Letter from the CFO
Peter Crawford, Chief Financial Officer
Raising our sights
After 16 years at Schwab, I was fortunate enough to assume the role of CFO in May with the company better positioned than ever. Through a consistent focus on clients, proven strategy, competitive strength, and some help from the broader economic environment, we've now leveraged that positioning into the best results in company history. In the 2016 Annual Report, my predecessor and colleague, Joe Martinetto, remarked how there was "room to run" in 2017, and we certainly ran fast, with total client assets up 21% to $3.4 trillion, revenue growth of 15%, expense growth of 11%, a 240-basis-point rise in our pre-tax profit margin to a record 42.4%, and diluted earnings per share up 23%. In my first letter to you as CFO, I'd like to share how we capitalized on the more favorable environments in 2016 and 2017, executed on our strategy, and positioned ourselves for further success in 2018 and beyond.
But first, I thought I would briefly mention what I am hearing in my meetings with clients, investors, and employees as the new CFO. One question I am often asked is, "What are you going to change?" The short answer is, not much. I don't see a reason to dramatically alter our course, as our longstanding financial formula continues to ring true—driving solid business growth through a relentless client focus, generating strong revenue growth from diversified sources, and building improved profitability through continued expense discipline—which enables us to continue making investments in both our clients and long-term profitable growth. Schwab is, and will remain, a growth company, and my colleagues and I intend to do everything we can to continue making sound investments to grow in the future while delivering on our near-term financial commitments.
Last January, we set our 2017 plan. We had two rate hikes behind us and the hope of a few more on the horizon. The election was over and the markets were rallying ahead of the inauguration. Our financial scenario for the year assumed one rate hike in June, equity market appreciation of 6.5%, the 10-year Treasury averaging just north of 2.45%, and our trading levels relatively flat to 2016 levels. With these assumptions, we expected revenue growth in the low double digits, a gap between revenue and expense growth of 200-300 basis points, and a pre-tax profit margin of at least 41%. Confident that we had turned a corner and were accelerating into 2017, we embedded within our baseline scenario a series of bold and strategic pricing investments to drive growth. These moves included reductions in our equity and options commissions and index fund expense ratios in the first half of the year, and lower pricing on our money funds in October. Altogether, our 2017 pricing actions added up to nearly $400 million in annualized savings for our clients.
Where did we land? The equity markets were consistently strong, with the S&P 500® Index finishing 2017 up 19.4%. Instead of the one rate hike in our baseline scenario, the Fed hiked rates three times, in March, June, and December (although these didn't move the long end of the curve higher, with the 10-year Treasury yield averaging only 2.33% for the year). Client sentiment reached highs not seen since the 2000s, and investors engaged more actively with the markets.
The environment definitely helped us, but we also drove organic growth by consistently investing on behalf of our clients over the years in areas such as pricing, service, products, and technology. As Walt discussed in his letter, we strive to provide a "no trade-offs" combination of value, service, transparency, and trust to our clients and are convinced that the moves we made have not only improved the lives of our clients, but also our long-term competitive position. Our 2017 results bear this out. Clients opened more than 100,000 accounts in each month of the year, an unprecedented event. In addition, clients brought $198.6 billion in core net new assets to Schwab—the most in our history and marking a 7% organic growth rate—resulting in record total assets of $3.4 trillion. Our transfer of account ratio, which measures the dollars flowing into Schwab from our competitors divided by the dollars going out to our competitors, went from 1.6 in 2016 to 2.1 in 2017. And our Client Promoter Score, which measures how likely a client is to refer a friend or colleague to Schwab, rose in both our Retail and Advisor Services businesses to 63 and 57, respectively—levels only seen at world-class service organizations.
Our strong asset gathering and the improved interest rate environment helped produce record 2017 revenues of $8.6 billion, up 15% over 2016. Net interest revenue rose 29% to $4.3 billion, and Asset management and administration fees increased 11% to $3.4 billion, both records. These increases in our two largest revenue sources were more than enough to offset a reduction in trading revenues resulting from our pricing actions.
On the expense front, our spending rose 11% year-over-year, consistent with our expectations, including higher compensation due to increased staffing levels and incentive costs relating to our strong asset gathering, as well as increased project spending and other investments to lay the foundation for growth in 2018 and beyond. With the help of the environment, the gap between revenue and expense growth widened to 440 basis points, and we reached both a record pre-tax profit margin of 42.4% and an eight-year high for ROE, at 15%. Schwab's 2017 results demonstrate what can happen when our disciplined financial management meets a favorable external environment. We believe we are heading into 2018 with even stronger momentum!
Effective balance sheet management remains core to sustaining our success. We support balance sheet growth primarily with capital generated through earnings, as well as with external sources (like preferred stock) if necessary— while maintaining a consolidated Tier 1 Leverage Ratio above our objective of 6.75%–7.00%. In the last several years, we have chosen to utilize our capital to support balance sheet growth from both new client cash balances and bulk transfers of sweep money market funds to Schwab Bank as part of our long-term cash migration strategy. In 2017, as clients engaged with the markets, they pushed their cash levels to historic lows as a percentage of total client assets—10.8% at December 31. Given that we were mindful of approaching the $250 billion consolidated asset threshold, which brings somewhat heightened regulatory requirements, we intentionally limited the amount of bulk transfers of sweep money market funds to just $2 billion.
Another part of managing our approach to $250 billion involved the utilization of Federal Home Loan Bank (FHLB) advances to provide temporary funding for Schwab Bank portfolio investments; these advances will eventually be paid down as bulk transfers occur. The FHLB borrowings, which totaled $15 billion at year-end, enabled us to strengthen net interest revenue by getting a head start on anticipated 2018 bulk transfers while controlling our approach to the threshold. By month-end December, our consolidated balance sheet totaled $243 billion, and our year-end Tier 1 Leverage Ratio was 7.6%, well above our operating objective. We maintained our target 20%-30% dividend payout ratio by raising our quarterly cash dividend from $0.07 to $0.08 in January 2017 and then to $0.10 in January 2018. We also worked to optimize our capital mix by redeeming our Series B 6.00% preferred shares and replacing them with a lower rate preferred offering, and by issuing $1.5 billion of senior notes in advance of 2018 debt maturities and to support continued business growth.
Moving into 2018, we intend to deploy excess capital by actively transferring more sweep money market fund balances to bank sweep. We continue to see a total net bulk transfer opportunity of approximately $60-$80 billion moving to our balance sheet, where we can optimize the spread earned on sweep balances while paying clients a competitive market rate for such deposits. Operationally, it would be challenging to complete all of those transfers in a single year, so we currently expect to manage them at a rate consistent with overall balance sheet growth of approximately 15% in 2018, after taking client-driven growth into account, and cross the $250 billion threshold sometime in the first half of the year.
There are multiple variables at play, so let me walk through each one. First, existing clients may decide to engage more with the markets, as we saw in 2017, or take money out of the markets—thereby reducing or increasing their bank sweep balances. Second, clients make decisions about how much of that cash they want to move off our balance sheet in search of higher yields in CDs, purchased money funds, etc. Third, a portion of the net new assets we attract will be allocated to cash. Putting it all together, we will monitor client cash allocations from both existing and new balances and then complete bulk transfers so that the net effect of all three pieces is balance sheet growth at a pace consistent with working our consolidated Tier 1 Leverage Ratio toward, but not through, our operating objective.
Along with the "engineered" improvement in earnings power provided by bulk transfers, we are also planning for stronger revenues from continued growth in our business. Overall, assuming 6.5% S&P 500® Index appreciation, daily average revenue trades up slightly from 2017, one rate hike in June, and an average 10-year Treasury yield of 2.55%, we believe we can produce low double-digit revenue growth, a gap between revenue and expense growth of 100-200 basis points, and a pre-tax profit margin of around 43%. This scenario is consistent with our goal of balancing near term profitability with investments for long-term growth, and contemplates further improvement in our pre-tax profit margin, even after a 12+ point increase since 2012.
As many of you know, we typically highlight our ability to "flex" expense management as conditions unfold during a given year. This year may feel a little different, as we intend to make these planned investments regardless of the environment, barring some major event. Why? Part of exercising discipline is knowing when to pull back and when to push forward, and we feel the time has come for a steady hand on the throttle—we have the business momentum, with 7% organic growth; the record profitability, with margins of 42.4%; the opportunity, with more than $30 trillion in U.S. investable wealth; and the know-how to continue growing profitably and widen our competitive advantage into the future. So we expect to make significant investments in digital, our technology infrastructure, and business process redesign through 2018—all so we can "bend our cost curve" while continuing to drive revenue growth, i.e., extend our ability to increase revenues faster than expenses, into the future. None of this is new—we have always striven to leave as much as possible in our clients' pockets as we serve them, while improving our efficiency and scale, so that the net result benefits both clients and stockholders. Even as our revenue generated on client assets, or ROCA, has declined from 39 basis points in 2004, to 29 in 2010, to 28 today, we have reduced our operating expenses on client assets, or EOCA, from 32 basis points in 2004, to 24 in 2010, to 16 in 2017—enabling our pre-tax profit margin to expand from 16% to over 42% during that time. As Walt discussed in his letter, this discipline not only helps clients and stockholders, it also puts us in a formidable position versus competitors. The net effect of all of this is that there may be more pre-tax profit margin variability than expense variability versus our baseline in 2018, as we focus on a certain level of spending— if we have any help from the environment (e.g., more than one rate hike), the margin and therefore gap between revenue and expense growth should expand.
Before I close, I wanted to take a brief moment and discuss taxes. With 2018 tax reform, Schwab stands to benefit from the reduction in the statutory corporate tax rate going from 35% to 21%. While there are a number of factors that will impact the actual rate, the bottom line is that we currently expect to capture the majority of this reduction and estimate that our 2018 effective tax rate will be around 23%-24%.
While I haven't been Schwab's CFO for very long, I know that investors are always very focused on what's to come in the year ahead. I hope this letter has provided you with a good review of 2017 and the perspective you're seeking for 2018—but more importantly, I hope that you see all the opportunity that lies beyond. It's time to invest even more in driving growth. It's time to extend our competitive advantage. It's time that we all raise our sights. We are preparing Schwab for growth not just in 2018, but for the next 5, 10, even 20 years. This takes fortitude, but it's consistent with our purpose—"To champion our clients' goals with passion and integrity." As we head into 2018 and beyond, I am more excited than ever about the opportunity to demonstrate that when we do right by our clients and put them first, our stockholders and our employees also win. Thank you for your ongoing support as we build the Schwab of the future.
March 2, 2018