A couple of weeks ago we hosted an event in Edinburgh on the topic – Is inflation the secret killer of your business? We have created a three part summary of the discussion, as we believe this will be of interest to those who own or operate an IFA practice.
Financial repression on the horizon
There is a prevalent feeling that asset classes are overheated, from stocks and bonds to residential property. This is against the backdrop of a surprisingly robust economy, which means more jobs, and unemployment at multi-year lows. The broader backdrop is of a global debt burden that has not been dealt with since the Financial Crisis. Our belief is that we could be entering a period of ‘financial repression’ where inflation is used to reduce the debt burden and interest rates are kept low.
With the financial planning business model closely connected to the fortunes of markets, there could be tough times ahead. How can you, as a business owner, ensure your business is robust enough to weather these conditions?
In this series of articles we will first look at the problems this inflationary environment will present, then at potential solutions and finally how this environment would affect the market for financial planning businesses.
So what’s so bad about inflation?
It’s a common investment adage (attributed to Mark Twain) that “History doesn’t repeat itself, but it does rhyme.” This means we can try and learn from it. The last time we experienced financial repression-like conditions was in the late 1960s and 1970s.
In the below chart, we modelled the balance sheet of a modern, listed financial advice firm, taking account of revenue, costs, profit and AUM over ten years. Assuming the firm’s assets under management (AUM) comprised a balanced portfolio of 50% bonds and 50% equities, we applied the asset class returns experienced during the 1970s to this modern firm.
If history rhymes, what’s the likely impact on a financial advisory firm?
The chart below captures this work and three things jump out at you:
Performance 1970-1980 using real returns for a representative advisory firm
- The effect of inflation means that in real terms AUM doesn’t recover for years.
- Staff costs consistently rise over the period
- The business suffers as profits decline.
The end result is that the firm probably doesn’t survive much beyond the early 70s.
Let’s delve a little deeper in to how this environment transmits through in to a negative outcome for this business.
The specific challenges for an advice business
There are three key issues that lead to the advice firm’s declining fortunes:
» Inability to borrow. Businesses like financial planners tend to have few tangible assets; they rely on human capital and relationships. As a result they find it difficult to borrow. Add to this the fact that the regulator isn’t terribly keen on financial planning firms taking on leverage and your funding options in a crisis are severely limited.
» Revenue tied to AUM. This is the fundamental issue. Where financial planners are charging fees based on a percentage of the AUM then anything that reduces the long term value of that pot of assets is very bad for business. In the specific scenario of ‘financial repression’, the lesson from the 1970s is that AUM dips sharply at the start of the inflationary period and then doesn’t recover for around a decade. Bonds and equities suffered 15 years of real losses. Fundamentally there is a real risk this charging structure leads to a permanent reduction in the revenue the business can generate.
» Increasing costs. In an inflationary environment both staff costs and provider costs will increase. But while your staff costs are absolute, as we’ve pointed out above, your revenue is relative. Wages will keep pace or people will leave your employment. Revenue will not keep pace though. The widening gap between rising staff costs and falling revenues will eat in to the firm’s profit.
If this ‘financial repression’ scenario does transpire, how might a financial planning business cope? We will explore some options that might help mitigate the risks in the next instalment.
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