June 2000 Bullish on Management Science In response to discount online competitors, brokerage leader Merrill Lynch turns to a small team of analysts for answers. The result? A revolutionary suite of services that has rivals scrambling to catch up. By Raj Nigam, Russ Labe and Stuart Altschuler The buzz at Merrill Lynch's World Financial Center headquarters was at a fever pitch on the morning of June 1, 1999. The crowd of reporters attending the press conference speculated as to what the market leader in full-service brokerage was about to announce. Would Merrill Lynch finally succumb to competitive pressures and offer a "me-too" discount online trading service? Would they risk alienating their nearly 14,000 financial consultants? Would they surrender a sizable portion of their revenues to keep up with online discounters that had driven stock commissions into the single digits? Moments later, Merrill Lynch CEO David Komansky took the podium. The new offering was unveiled. The scope of the new offering and its pricing levels raised the bar beyond anyone's expectations. Merrill Lynch, the firm that spent nearly a century guided by the vision of bringing Wall Street to Main Street, would now be the one-stop source of financial services. Called Integrated Choice, the new product and service offering would allow clients to choose the level of advice and the manner in which they wanted to transact their business. ("By mouse, by phone, by human being" read one of the ads.) Clients wishing to invest online without the advice and guidance of a financial consultant could do so by opening an electronic Merrill Lynch Direct account. Clients desiring a relationship founded on advice from a financial consultant could select the Merrill Lynch Unlimited Advantage account. The pricing was based on assets at a blended rate of 1 percent of equity and mutual fund assets and 30 basis points of cash/fixed-income assets. Of course, clients could continue to choose the traditional commission-based accounts as well. Merrill Lynch could confidently present the Integrated Choice offering thanks to several months of analysis and recommendations by a cross-functional team under the leadership of the director of Strategic Pricing. Talent assembled from several functional areas helped analyze and recommend what new services should be offered and at what price. Many questions had to be answered. How would new services cannibalize the existing services? What would be the total revenue at risk? Which clients would likely opt for ML Direct and which ones for ML Unlimited Advantage? Which financial consultants would feel the greatest impact? Given the size and complexity of the problem, Launny Steffens, vice chairman of the Board and head of the U.S. Private Client Group, had called in the company's Management Science team to help provide quantitative answers to these questions and assess the sensitivity to various factors. Steffens was pleased with the results. "The revenue at risk to U.S. Private Client Group ranged from $200 million to $1 billion," Steffens said. "The analysis by the Management Science Group helped clarify the critical variables and their potential impact. Of course, our actual offering mitigated several of the risk factors." Teamwork, Discipline and Business Driven The Management Science Group was established in Merrill Lynch in 1986 and has been part of the Private Client organization since 1990. The group was instrumental in helping Merrill Lynch Private Client win the 1997 INFORMS Prize for the effective use and impact of management science on the success of the Firm. There are currently 20 members in the group. The mission of the Management Science Group is to provide high-end quantitative analysis, modeling and strategic decision support. We support executive management and business units by analyzing data on clients, products, services and the marketplace. We develop and implement models to help financial consultants deliver value-added solutions to clients. We also identify new analytical technologies and pilot those with high potential. We provide analytical and business assistance in many functional areas that are vital to Merrill Lynch's core strategy. These include asset allocation modeling, mutual fund portfolio optimization, investment strategy development and research, financial planning, prospecting and cross-selling models, campaign and pricing analyses. Over the last few years we have focused considerable energy in the areas of client satisfaction and investment performance — the two areas that have been deemed very important by our clients and executives. The group has developed models, analysis and tools that are critical to supporting these areas. During its 14-year existence, the group has developed a reputation for high quality work and is viewed with respect within the organization. What has led to this success? Certainly a track record of successful projects is a big help. Technical expertise is a baseline requirement for any analytical group. But these, while necessary, are not sufficient by themselves. Some of the critical success factors, which are central to our approach, include the following: Objective analysis. Focus on business impact and implementation. Teamwork. Adopting a disciplined consultative approach. Let's look at these one at a time, even though, as is true for life in general, they are intermingled. Objectivity. Raj Nigam, director and chief scientist of the group, is passionate about objectivity, and considers it in two parts. First of all, analysts have to be objective, no matter what. Second, senior executives must view you as objective. These parts take different kinds of sustained efforts to establish. Being objective is the easier of the two because our discipline is based on scientific method, analysis of data, mathematical equations, etc. It is important to focus on the data and let it speak for itself. It is also important to work with all of the various players and functional areas within the organization to make sure the data is complete and to hear different points of view. However, there are many times when the same data will support (or at least not negate) several hypotheses; so we must be very careful when we say that there is only one answer. We have to be our own harshest critics. Having an objective stance may also not put us on the same side of the table as our clients. Sometimes an objective, independent analysis requires delivering bad news. It requires questioning "accepted truths" and conventional wisdom. But if you are truly implementation focused and have a constructive attitude, such hurdles can be overcome. We adopt an approach that dwells less on the past and focuses on what can be done going forward. The second part of objectivity — being perceived as objective — is a reputation you build up one step at a time. And once you reach a certain level, it really builds upon itself. We have been called in to analyze several critical, high-impact situations just because a senior executive asked, "And what does Management Science have to say about this?" You have to keep on your toes because one or two missteps are all it takes to lose such a reputation in a hurry. High risk, high reward. Focus on business impact and implementation. "When it comes to focus on business impact and implementation, I don't even know where to begin because I just can't imagine where we would be without it" says Russ Labe, director in the group. As a group we have a passion for it, and we show it. When a new project is requested, we evaluate its importance in terms of business value or bottom-line impact. We try and understand up front how business practices, tactics or strategies will change depending on different possible outcomes. Hard questions like "Whose life will this change? And how?" are best asked at the beginning of a project rather than toward the end. We recommend this strongly to everyone; it is time well spent. It is part of our disciplined process. To ensure a focus on implementation, we are willing to get involved in all aspects of a project. This includes the data collection phase, model development, analysis and generating recommendations. We work with data on mainframe, workstation and PC platforms. We spend time in pulling together data from multiple sources, cleaning it up, and then creating and maintaining the data to support the analysis. And as we mentioned earlier, to ensure implementation we work closely with our clients and business partners to be constructive — to dwell less on the past and focus on what can be improved. Teamwork. "Teamwork is an essential ingredient if you want to tackle problems that are bothering your CEO or senior executives," Nigam says. "These problems are complex, multi-functional, ill defined and poorly structured. And that is why they are great!" The business issues encompassed by such problems are beyond the capability of any one individual or even any one department to tackle. They need to be looked at and analyzed from several different perspectives; and that is why teamwork or the ability to operate in a team is a critical success factor. We need to work together and get along with people of different skills, perspectives and motivations. Unfortunately, there is very little emphasis on this in our schools. Where are school and college level courses in teamwork, negotiating skills or conflict resolution? Why do we have to pick these up through the school of hard knocks? We'd love to see such courses starting at the primary school level. Consider the pricing problem mentioned earlier. The analytical modeling we did was critical, but it was only one of the many inputs needed and used by senior executives to make a decision that is changing the historic landscape of the financial services industry. Disciplined consultative approach. When we think of a disciplined process, we are reminded of the times when we would knock off factor analyses in a few hours. But now we tend to ask a lot more questions up front. In our group, we have learned slowly over time that having a good idea of the overall business picture is far more important than another scenario to be analyzed. This is where the value of a disciplined process comes in. That discipline becomes necessary if you are business focused, derive your kicks from implementation, and are into solving complex problems. At Merrill Lynch, we initiate all major projects with a written proposal. We take time to completely understand the specific problem we are being asked to address, including the background, the objectives and the likely business impact. Once we get a good feel for these, we will write a proposal outlining our approach, data requirements, methodology, resources needed from the clients as well as ourselves and a timeline. This enables us to be explicit about what we are delivering. And we start work only when we get an okay back from our client. Through this contracting process, we make explicit the expectations of both parties, develop a common understanding of the issues, and thereby foster a partnership. This is good for us and for our clients. And by the way, we just don't do factor analyses in a few hours anymore. Putting the Pieces Together All of these attributes of the Management Science Group were brought to bear on the questions raised by the pricing task force. The questions originally posed to us were rather broad and directional. We worked with the pricing task force and executive management to focus on the following: Determine the total revenue at risk if the only clients choosing the new pricing options were those who would pay less to Merrill Lynch (adverse selection). Determine a more realistic revenue impact based on a client's likelihood of adopting one of the new services. Assess the revenue impact for various pricing schedules, minimum fee levels, product combinations and product features. Assess the impact on each financial consultant and identify those who would be potentially most affected. Once an understanding was developed of where our unique role would have the greatest impact, we initiated an extensive review and assessment of client level data. We assembled data on 4 million clients and 14,000 financial consultants representing over a trillion dollars in assets. For each client, we obtained historical data for six categories of revenue, four categories of account type and nine asset allocation categories, along with data on number of trades, mutual fund exchanges and redemptions, sales of zero coupon bonds and purchases of new issues. To accomplish this, we merged, reconciled, filtered and cleaned up four different production databases. Talk about details; but we felt that, for such an important, strategic decision, behavioral modeling at a client-by-client level was required. An aggregate analysis would just not suffice. The first model we built, to assess total revenue at risk, was a mathematical behavioral model at the client level, based on the assumption that a client would switch on a purely economic basis — clearly an extreme scenario. We designed the model with a lot of flexibility. Different pricing levels, architecture of the offerings (did the client have to allocate all their assets to a single channel or could they allocate assets across channels?), eligible assets and pricing structures (a single rate versus separate rates for equity and fixed income assets) could easily be studied. Having established an upper bound for revenue at risk using the prior model, we ventured to develop a more realistic estimate. We enhanced the model by adding a probabilistic simulation feature that allowed us to combine the client's rational economic motivation with their affinity to the financial consultant. We translated the affinity into a zone of price indifference: clients with high/low affinity to their FC would have a high/low level of price or economic indifference (e.g., 15 percent/5 percent). With either model, results could be rolled up from the client level to the firm level to assess the overall revenue impact on the firm. Alternatively, by rolling up the data to the financial consultant level, and by incorporating their individual payout rates, we were able to evaluate the impact of pricing policy and compensation policy changes. All in all, we assessed more than 40 combinations of pricing offerings and architectures. Most significantly, we were able to analyze new scenarios with a new set of offerings very quickly — the firm and we were under very heavy self-imposed deadlines. Listen Intently, Respond Succinctly Certainly, our mathematical and statistical skills were critical to the success of this project. Just as important was teamwork — within our group, with the other members of the pricing taskforce and with executive management. Because of the strategic nature and high impact of the project, we met or spoke with the leadership of the task force on an almost daily basis. Before a single record of data was analyzed, we clarified the role of our analysis, the key assumptions, important deadlines and ultimate objectives. We quickly realized that we would need to divide the work among us in order to meet the deadlines. Je Oh, Bonnie Liao and Stuart Altschuler — senior analysts in our group — all contributed to the project. We also worked closely with Marketing Research and provided support for their conjoint analysis survey. Our goal was to understand the data that would be available from their research and to determine how it would fit into our models, particularly in the parameters dealing with price sensitivity and the zone of price indifference for our clients. We assembled results from each run of the model into a summary document and distributed it to the task force. Key statistics and numbers were highlighted, and a common display was developed to enable meaningful comparisons across several diverse scenarios. The communication was two-way: these results were instrumental in executive management's ability to specify new pricing alternatives and arrangements for testing. Regular meetings with executive management in marketing and finance further facilitated the flow of ideas. An example of the benefit of these meetings was the idea to construct a list of the impact on commissions for our top 200 financial consultants. These highly valued lists enabled executive management to put faces to all of the aggregate revenue estimates. Toward the end, Board Vice Chairman Steffens continued to keep up the pressure, challenging us with questions like, "So what does this all mean? What do you recommend?" We responded by submitting a one-page summary (no equations, no jargon, just English) of our recommendations. We argued that, despite the seeming plethora of choices, there were very few real alternatives. In essence, Merrill Lynch had limited choices when it came to offering unprecedented choices to our clients! Seizing the Initiative Retrospectively, the Integrated Choice strategy has enabled Merrill Lynch to go on the offensive. The daily media speculation of "How will Merrill Lynch respond to pressure from low-cost competitors?" has shifted to "How will the industry respond to Merrill Lynch?" All full-service brokerage competitors who had the technological capability to match at least some part of the Integrated Choice strategy responded in kind. One full-service firm with a separate, independent discount brokerage arm subsequently announced that they would integrate the two channels. A leading discount broker now emphasizes the availability of a full-service brokerage relationship in all of its press releases. Make no mistake: the bull is charging! And Merrill Lynch's Management Science Group helped point it in the right direction. Raj Nigam is the director and chief scientist of Merrill Lynch's Management Science Group in Princeton, N.J. Russ Labe is a director within the Group. Stuart Altschuler is a vice president in the Group. Table of Contents OR/MS Today Home Page OR/MS Today copyright © 2000 by the Institute for Operations Research and the Management Sciences. All rights reserved. Lionheart Publishing, Inc. 506 Roswell Street, Suite 220, Marietta, GA 30060, USA Phone: 770-431-0867 | Fax: 770-432-6969 E-mail: lpi@lionhrtpub.com URL: http://www.lionhrtpub.com Web Site © Copyright 1999, 2000 by Lionheart Publishing, Inc. All rights reserved.