CUSTODIANS FACE DAUNTING MARKET

The great riddle for The Charles Schwab Corp., Fidelity Investments and other firms providing custodial and business services to independent advisers as they enter 2009 is how to maintain and improve their services when tanking markets and a crippled economy are strangling their budgets.

Schwab, which remains the biggest custodian by far for independent advisers, has pulled no punches about the challenges. Firm founder Charles Schwab in November said he expected investors to remain cautious for a long time, pressuring the firm’s revenue.

Then, last month, Schwab president Walt Bettinger unveiled plans to cut 8% of the San Francisco-based firm’s annual expenses, eliminate at least 100 senior positions and make further unspecified staff reductions through the first half of 2009.

Fidelity, the second-biggest custodian by RIA assets, already has announced a 7% staff reduction through early next year, and firm chairman Ned Johnson told the Boston Herald last month that more cuts may follow if markets and the economy remain despondent. Like Mr. Schwab, he characterized the outlook as weak.

Both firms are particularly vulnerable to the low short-term interest rates promulgated by the Federal Reserve Board.

Rates hovering near 0% squeeze their net interest income, reduce profitable margin lending as clients pull back from investing and — most importantly for registered investment advisers who use fund supermarkets and money market sweep services — pressure the custodians’ ability to maintain fees on funds that yield zero returns to investors.

“We expect pressure to mount for [Schwab] to waive fees” on its core U.S. Treasury Fund, said Richard Repetto, an analyst at Sandler O’Neill & Partners in New York. Interest rate related declines will more than offset gains from cost cutting, said Mr. Repetto, who does not cover privately held Fidelity.

Advisers, the fastest-growing segment of the wealth management community, said they will be carefully monitoring how these pressures will affect service levels and the development of new practice-management and technology tools.

“It will be a difficult year for them, and we have to watch their performance carefully at a time when their competitive pressures are increasing,” said Rudy Adolf, chief executive of Focus Financial Partners LLC, a New York-based firm that at the end of September had about $28 billion under management through its ownership interests in registered investment advisory firms.

If market conditions remain difficult and advisers begin feeling fee pressure from clients, they may up the ante with custodians by seeking lower charges for execution services and other products, according to some observers.

Clients could even become sensitive about high or duplicative fund supermarket and fund-of-funds costs, leading advisers to renegotiate transaction costs they previously ignored as they gravitate toward picking individual stocks and exchange traded funds.

Spokespeople at Fidelity and Omaha, Neb.-based TD Ameritrade Holding Corp. — the third-largest custodian, according to The Tower Group Inc., a Needham, Mass., consulting firm — said they have not felt any pressure on rates from RIA clients.

A Schwab spokeswoman de­clined comment, as did a spokesman for Pershing LLC, a unit of Bank of New York Mellon Corp., though he said that the Jersey City, N.J.-based firm will “continue to work collaboratively with our customers to help them enhance their productivity and meet the challenges this new investment environment presents.”

Several advisers expressed confidence in their custodians, saying they mutually understand each other’s challenges, including the necessity to keep clients happy.

“We’re all faced with providing a higher level of service for less money,” said Diahann Lassus, president of Lassus Wherley & Associates PC in New Providence, N.J., which manages around $300 million. “It’s a lot less expensive to hold on to existing clients than recruit new ones.”

Ms. Lassus, who is chairwoman of the National Association of Personal Financial Advisors in Arlington Heights, Ill., said her firm custodies assets with Schwab, Fidelity of Boston and National Advisors Trust Co. FSB in Overland Park, Kan.

The custodial leaders, for their part, have made organizational changes they say will bring efficiencies to their own operations and to RIA clients.

Schwab in November merged its RIA unit with its retirement services unit in a move it touted as smoothing financial advisers’ access to retirement-planning services.

It also eliminated costs, as Schwab centralized research and other support services for the two businesses and eliminated the position of Charles Goldman after his 18-month stint heading the rapidly growing RIA unit.

Fidelity, meanwhile, pushed aside the head of its RIA division, re­cruited a top retail-sales executive from New York-based Morgan Stanley to replace him and then im­ported Mr. Goldman to oversee both the RIA unit and its National Financial Services LLC correspondent-clearing unit for broker-dealers.

RIAs are closely watching the changes, which are evolving in a wildly volatile investment environment. At the same time, competition among custodians is growing.

To differentiate themselves, the various players have been developing technology and management tools aimed at improving RIAs’ business management and investment skills.

TD Ameritrade, after losing market share in 2007 due to merger-related customer service problems, has become “a serious contender,” said Sean Cunniff, an analyst at Tower Group, cautioning that Schwab’s dominance still remains daunting.

E-mail Jed Horowitz at [email protected].