Letter from the Chief Financial Officer

Those of you who are familiar with Schwab’s recent history are aware that our business model has evolved substantially over the years as we’ve developed a more comprehensive set of products and services to help investors achieve their financial goals. By 2007, we earned less than 20 percent of our revenues from client trading activity, down from 53 percent in 1999. At the same time, asset management and administration fees tied to our mutual fund and advice offerings had risen to about 45 percent of total net revenues, and net interest revenue relating to our cash management and banking offerings totaled about a third.

We’ve certainly built a more diverse and stable revenue stream compared to the trading-dependent Schwab of old. If, however, someone wanted to test our current business model by throwing us into the toughest operating environment imaginable, it’s hard to see how they could have done better than what we actually faced in 2008: a faltering economy weighing on our clients’ willingness and ability to invest in the capital markets; declining equity values pressuring our asset-based revenues; and falling interest rates squeezing the spread revenue we earn on cash balances.

In my letter to you last year, I discussed how our baseline formula for financial management focuses on leveraging our operating scale and expense discipline into profit margin and earnings growth, and then leveraging capital discipline into even higher earnings per share growth. Part of the formula’s power is that it works across a broad range of conditions – even when economic growth is slowing and rates are moving toward cyclical lows. In extraordinary circumstances, however, just mechanically following the formula when factors beyond our control are pushing revenues down significantly might not be in our clients’ or stockholders’ best interests.

For example, clinging to a particular expectation for profitability or EPS growth might lead to expense cuts so severe that our client service capabilities are impaired, or to capital levels that provide a thinner-than-desired cushion against potential stresses on the company’s balance sheet.

With a 40 percent drop in the broad equity indices during 2008 and a decline in the Fed Funds rate from 4.25 percent to essentially zero, it was clear we needed to act. Our philosophy of taking the long view in building value for clients and stockholders meant that our path was also clear: balance the more aggressive expense management needed to offset declining revenues against the ongoing investment needed to drive future growth. We also recognized the need to work with the other elements of the formula under our control – a relentless focus on our clients and their needs, as well as careful risk and capital management – in order to deliver the strongest possible near-term performance while protecting our longer term opportunities.

Did our balancing act succeed in 2008? As Walt has shared with you in the preceding CEO letter, by sticking to our strategy and putting the needs of our clients first and foremost, we were rewarded with another year of strong asset inflows as clients remained engaged in managing their financial affairs.

This success with clients, in turn, helped asset management and administration fees stay comparable to 2007 levels and net interest revenue to rise by 1 percent despite the deteriorating environment, while trading revenue actually rose by 26 percent. With overall net revenues up by 3 percent and minimal impact from the ongoing mortgage and credit market meltdowns, we were largely able to concentrate on sustaining our momentum, and we even increased our marketing investment by approximately 6 percent. Our ongoing efforts to improve operating efficiency and leverage the scale in our support enterprises enabled us to trim overall expenses by 1 percent, which in turn led to a 39.4 percent pre-tax profit margin and a 10 percent increase in income from continuing operations to $1.2 billion, both records, as well as a 31 percent return on equity.

As we think about the outlook for 2009, we have to acknowledge that, as of today, there’s no positive catalyst in sight for the economy or those two big external influences on our revenues – short-term rates and equity valuations. Given that these drivers are starting out dramatically lower than a year ago, we believe this is a case where even more aggressive measures are called for if we wish to maintain critical investments for the future and still deliver the solid financial performance our owners expect. As a result, we currently plan to cut our total expenses by 7 to 8 percent between 2008 and 2009. This reduction will come from lower levels of staffing, professional services, development projects, and certain aspects of our marketing efforts. Including these expense cuts – but excluding any related charges – we’d expect to achieve a pre-tax margin of at least 30 percent for 2009 if equity valuations and short-term rates are consistent with or above year-end 2008 levels.

I should note there’s no bright line here in terms of minimum performance expectations in tough environments, nor do we think you’d want us to impose one. Instead, we believe the ongoing application of judgment in determining and maintaining the right mix of operating costs, investments for the future, and current profitability will enable us to maximize the company’s long-term value to clients, stockholders, and employees.

There are, however, certain areas where you can expect a more dogmatic approach from us in running Schwab. First, the company’s struggles following the Internet bubble provided a firm reminder that we cannot solve revenue or profitability challenges by imposing on the goodwill and loyalty of our clients. Our pricing, client service capabilities, and product offerings must remain competitive through all environments, and we’ll just have to make the tradeoffs necessary to ensure that happens.

In addition, we intend to sustain a conservative approach to managing financial risk at Schwab. Our philosophy is straightforward – we’re not trying to eliminate risk across our businesses, but we do expect to identify and manage it on a continuing basis. Schwab exists to help investors become financially fit, and we intend to earn our keep by serving that need, not by artificially manipulating the balance sheet, wandering into activities where we lack core competencies or clear client need, or chasing after higher returns on our investments without regard for credit quality.

We may very well have more tough choices to make before the operating environment improves, but the old expression “That’s why it’s called management” comes to mind – if all we had to do was set and then rigidly follow a formula, you’d rightfully be asking what the Schwab executive team was doing with the rest of our time. Whatever 2009 and beyond holds in store for us, I can assure you that this team is dedicated to coming to work every day with the goal of finding a better way to serve clients, and then turning that success into standout financial performance. We hope to earn your continued support.

Joe Martinetto

March 12, 2009