Adapt and Thrive

Recently I took a few moments to go back through a stack of Schwab's annual reports. It was satisfying, though not surprising, to see the common threads of our firm's mission, values, and "Through Clients' Eyes" strategy woven throughout the pages and across the years. This stroll down memory lane is a clear example of the equation Walt highlighted in his letter this year: Consistency plus continuity drives long-term performance.

Hopefully that equation sounds familiar to you since it is essentially a distilled version of our through-the-cycle financial formula: Our dedicated focus on individual investors and the advisors who serve them drives business momentum, a diversified revenue model enables top-line growth, and the combination of continued expense discipline and thoughtful capital management helps us deliver long-term results for owners. The power of this formula rests in the simplicity of a singular focus on doing right by our clients as well as its resiliency across a range of environments. The last two years have certainly shown the importance of this resiliency.

I think you will agree with me that 2021 and 2022 were two very different years. During 2021, the world remained deep in the throes of the COVID-19 global pandemic; interest rates were at ultra-low levels; and meme stock mania captured the market's imagination for much of the year. In 2022, the market exuberance of the prior year faded quickly. Russia's invasion of Ukraine increased global geopolitical tensions; inflationary trends accelerated to historic highs; and the Federal Reserve embarked on its most aggressive rate-tightening cycle in over four decades.

While the macroeconomic backdrop for these two sets of conditions could not have been more different, there was one constant: Schwab's persistent focus on its clients yielded record financial results across both years! I believe our ability to not just adapt but thrive against an ever-changing landscape differentiates us from other financial services firms and helps keep us positioned to deliver for all of our stakeholders-clients, employees, and stockholders.

Before we jump ahead to the bright future still ahead of us, let's take a look back at last year.

2022

At the end of last year's letter, I promised that regardless of how the environment might shift, we'd stay focused on the things within our control: serving our clients and working tirelessly to advance our three strategic initiatives of scale, win-win monetization, and segmentation. When I made that statement, I am not sure I fully appreciated just how much the world would soon change.

As I sat down to write this letter at the beginning of last year, client engagement had softened from the frenzied pace of 2021. With inflation no longer viewed as "transitory," the markets expected the Fed to begin increasing rates gradually during the year. And the markets responded by dropping over 8% during the first two months of the year. Then things changed dramatically. Inflation grew stronger, and the Fed reacted by embarking on the most dramatic tightening cycle in history, sending the Fed Funds rate to 4.50% by the end of the year. Over the course of the year, both equity and fixed income markets dropped in tandem, leading to the worst annual performance for a traditional 60/40 portfolio since 2008. And our clients moved some of their transactional cash off our balance sheet and into higher-yielding alternatives—as they have in past cycles. In the face of these changing conditions, we adapted by focusing on the things in our control. That meant staying close to our clients and helping them navigate this extremely challenging environment, while taking the appropriate steps to enhance our model's flexibility by building additional liquidity to support client cash allocation decisions. We also observed the benefits of prior strategic investments as investors increasingly turned to fixed income opportunities—taking advantage of our self-directed tools, income-focused advisory solutions, and expansive selection of proprietary and third-party fund products.

Amidst these crosswinds, our all-weather business model helped enable us to convert our ongoing success with clients into record financial results. Total revenue grew by 12% year-over-year as higher rates drove a 33% increase in net interest revenue, which more than offset softer trading and asset management and administration fees. We managed 2022 GAAP expense growth to 5%, which equates to the low end of our updated 7%–8% adjusted target range, and delivered a 50% adjusted pre-tax profit margin.^1,2 This level represents approximately 250 basis points of incremental margin expansion for the year. Hopefully you will agree that this was no small feat when dealing with a pretty challenging environment and preparing for the client conversion phase of the largest acquisition in the history of our industry.

¹_{Further details on non-GAAP financial measures are included within our 10-K filed on February 24, 2023.}
²_{Adjusted pre-tax profit margin is calculated as adjusted income before taxes on income divided by net revenues. 2022 adjusted income before taxes on income equals net revenues of $20.8 billion less total adjusted expenses of $10.4 billion, or $10.4 billion. Dividing this adjusted income before taxes on income of $10.4 billion by net revenues of $20.8 billion equals an adjusted pre-tax profit margin of 50.0%. 2021 adjusted income before taxes on income equals net revenues of $18.5 billion less total adjusted expenses of $9.7 billion, or $8.8 billion. Dividing this adjusted income before taxes on income of $8.8 billion by net revenues of $18.5 billion equals an adjusted pre-tax profit margin of 47.5%. 2020 adjusted income before taxes on income equals net revenues of $11.7 billion less total adjusted expenses of $6.8 billion, or $4.9 billion. Dividing this adjusted income before taxes on income of $4.9 billion by net revenues of $11.7 billion equals an adjusted pre-tax profit margin of 42.2%. Further details on non-GAAP financial measures are included within our 10-K filed on February 24, 2023.}

Our balance sheet contracted 17% during the year as a result of clients reallocating some of their cash toward different investment options. Our strong earnings power, along with the decline in cash housed on the balance sheet, boosted our Tier 1 Capital Ratio above our long-term operating objective—allowing us to accelerate meaningful capital return to our stockholders, including increasing our quarterly common dividend by 22% during the year, redeeming $1 billion of preferred stock, and repurchasing 47 million common shares for $3.4 billion. In total, these actions represent a payout ratio in excess of 80% for 2022—which further accentuates the 20%+¹ increase in earnings per share we delivered versus the prior year.

We are very proud of our financial performance in 2022. While there were plenty of ups and downs—and opportunities to get distracted—we stayed on course by doing what we have done for 40+ years: allowing our “Through Clients’ Eyes” strategy to power business momentum, generating revenue through diverse sources, and delivering strong financial performance through sustained expense discipline and thoughtful capital management.

2023

When I think of the year ahead, the image of a springboard keeps coming to mind. We are entering what is essentially the final year of a multiyear odyssey to complete the integration of the largest acquisition in our industry’s history. Our teams have been working around the clock since the TD Ameritrade deal closed in October 2020 to prepare for the opportunity to bring the Schwab and TD Ameritrade clients together onto what we believe will continue to be one of the leading wealth management platforms in the U.S. The remaining “last mile” of work required to move clients to the Schwab platform in 2023 and early 2024 influenced our financial outlook. At the end of the year, all of this effort and investment will have us prepared to spring into our next chapter with tremendous momentum and opportunity still in front of us.

As we exited 2022, there remained various opinions about the future path of interest rates. Depending on how this plays out, and assuming equity markets revert back towards longer-term average returns and client trading activity hovers around fourth quarter 2022 levels, we’d expect revenue growth somewhere in the mid-to-upper single digits. From an expense planning perspective, supporting our growing business while advancing the TD Ameritrade integration efforts remains our top priority. With the aforementioned client conversion starting this year, our spending will include incremental client-facing staffing and select technology outlays to help effect as smooth a transition experience as possible. Keeping all that in mind, along with certain other fee increases that are out of our control, we expect both total GAAP and adjusted expenses¹ to rise by 7%–8% versus 2022, respectively.

Bringing it all together, we believe the range of potential financial outcomes positions us to deliver at least a 48% adjusted pre-tax profit margin¹—with some potential room for upside depending on how the year evolves. In addition, owners should expect to see accelerated capital return alongside these already healthy results. When allowing for the enhanced organic capital formation of our model under the current environment, we could see our payout ratio exceed 125% for the year. Schwab’s trifecta of business momentum, financial growth, and meaningful capital return differentiates us from other firms. When you package that outstanding financial story with a track record of consistently helping clients achieve their financial goals—I truly believe we are one of the more unique companies in all of financial services.

Looking ahead

As we progress through 2023, undoubtedly, there will be a lot of focus on how reality will unfold. When exactly will cash sorting abate and the balance sheet return to growth? How will monetary policy evolve? Will expectations of a softer landing bolster consumer and investor sentiment? While these are important questions, the various potential answers actually point toward a similar conclusion. Schwab is approaching an exciting, perhaps transcendent, inflection point in our company’s history. The decisions made over the last decade have not only built upon the firm’s strong foundation Chuck laid down 50 years ago, but have also set Schwab up to thrive like never before. Following the completion of the TD Ameritrade integration, we believe our scale and efficiency within the wealth management space will be unmatched, our focus on advancing win-win monetization opportunities will further enhance our attractive “no trade-offs” approach, and our dedication to meeting the needs of individual investors and the advisors who serve them will position us for sustained growth over the long term. This combination will continue to fuel our simple, but powerful, financial formula that has performed over multiple decades—and will help enable our growth plus meaningful capital return going forward.

Thank you for your continued support of our firm’s mission, and I look forward to updating you on our progress during the year ahead.

Peter Crawford
March 7, 2023
 

¹_{Further details on non-GAAP financial measures are included within our 10-K filed on February 24, 2023.}