Wealth management firms are finding themselves at a crossroads, facing increasing pressure to raise interest rates on clients' uninvested cash. This pressure, however, comes with the risk of significantly impacting their earnings, creating a challenging scenario for firms navigating the current financial landscape.
In recent weeks, the financial community has closely monitored the potential impact on wealth managers' earnings, leading to a noticeable decline in their share prices. Investors' concerns have been fueled by a series of lawsuits against some firms and announcements from industry giants like Wells Fargo and Morgan Stanley about raising rates on client cash.
A new research report from William Blair analyst Jeff Schmitt highlights the potential financial ramifications for certain companies if advisory sweep rates rise without corresponding policy adjustments. Schmitt's analysis indicates that a rise in advisory sweep rates to 2.5% in the first quarter of 2025 could result in significant declines in earnings per share (EPS) for firms like LPL Financial and Charles Schwab. Specifically, Schmitt projects a 20% drop in EPS for these companies, assuming two Federal Reserve rate cuts before then. Ameriprise Financial might experience a more moderate 5% decline in EPS.
The extent of the impact varies across companies, largely due to differences in their business models and the mix of brokerage versus advisory cash. For example, Schmitt notes that spread income constitutes a larger portion of Schwab's revenue, making its EPS more susceptible to changes in sweep rates.
However, Schmitt believes that these companies are likely to take steps to mitigate potential earnings declines. Possible measures include implementing custody fees on advisory assets, increasing advisory fees, reducing advisor payouts, or cutting operational expenses. Schmitt suggests that the least disruptive approach might be to reduce expenses and introduce a modest custody fee of around two to three basis points, which would be passed on to clients. For a client with $100,000 in assets, this fee would amount to only $20 to $30 annually, with clients benefiting from a higher yield on their sweep cash in return.
By implementing these offsetting measures, or "enhancements," as Schmitt calls them, the impact on earnings could be less severe, potentially leading to an upside in the companies' stock prices. For instance, Schmitt estimates that under the enhancement scenario, LPL's 2025 EPS would decrease to $17.70 from $19.50, but with a price-to-earnings ratio of 15 times, this could imply a stock price of $266, representing a potential 21% upside. Similarly, for Schwab, 2025 EPS would decline to $3.84 from $4, but with a multiple of 20 times, this could imply a stock price of $77, offering a 19% upside.
Despite these potential upsides, shares of LPL and Schwab have taken a hit this year, with both stocks down 2.3% and 5.6%, respectively, while the S&P 500 has risen 17.7% over the same period.
Both LPL and Schwab are among the largest wealth managers in the nation. LPL serves over 23,000 advisors and reported $1.5 trillion in client assets at the end of the second quarter. Charles Schwab, which caters to both retail investors and independent financial advisors, had total client assets of $9.6 trillion as of the end of July.
Ameriprise, another major player, could also adopt similar enhancements to offset the impact of higher advisory sweep rates. Schmitt estimates that if the sweep rate increases to 2.5% in the first quarter of 2025, combined with a two-basis-point custody fee and $40 million in expense cuts, the overall EPS reduction for Ameriprise would be just $0.52.
Schmitt rates the stocks of all three companies—LPL, Schwab, and Ameriprise—at Outperform, reflecting his confidence in their ability to manage through these challenges.
While LPL and Ameriprise declined to comment, a spokeswoman for Schwab dismissed the report as overly simplistic, arguing that it fails to consider the significant differences between Schwab's self-directed and custodian business models compared to other firms.
For years, clients' uninvested cash has served as a key profit driver for wealth managers. Many firms have traditionally swept clients' uninvested cash into accounts that offer minimal interest while reinvesting or lending that cash at higher rates. However, as the Federal Reserve has raised interest rates since 2022, clients have become more aware of what they are earning on their cash, leading to increased scrutiny of these practices.
Moreover, regulatory and legal pressures are mounting. The Securities and Exchange Commission (SEC) is investigating the cash sweep practices of firms like Morgan Stanley and Wells Fargo. Additionally, several wealth management firms, including Morgan Stanley, Wells Fargo, and LPL Financial, are facing lawsuits from clients who accuse them of breaching fiduciary duty by not securing higher interest rates on clients' cash. These lawsuits, which seek class-action status, allege that these firms failed to act in their clients' best interests.
Adding to the pressure, Moody's Ratings recently warned that the need to increase sweep rates could pose a "credit negative" risk for some independent wealth managers, particularly those that are highly leveraged and backed by private-equity firms.
