Feature (cover): What I Learned During the Economic Slump

In the two years since Context last chatted with David Pottruck, the co-chief executive of Charles Schwab & Co. (www.schwab.com) hasn’t changed much. He is still a physically imposing man who speaks slowly but forcefully about his beliefs and passions. Yet the business landscape around Pottruck has changed so much as to be almost unrecognizable.

Congress has launched a far-reaching investigation of Wall Street. Competitors have lost the trust of investors because of conflicts of interest—Merrill Lynch & Co. (www.ml.com) paid $100 million to settle just one case against it. The stock market has collapsed. At Schwab itself, the decline in the value of clients’ assets has carved $1.5 billion of annual revenue out of the once-highflying firm and forced it to go through three painful rounds of layoffs. Schwab has moved away from its original vision of being solely a discount brokerage firm; it now offers clients investment advice and counsel, a change that is requiring new approaches in every part of Schwab’s operations.

In a candid interview with Context Editor-in-Chief Paul Carroll, Pottruck relates that he is a humbler man in these tough times. But he says that both he and the firm are better for the experience.

He also offers some blunt thoughts about: how senior executives must “earn” the right to communicate with employees; how companies should de-emphasize selling; how traditional incentive systems don’t work; how centralization is now a must; how unprofitable customers have to be turned into profitable ones; and why Schwab has kept spending near-record amounts on information technology.

In the end, Pottruck says just what he did two years ago: that a successful business is based on strong, clear values. “Why are we in business?” he asks. “What are we trying to accomplish? What are the values that we will use as the litmus test for everything you do?”

CONTEXT: As background, could you sketch out the main issues you’re grappling with today?

DAVID POTTRUCK: When I joined Charles Schwab in 1984, our average client had $7,000 invested with us. Today, that client has about $180,000 at Schwab and about $400,000 in his total portfolio. As our clients have become wealthier, their demands for us to provide more advice and guid-ance have grown dramatically, as well.

So, for the past six years, we have been working on reinventing our company to be able to provide advice and guidance, but in a different way than traditional firms do. We’re trying to become something different, a third category, neither discount nor full-service. More advice than a discount firm, but a different cost structure, a different pricing structure, and without the fundamental conflicts of interest that are so inherent in the structure of most Wall Street firms.

The good news is we’re beginning to move our image. The bad news is that it’s slow. People don’t change their opinions overnight. For more than 20 years, we have invested maybe a billion dollars in advertising telling people we don’t give advice, that we’re a discount brokerage. Now we have to convince people that not only do we give advice, but also that we don’t do it like everybody else does.

Also good news is that among companies that report net new assets, there’s no one that we’re not outperforming. The bad news is that, though we earn about 50 to 52 basis points [hundredths of a percentage point] for every new dollar put in custody at Schwab, over the past year and a half the stock-market contraction has decreased the value of the assets at Schwab by $300 billion. That’s $1.5 billion of revenue that has been wiped out from a company that today is doing about $4.2 billion to $4.3 billion of revenue. That’s a big kick in the pants.

I’m much humbler than I used to be. Facing the difficulties has been good for all of us at Schwab in that it has made us stronger and even more focused on our goals here.

CONTEXT: What can you do to relieve the pressure?

POTTRUCK: In the past, our business was all about speed. We were reinventing ourselves around the Internet, trying to move faster than our competitors were moving, and bringing new ideas to market. If we missed the mark a little bit, yet were still directionally correct, that was good enough.

Not anymore. Today, we need more precision.

When your fundamental revenue model is challenged, you have to look at what client segments are not pulling their weight. There are, for instance, some people who call us thousands of times a year while providing little revenue.

We also are now re-examining everything that during the go-go years moved us toward a decentralized organizational structure, as we tried to get more decision-making capability closer to the customer. In times like these, we’ve had to focus on what things would be more efficient by being centralized, even if they may be a little less effective.

We’ve had to spend a large amount of time communicating within the company, getting people to understand not just what management is doing but also why we’re doing it. I don’t think a firm can overcommunicate with its employees during tough times.

Of course, as revenue comes down, marginal operating costs also have to come down. In our business, those are largely around people and technology, meaning we’ve had to take restructuring charges and conduct layoffs. Until recently, we hadn’t done a layoff since 1988, and at that time we laid off only 150 people, but we just announced our third round of layoffs, which is personally very painful for me.

CONTEXT: Let’s drill down more deeply into three major areas you mentioned: your new business model, technology, and people. Let’s start with what you’re doing in terms of rebranding Schwab.

POTTRUCK: Obviously, we had to create a whole host of advertising around this notion that Schwab is in the business of providing relationships and advice.

We also had to provide real evidence of change. So we made two very important acquisitions.

First, we acquired U.S. Trust Corp. [www.ustrust.com], which is one of the leading wealth-management firms in America. We thought U.S. Trust would do two things for us. It would help us create a full spectrum of segmented offerings that would go from the beginning investor all the way up to people who have $100 million of personal net worth. It would also teach us how to serve affluent investors. Remember, for the first 25 years of our existence, our clients never had a designated one-on-one relationship with a broker at Schwab. Any of our account specialists had all the information about your account and could handle your needs. That was reasonably efficient for us but not emotionally satisfying to our clients. An increasingly important segment of our clients is now saying, “I want more individualized attention.”

Second, we bought Chicago Investment Analytics [www.cianet.com], which had an automated stock-research and a stock-rating service that we’ve re-created and provided to retail investors under the name Schwab Equity Rating System. A model portfolio based on its picks has done quite well. Unfortunately, regulations don’t allow me to quote specific performance numbers without several paragraphs of legal disclosures.

We’ve also told the world that within Schwab Private Client we have about 350 people who are certified as advice-givers. I don’t think it would have been believable for us to suggest that all of our 4,000 employees who provide client service all of a sudden went from order-takers to advice-givers.

CONTEXT: You mentioned that you have to figure out which clients aren’t profitable. I assume that can be hard.

POTTRUCK: One of the things that we have struggled with over the years is understanding profitability by client segment. So we’ve done a lot of work on how to segment our client base, and we now think about clients in far more discrete groupings. We also are monitoring the profitability of those groupings closely.

We don’t want to stop serving our low-end clients, and we don’t want to beat them into oblivion with fees and charges. But we have to ask: How do we modify our costs or how do we enrich the palette of products that we offer so that there is a profitable relationship there? That question has led to a lot more testing. We might quickly test a bundle of services priced at $300, $350, $375, and $425, so we can understand the demand curve at each price. We never did that before. We would do some research, gather in a tribal session, pick a price, and go with it. Now we’re recognizing that leaving $20 on the table is something we can’t afford to do anymore.

Making our segmentation more precise provides another benefit. It gives our front-line employees a much better sense of where to begin a relationship-development conversation.

We like to say at Schwab that the difference between sales and service is relevance. If a client perceives us as presenting a solution to a problem he doesn’t have, that is selling. That feels really bad, and it’s a huge waste of time. On the other hand, if the client sees us as presenting a solution to a problem he does have, that’s service. That’s not sales.

Segmenting clients more carefully can help employees quickly understand the person they’re dealing with, which increases the probability that a sales presentation will be relevant and will be welcomed as service.

CONTEXT: How about the technology piece? You’re cutting technology spending, but you’re also having to add a fair amount of capability to support some of the new things you’re doing. How do you cut and grow at the same time?

POTTRUCK: Well, you reset your priorities. In my view, the CEO must be intimately involved in this process of deciding how to spend discretionary technology money.

We’ve decided there are two main areas where we’ll spend. The first is productivity. What’s interesting about productivity is that, even though we have four main business units, a huge amount of the productivity investments we make are usable across all of them. In the old days, we would have had each business work on those things separately, to make them happen faster. Now top management is focusing on common platforms and common efforts.

The second area of spending is metrics. If we’re going to say “directionally correct” is no longer good enough, then we have to give people the tools to be more precise in their decision-making. We’re trying to understand our clients better than the competition does by, perhaps, trying 10 different marketing approaches so we can find the three that work best and put effort into them. That means having an environment that can quickly test, measure, and act.

I was once quoted as saying that Schwab is “a technology firm in the financial-services business.” That was mostly a comment about our fast pace of change. Clearly, though, technology is one of our differentiators. How we blend technology and people is at the heart of our competitive advantage. So we’re still spending a huge amount on technology. This year’s spending will be down from the past three years but will still be our fourth biggest ever.

CONTEXT: The third element I wanted to ask you about is people. When we talked a couple of years ago, you spoke a lot about building the culture at Schwab, about passion. Schwab obviously has a very strong culture. But now, it seems to me, you’re asking people to change at least what they do, if not their belief structure. How do you do that?

POTTRUCK: I don’t think we’re changing the culture of Schwab. We’re changing the business practices. That may seem like just a semantic distinction, but I think it’s a very important point.

We talk about culture as being the fundamental vision and values. Why are we in business? What are we trying to accomplish? What are the values that we will use as the litmus test for everything we do?

At Schwab, our vision is to be the most useful and ethical financial-services firm in the world. We don’t talk about that much outside the company. You’re not going to see that in an ad. But inside the company, for the past 15 years, that’s the language we’ve used. We also identified six values—being fair, empathetic, responsive, striving, trustworthy, and team-oriented—that guide all our decisions about products we develop, incentive systems we have, the way we serve our clients, the way we serve our employees.

When the current economic problems caused us to do our first round of layoffs, our values dictated that we treat employees generously. But we expected to do only one round. Now we’re doing our third. So we asked ourselves whether we could afford to continue being so generous. We decided the answer was that we had to keep our policies the same because it was the fair thing to do.

That fundamental vision of the business hasn’t changed. But, as we’ve explained to employees, everything else is going to change all the time. The business practices can’t be “count on” stuff because they have to be responsive to the marketplace, to what clients want, to changing opportunities, and to changing economic conditions.

How does this work in practice? Well, for the first 15 years of the company’s history, we believed that giving advice carried an inherent conflict of interest. But our clients basically started demanding advice from us. So we put a lot of time and energy into figuring out how to provide guidance without creating conflicts of interest. It has been challenging. We’ve had to change our recruitment practices, our orientation, our training, our incentives, and our measurements. But we haven’t changed our beliefs.

CONTEXT: You said you can’t overcommunicate with employees. What are the best methods for communicating?

POTTRUCK: Modern technology—e-mail, voice mail, video clips, and all that—is fantastic, and you can accomplish a great deal with it. However, I think I have to earn the right to communicate with people through those means. I earn that right by appearing before them in public, personally, talking about where the company is going, talking about why we’re going in these directions, and then taking questions. Chuck [Schwab] and I last year did 11 face-to-face meetings, getting together with almost every employee in the company.

I’ve always tried to get questions started with a zinger. You know, one that goes something like: “Mr. Pottruck, we’ve all seen our compensation go down, and yet you and Mr. Schwab still earn millions of dollars annually. How do you justify that?” I respond something like this: “You know, that’s probably a question that’s on a lot of minds of people in this room, and I think that if we’re going to accomplish anything today we need the heartfelt questions like that one. So how about a big round of applause for that employee who had the courage to ask that question?”

Then you have to stand back and get ready because there are going to be a lot of tough questions.

People will appreciate that you didn’t duck the questions. Afterward, all the e-mails, voice mails, and other stuff will be more credible.

CONTEXT: How do you keep people motivated?

POTTRUCK: One of the mistakes I made was thinking that, if I changed our incentive systems in certain fundamental ways, I would change behavior. What I’ve come to understand is that people do things because of lots of different motivations. Incentive systems alone can’t do it.

People in sales jobs are very economically oriented and will typically respond enormously to changes in compensation. Many technologists, on the other hand, take pride in developing intellectual property, in working on the latest things. If you put such a person on technology maintenance, even if you pay him more, he won’t be happy.

Another thing I’ve learned in the past two or three years is that we constantly underestimate how powerful recognition is. People will respond tremendously to recognition—especially in times like these, when people are feeling so bad about so many things. Feeding people’s emotional souls is such an important thing. One of my guiding thoughts when I speak with employees, one on one or in large groups, is that they may forget exactly what you said, but they will remember how you made them feel.

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