to equalize. So if the firm brings in $10 million of new assets but already has $50 million of existing assets generating call it $500,000 of ongoing revenue as a 1% AUM fee, the bonus of the staff member isn't 10% of the $100,000 of new revenue, which would be $10 grand, it's 2% of the entire $500,000 of revenue, just actually still the same $10,000 bonus. So it's not necessarily a different number, it's just instead of doing a bigger percent on the new business, it's a smaller percent on the entire revenue of the practice.
And I find this approach to be increasingly common in advisory firms more so than the percentage of new revenue for a couple of reasons. The first is that it just recognizes, I think more properly, that as the industry shifts from commissions that get paid once upfront to AUM with ongoing revenue, that it's important not just to reward getting clients and new clients, but retaining the existing ones too. Because in the early days with the finder, binder, grinder, minder framework, it was popular because advisors were all getting paid upfront commission, so the only revenue was the new revenue anyway. So we split new revenue because that was the only thing there was to split. And you had to always be going out to get new revenue because otherwise as soon as you stop getting new clients, you stop getting commissions and your income went straight to zero.
But in the AUM model with recurring revenue, it's different. In fact, the truth is that once you get to a certain level of critical mass as an advisor, you could make a pretty amazing income without getting any new clients, and simply doing a great job servicing and retaining your 50 great clients to earn the ongoing fees that they pay you. Which means if you're going to have bonuses tied to the financial success of the business in the first place, it's a good idea to have a bonus that rewards retention of existing clients as well as just getting new ones. Because even if the firm gets $10 million in new assets this year, if it loses $10 million of assets out the door from existing clients, the firm has no new growth. And so the employees' bonus compensation shouldn't go up when the firm isn't growing and going up either. If the employee wants more comp and a bigger bonus, the employee needs to either support more and more growth on top of the clients loss, or do a better job helping to retain those clients so they don't leave in the first place.
Which is the point. As practice management consultant Angie Herbers likes to point out as well, this really makes the employee's interest much more aligned to the overall interest of the business. Because even if the employee wasn't there to get the client, the employee is still there to retain the existing client. And the whole point of a recurring revenue AUM model is that it isn't just about getting clients and revenue from the new ones, it's about retaining the existing clients as well, which for an existing firm hiring new employees is actually usually the bigger piece of the pie anyways. There's more existing clients and revenue than there is just new clients and new revenue in the next year.
And more generally, I think just the whole percentage of gross revenue bonus structure is strong for overall alignment of the firm. If the firm is adding clients but losing clients is bad for the firm, it's bad for the bonuses. If the market is up, which in AUM model is a material factor for firm profitability, the firm is doing well, the employees are getting bonused more. And perhaps more important for the business's perspective, if markets are down and revenue is down, we hit turbulent times in the market like we have recently, the business has a natural buffer because employee compensation will go down as well since their bonuses are tied to the declining revenue from the market. So when there's a need to cut expenses, maybe, for an advisory firm in a bear market, bonus structures that are a percentage of gross revenue naturally trim themselves. That's the benefit when everybody is tied to the one key benchmark of the firm.
Now, I'd also note that the other reason that firms tend to use percentage of gross revenue is that I see a lot of them going to this as a replacement of percentage of profits. Which is still sort of the core driver of the business obviously, right? We need to actually generate a profit as a business owner. But for most advisory firms, profit-based bonuses don't work well in practice. And the reason is that the owners just have too much control of the profits of the firm to always be fair as a bonusing mechanism. You know, in part, it's just because it means if the business owner decides to reinvest for growth, hire more staff, try to drive more growth, generate less in profits as part of a growth strategy, the employees get hurt because they don't get the bonus off the profits if the owner is reinvesting the profits with new staff. And while the business owner might make that back in the higher value of the business in the future with growth, the employees just lose when the business owner reinvests, which is not a good dynamic for the business.
And in some cases, you know, advisory firm owners, as all small business owners, get a little, shall we say, creative about business expenses because, you know, anything you can put through that business P&L as a tax write-off, except when employees are getting bonused based on the profits of the firm, your creative tax strategy, you know, running your car through the business or hiring your kids in the business, becomes your employees' foregone bonus, which is not always healthy for your employee relationship. So to an essence, keep it clean. I see more advisory firms bonusing based on gross revenue, which considers growth and retention but not the owner-controlled expense decisions about how much profit to reinvest for future growth versus not that employees don't necessarily benefit from anyways.
Managing The Risk Of Bonus Compounding: Paying A Flat Bonus Tied To Business Goals Instead [10:09]
Now, one of the big caveats that's important to recognize in setting bonus structure, especially percentage of revenue bonuses, whether it's new revenue or total revenue, is that as businesses with recurring revenue that continue to grow, revenue can become a big number over time, which can create a serious problem with all these percentage of revenue bonuses.
So a good example of this was a good friend of mine from a couple of years ago who, you know, took a big leap, hired his first paraplanner back when he only had about $15 million in assets, so he could, you know, kind of barely afford to do so. It was a big hit. And since the hire was a stretch in the first place, he decided not to pay what at the time would have been about a $50,000 base paraplanner salaries, like, the going rate in his metropolitan area, instead, he offered a $30,000 base salary and a 20% of new revenue bonus. He had the goal of bringing in $10 million of new assets. That would be $100,000 in new revenue. So ideally, the paraplanner would make her, $50,000, $30,000 base, 20% of the $100,000 of new revenue, and that would get her the $50,000 she wanted. But if the business didn't grow as well, for some reason, my advisor friend wouldn't have to pay as much in salary and could save a little on the bonus, right? It was managing business risk.
Except, what he forgot to consider in his fear of, "How can I pay less if this doesn't work out" is, "How much will this cost me if it does work out?" Because, over the 10 years since, he actually grew the business off the bottom of the bear market from $15 million to $100 million, which means he's added $85 million of new assets, almost $850,000 in new revenue, and his paraplanner gets 20% of new business on top of a salary. She's now making $200,000 a year as a paraplanner. And it's killing his business because he now can't hire other staff he needs to hire to grow because there isn't enough money left because the paraplanner is making $200,000, and the paraplanner has now been so involved in the business for so long, he's terrified to fire the paraplanner because he doesn't want to have the business ramifications, but he can't afford to keep her. And he's stuck. Because in this recurring revenue model which started out as just 20% of new business growth after 10 years became 20% of the business. Like, she's a partner, essentially, without any of the risk that goes with being a partner and is choking off the rest of the ability of the business to grow.
So his problem, ironically, is that it worked, and he underestimated what I call the compounding risk of paying bonuses with upside on revenue that's recurring. This wasn't a problem in the commission-based world, but it is in the AUM world, or recurring retainers or any revenue that repeats.
And because of this, a number of advisory firms, including and especially I think ones that have maybe even burned on the past from some of these compounding risk percentage of revenue or percentage to new growth bonuses, are instead shifting to more fixed bonus structures instead. So for instance, the firm might say the bonus is $5,000 for every quarter that the firm brings in at least $25,000 in new revenue. So if you do the math, the firm is going to pay 20% of new revenues as a bonus, but the employee doesn't get the message, "You get 20% of our growth this quarter and every quarter forever," the employee gets the message, "You get $5,000 if we hit our goals."
And that's important because it means next year you can reset the $5,000 bonus to whatever the new goals are next year. "Hey, thanks to the great growth we had last year, this year we're hiring a new team member to support our marketing, and the $5,000 bonus now comes when we hit a $40,000 new revenue target each quarter." And now the percentage of the bonus starts going down as the business grows and compounds. Which isn't anything nefarious, it's just a simple recognition, as the business grows, successful employees still get a smaller slice of a larger pie. There's more employees to participate in the bonus in the first place. And you have to change the percentages or you get stuck in the situation my friend where one successful employee chokes off all the money for you to hire anybody else.
The real key, though, is that by setting bonuses that are flat dollar amounts based on concrete metrics, you as the business owner can budget as a percentage of revenue if you won, but you don't create a permanent expectation in the minds of employees that they'll get a permanent indefinite sharing of a percentage of revenue in a manner that you can't actually sustain if you really do continue to grow and compound the business. Instead, bonuses are dollar amounts for hitting goals, which implicitly recognizes that the goals of the business can and will change over time, and it makes the bonus structure more dynamic to the needs of the business over time and avoids that compounding risk problem.
Making “Bonuses” Non-Financial Rewards For Achieving Company Goals [14:46]
Now, it's all worth noting, there's one other approach that's out there as well, which is just to not pay bonuses at all, or at least not to make bonuses a financial thing. So the bonus for $25,000 of new revenue or whatever your target would be is not, "Hey, everyone gets a $5,000 bonus," instead it's, "Hey, we're going to do a team outing with family members to the local amusement park. We're all going to have a great time and a great experience together."
Now, this kind of alternative bonus approach comes, at least I read it first from author Daniel Pink in his book "Drive," which is all about the motivators that drive us. And it recognizes that there are really two types of motivators that drive us, what's called intrinsic motivation, where we're self-motivated by just the good feelings of what we accomplish and do, and extrinsic motivation, where we're externally motivated by things like money or recognition. Financial bonuses, classic example of extrinsic motivation. And while extrinsic motivators can give us a helpful nudge, the problem is that we soon adjust, and then we expect them, and then we can get to the point where not only are they not very motivating anymore, but if you take them away completely eliminates anybody's motivation to do the task at all, even if they previously enjoyed it. In essence, you turn an intrinsic motivator into an extrinsic one that's just about the money if you're not careful.
And what Daniel Pink found in his research for the book is that, especially for tasks that require creativity and original thought like how to handle complex planning situations in an advisory firm, intrinsic motivators work best. And if you use these types of if-then financial bonuses, you know, if we get this goal, you get that financial bonus, can really undermine someone's intrinsic motivation in the long run and turn what would have just been a natural desire to do well into a money thing instead.
And so the idea goes, just make sure that employees are actually paid enough in base salary that it addresses their core financial needs. Because obviously, if they're under financial distress, they'll be pushing to make more money because they really need more money. But once there's a reasonable baseline of salary, big money bonuses that may seem motivating in the short term can actually undermine motivation in the long term. Which means if you're going to have any kind of bonus, you make it something experiential that everyone in the team can enjoy socially without actually making it about the money, and you can still celebrate achievements and success for the business just without undermining intrinsic motivation in the process.
To Bonus And How: What Do Employees Really Want? [17:05]
The one other thing I notice, as we wrap up the discussion as well, just because I often see it in advisory firms, is that sometimes we as advisors and entrepreneurs and business owners sometimes forget that our motivations are very different than our employees'. For many of us, we do want and need these financial motivators. We respond well to them. We like financial status, that's why we're crazy enough to go start a financial advisor business, because we're comfortable with that risk and we like the reward potential. But that's not true for a lot of employees. If they wanted a bunch of risk-based compensation, they can go find another job that works in commissions or sales or something else with a high-risk high-reward potential, but instead, they're coming to the tables as employees for us because that's not the path they're choosing.
And I see a lot of advisors take what I think is sometimes an excessive focus on, "Sure, there's some risk in their bonus, but I want to give my employees the upside." When in truth it's not actually what their employees were asking for, it's just what they would have wanted themselves. You know, just because it's a job that you as the advisor wouldn't take because it doesn't have the upside you want doesn't prove it's a job your employee wouldn't take. Because they may have different goals. That's why you choose to be an advisory firm business owner and the employee chooses to be an employee. Your financial motivations are not necessarily your employees'. Your risk tolerance is not necessarily your employees' either. And you have to be really careful not to project what you would want into what you think they want. What they want is actually a stable salary and a stable job they can depend on while you take the risks as the business owner.
Now, obviously, there are some employees who may in fact really be interested in more upside potential, great, but then give them a path to get there that's not the equivalent of phantom equity revenue-sharing while they ride the wave that you're surfing as the owner. Give them the opportunities for more responsibility to have a greater impact in the business and reward them for actually taking on more responsibility and succeeding with it, because that rewards them for actually helping to create business value and doesn't just compound their bonuses over time for the sake of doing the same job while they ride the wave, it rewards them for creating value in the business that's good for everyone.
So to get back to the original question that Adam asked, Adam, I know your inclination and temptation is to pay a percentage of new revenue because that's what motivates you, but I'd really encourage you to go another direction. If you're willing to set aside a bonus that's 20% of your growth this year, great, but then set your growth goals and set a flat dollar amount bonus, or you can tier it if you want, and make that the bonus, so you don't create this untenable long-term compounding problem of paying a percentage of only new revenue that years from now may be a dangerously high percentage of all your revenue with growth. And recognize that it's much easier to get this right now than to set her up on a percentage of revenue schedule now and then try to change it later when she's seeing the upside. And by then, well, by then it's a money thing, and it'll be much harder to change it because it'll feel like you're taking something away. Problematic bonus structures are much harder to fix later than they are to structure properly in the first place.
Or alternatively, if you're, you know, actually paying what appears to be a very reasonable starting salary, $60,000 to a paraplanner in the first place, consider not making a financial bonus at all and instead tying the accomplishment of your quarter or the annual business goals to something else that's maybe a little more fun and a little less financial. And if you want to, take the money you would have put aside as a bonus and put it instead in emergency fund for your business to keep your paraplanner employed. You could even tell her you're building up business reserves to ensure she has a job. You may be shocked by how much she appreciates the job stability.
And at worst, if it really does turn out that she wants upside, well then, you have a few years to figure out how to give her upside, not by trying to give her a compounding bonus to your business growth, but figuring out how to develop her into a full-scale service advisor who manages relationships or a lead advisor who develops business, or maybe even someday your future partner, who then gets much more financial reward because she's actually your partner, sharing and building a bigger pie that the two of you create together.
So I hope that's helpful as some food for thought about the nature and structure of bonuses in advisory firms. This is Office Hours with Michael Kitces. Thanks for joining us, everyone, and have a great day.
Disclosure: Michael Kitces is a co-founder of New Planner Recruiting, which was mentioned in this article.