Weekend Reading for Financial Planners (Apr 2-3)

Author: Michael Kitces

Team Kitces

Michael Kitces is Head of Planning Strategy at Buckingham Strategic Wealth, which provides an evidence-based approach to private wealth management for near- and current retirees, and Buckingham Strategic Partners, a turnkey wealth management services provider supporting thousands of independent financial advisors through the scaling phase of growth.

In addition, he is a co-founder of the XY Planning Network, AdvicePay, fpPathfinder, and New Planner Recruiting, the former Practitioner Editor of the Journal of Financial Planning, the host of the Financial Advisor Success podcast, and the publisher of the popular financial planning industry blog Nerd’s Eye View through his website Kitces.com, dedicated to advancing knowledge in financial planning. In 2010, Michael was recognized with one of the FPA’s “Heart of Financial Planning” awards for his dedication and work in advancing the profession.

Read all of Michael’s articles here.

Weekend reading for April 2nd/3rd:

Betterment Raises $100M To Step Up Efforts To Win The HNW Wallet (Lisa Shidler & Brooke Southall, RIABiz) – This week, Betterment announced a whopping new round of venture capital, raising $100M from the combination of a Swedish investment company and four already onboard VC investors, and pegging the company’s valuation at $700M (up from $450 last spring). Over the past 15 months, the company has grown from 50,000 clients and $1.1B of AUM to 150,000 clients and nearly $4B, though it is still rumored to be burning through about $30M of capital annually to fund its operations and marketing. In the core business, Betterment CEO Jon Stein indicates that the goal is eventually to make Betterment a one-stop shop for a wide range of investors from mass market up to high-net-worth clientele as well, building out capabilities from a Mint.com-style account aggregation service to future capabilities like being able to offer check-writing and accept direct deposit paychecks. Though some of the company’s best traction may be its 401(k) business, where it already has nearly 100 plan sponsors, including a number from firms with 500+ employees participating; the company is succeeding because its technology makes it feasible to charge barely half what the cheapest other 401(k) providers in the industry do, and still earn good profit margins. More generally, as Betterment increasingly pushes out into more and multiple channels at once, the company is looking less like other ‘niche’ robo-advisor players, and more like other established multi-channel financial services providers, including Schwab and Fidelity, going to all the common industry verticals (RIAs, retirement, and mass market consumers), but building on Betterment’s new ‘modern’ technology.

Wealthfront Turns To Artificial Intelligence To Improve Robo Advice (Ryan Neal, Wealth Management) – Yesterday, Wealthfront announced what it calls “Wealthfront 3.0”, the latest version of its platform that aims to incorporate an increasing amount of artificial intelligence into its advice. The idea is that Wealthfront will invite users to digitally connect all of their accounts to the Wealthfront platform (through account aggregation), and Wealthfront will then look at their actual actions to understand the client’s financial behaviors, and provide advice about what they might do differently. For instance, the software might look at a client’s spending, and the size of their emergency fund, and make a recommendation about whether or not the emergency fund needs to be increased given actual spending habits (and not just what the client thinks they might need based on what they think they spend). Or viewed another way, Wealthfront appears to be banking on the capabilities of Artificial Intelligence to become an actual "robo-advisor"! Notably, though, Wealthfront is remaining committed to being a Direct-To-Consumer company, and as a result is integrating directly to the kinds of software that Millennials use (e.g., Venmo for transferring money, the bitcoin wallet Coinbase, and the P2P platform Lending Club), and continues to insist it is primarily a technology company, not just one that competes for assets.

Fidelity Starts Testing Adviser Service On Existing Clients (Margaret Collins, Bloomberg) – Fidelity announced this week that it is expanding the reach of its Fidelity Go “robo-advisor” service, which previously was being used in beta by its employees, and is now rolling out to a small group of existing Fidelity customers as well. And similar to the focus of other “pure” robo-advisors, Fidelity notes that it specifically plans to target its service towards first-time investors between the ages of 25 and 45. Like other automated investment services, Fidelity Go will have clients answer half a dozen questions about their household income, financial goals, etc., and will then generate a recommended portfolio mix (to include both Fidelity index funds and BlackRock exchange-traded funds). Customers can ask additional questions by telephone or online chat. The Fidelity Go service will be priced at 0.35% - 0.39% (ostensibly that’s in addition to the underlying cost of the funds), with a $5,000 account minimum, and is expecting to launch the service to the broad public in the second half of the year.

Schwab Gives Salesforce The Heave-Ho As Hub Of Intelligent Integration (Lisa Shidler, RIABiz) – This week, Schwab announced that it is unbundling its deeply-integrated Salesforce partnership that was previously the hub of its Schwab Integrated Office platform, and instead will open its platform to allow advisors to adopt their own versions of Salesforce (or other CRM providers). Schwab reports that its decision to unbundle a deeply integrated Salesforce initiative dating back to 2010 is in recognition that while in the past advisors had few choices for CRM solutions, now there are more available (such that Schwab doesn’t need to offer its own). Critics, however, suggest that the Schwab statement is cover for a more embarrassing reality: that Schwab was just not succeeding in making its Salesforce integration work as expected, particularly because rising expectations for CRM customization left Schwab responsible for more service and support than they were prepared to give, and a growing number of advisors were grumbling. Now, however, nearly 150 advisors will be left in the lurch, scrambling to find a new CRM provider (and/or someone new to support their existing now-unbundled Salesforce license, which advisors can then independently connect back to OpenView) by Schwab’s July 31^st drop-dead date. More generally, though, Schwab’s retreat from its bundled platform may cast a pall over bundled solutions from any platform, a potential challenge for Fidelity’s coming WealthScape bundled platform, and a potential boon for players like TD Ameritrade that have pursued an unbundled open-architecture strategy from the start.

LinkedIn ProFinder Links Financial Advisers With Prospective Clients (Ali Malito, Investment News) – LinkedIn has launched a new tool called “ProFinder”, which helps LinkedIn users find professionals… including financial advisors. Consumers can submit a request for assistance, currently in ‘expertise’ areas including CFPs, CFAs, retirement planning experts, CPAs, wealth managers, and more. When a user selects their choice, a list of recommended professionals come up (who must have applied to be part of the service and been vetted by LinkedIn’s ProFinder team). One early advisor adopter of the platform notes that the lead he recently received appeared to be quality and in-depth in its request, though some suggest that most leads from ProFinder will likely be “middle market” clients, as it’s not clear that more affluent clients will necessarily seek out a financial advisor this way.

It’s Time To Retire Ruin [Probabilities] (Moshe Milevsky, Financial Analysts Journal) – Monte Carlo analysis, and the idea of a probability of failure (or ‘financial ruin’), has exploded in popularity amongst financial advisors in the past 15 years. But the idea of quantifying a probability of ruin has actually been used amongst insurance actuaries for nearly a century as a means to determine approach insurance premiums. In fact, it’s the basis by which regulators determine approach reserve and capital guidelines. It's also similar to how analysts set ratings and credit default risk probabilities for bonds. Notwithstanding this growth, though, Milevsky raises concerns about how ruin probabilities are being used, particularly amongst financial advisors. First and foremost is the fact that there’s no clear agreement on how much of a shortfall probability is acceptable. Should clients tolerate a plan with a 10% probability of failure, or only 0.1%, or as high as 25% (which, after all, is still 75% likely to succeed!). And of course, not all failures at a given probability are the same kind of failure, and one might have a far more severe magnitude of failure, which should be considered too (but isn’t from a pure probability-of-success number). In addition, these analyses assume we have a clear understanding of the underlying economic assumptions that should power the Monte Carlo analysis, which isn’t necessarily certain (history may be a guide about expected long-term returns, but it certainly isn’t a certainty). Notably, the issue isn’t unique to portfolio-based retirement projections, either; again, insurance companies use the same approach, and can succumb to the same problems (i.e., your lifetime annuity is only guaranteed to the extent the insurance company actuaries make better assumptions than your own retirement portfolio projections?). So what are the alternatives? Milevsky suggests taking a step back to a simpler and more straightforward approach, which begins by calculating (based on a reasonable net rate of return assumption) the likely time horizon of the portfolio (on average, how long will it last, and does that cover at least most of the client’s retirement anyway given a reasonable life expectancy assumption?), and only then proceed to the more nuanced calculations for the subset of scenarios where it’s necessary.

Eight Core Ideas To Guide Retirement Income Planning (Wade Pfau, Advisor Perspectives) – Wade Pfau is a recognized leading researcher in retirement, and in this article he sets forth the key messages and themes that underscore his research in retirement planning and the approach that it implies. The eight core ideas are: Play the long game (a retirement income plan should be based on planning to live, rather than planning to die, which implies the benefits of tactics like delaying Social Security, buying a lifetime annuity, setting up a plan to account for the risk of later cognitive decline, etc.); Do not leave money on the table (e.g., be certain to do partial Roth conversions or capital gains harvesting if available at 0% long-term capital gains rates); Use reasonable expectations for portfolio returns (e.g., don’t use long-term historical average return assumptions when valuations are known to be high and rates are known to be low!); Beware retirement plans that only work with high market returns (be cautious about spending more today in anticipation of higher market returns in the future, that may or may not manifest in time); Build an integrated strategy to manage the various retirement risks (from longevity risk and the unknown planning time horizon, to market volatility and macroeconomic risks, inflation and spending shocks, etc., which will require a range of products and solutions to cover a range of risks); Approach retirement income tools with an agnostic view (don’t get stuck focusing on ‘only’ investment or ‘only’ insurance-based solutions, as both can have value); Consider the entire household balance sheet (including human capital, home equity, and even Social Security which may not be a liquid asset but has material value nonetheless); and Distinguish between technical liquidity and true liquidity (being liquid enough to do your retirement spending is different from having ‘excess liquidity’ where you can truly do whatever you want with the funds because you don’t need them at all).

Are DIAs Better Than SPIAs – Maybe Not? (Joe Tomlinson, Advisor Perspectives) – Deferred Income Annuities (DIAs), also known as longevity annuities, have been gaining increasing visibility in recent years as a superior alternative to Single Premium Immediate Annuities (SPIAs), particularly after new 2014 Treasury Regulations that will allow such annuities to be owned inside of a retirement account (as a “Qualified Longevity Annuity Contract” [QLAC]). Notably, though, DIAs can potentially be used in different ways – some might buy the annuity earlier in life to have income start at retirement (e.g., buy at age 55 to begin payments at 65), while others might buy at retirement to fund just the later years of retirement (e.g., buy at 65 to begin payments at age 85). And in the earlier context in particular, the results actually aren’t very favorable for DIAs; an investor who was planning to buy a DIA at age 55 to begin at 65, given current rates, would just need to earn 3.8% from long-term bonds over the next 10 years to wait and simply buy a SPIA then at age 65. Of course, if interest rates rise over the next 10 years, the value of the bonds may fall, but if the prospective retiree plans to buy a SPIA at age 65, the future payout rates will improve with higher interest rates, which suggests the conservative investor is still at least partially inoculated against interest rate increases by waiting to buy the SPIA at retirement. Similarly, buying a QLAC in retirement (plus a Treasury bond ladder during the intervening years) doesn’t fare any better than a SPIA either, and in fact payouts out 13%-22% less in equivalent income (depending on whether the SPIA includes a death benefit guarantee as well). Of course, the DIA also creates the most liquidity and flexibility (since only 12% of the assets actually go into the DIA, and the rest remain invested in bonds), but Tomlinson suggests that’s simply part of the trade-off in considering a SPIA vs DIA strategy. And comparing a longevity annuity doesn’t even hold up well against a diversified portfolio either, unless future market returns are drastically lower than even the worst historical US scenarios.

No-Gift Irrevocable Life Insurance Trust Funding (Richard Harris, Wealth Management) – Owning life insurance inside of a trust is a popular tactic to keep the life insurance death benefit out of the estate of the insured. However, the classic challenge is how to get the premiums into the trust in the first place. The most common approach is to make outright gifts and use Crummey notices to ensure that the gifts are eligible for the annual gift tax exclusion. However, for particularly large insurance policies inside of an ILIT, this approach can be problematic, as premiums may exceeds the annual gift tax exclusion, with a survivorship policy half the annual exclusions are lost at the death of the first spouse, and large gifts can also complicate Crummey powers given the need to include hanging powers. One strategy to mitigate this challenge is to create a split dollar arrangement with the trust, where the premium funder retains the right to receive back the policy cash value or the sum of premiums previously paid, which reduces the size of the gift to just the annual cost of insurance for the net death benefit. Another alternative, though, is a “no-gifting” strategy by using a loan arrangement instead, which became permissible in 2003 after Treasury Regulation 1.7872-15 came into existence. The loan is made from the premium funder to the trust, for which the trust must eventually repay the principal and a “reasonable” rate of interest, but the interest rate is based on the Applicable Federal Rate (AFR), and in today’s low interest rate environment the cumulative loan interest is trivial. In fact, one version of the tactic is to make a lump sum loan for the anticipated cumulative amount of future premiums, and then let the trust invest the funds to generate sufficient interest/growth to fund the annual loan interest payments, which also makes it easy to exit the strategy if necessary – just liquidate the investment funds, and use them to repay the loan.

Do Actively Managed Small-Cap Funds Add Value? (Larry Swedroe, Advisor Perspectives) – It is a common contention of active managers that the market for small cap stocks is less informationally efficient, and therefore has opportunities for managers to find underpriced investments to buy and enjoy excess returns (or alternatively, overpriced small cap stocks to short). To assess the claim, Swedroe looks at the 10 largest small-cap funds (as measured by AUM), over a long-term time frame of 15 years (to smooth out any short-term economic cycles), noting that investors who added money later may have had lower performance and that choosing surviving 15-year funds implicitly introduces survivorship bias. When compared to a Vanguard small-cap index fund, or DFA’s own small cap funds, Swedroe notes that over the time horizon, most of the largest small-cap funds actually did outperform, with an average annualized outperformance of 1.5% (over the Vanguard index; 0.7% over DFA). However, Swedroe finds that when delving deeper, most of the excess returns can be explained by the managers’ exposures to some combination of known factors (e.g., low beta, quality, momentum, value, etc.), and that once the six leading factors are controlled for, the small cap manager alpha disappears (with only 4-out-of-10 funds producing positive alpha, and none statistically significant for a sample of this size). And taking a broader look only fares even worse; the SPIVA scorecard, which includes all small cap funds (including ones that are no longer around) over the past 10 years, finds a whopping 86% - 92% of small-cap active managers (depending on growth, blend, or value) underperformed their benchmark index. Similarly, a look at the full Morningstar database of small-cap funds that have 15-year track records also finds that the majority of actively managed funds underperformed (although a subset of “good” managers did outperform, albeit by less than the “bad” managers lagged). Of course, even a small cap index fund should have some negative alpha after adjusting for the known factors (by roughly the amount of their expense ratios plus trading costs), but on the whole active small cap managers are not even meeting this benchmark, with a few managers who outperform by a little but the majority underperforming by a lot (and of course, difficulty in knowing ahead of time which will turn out to be which!).

How The U.S. Government Inadvertently Launched The $3 Trillion ETF Industry (Eric Balchunas, Bloomberg) – In the aftermath of the crash of 1987, the SEC issued a report entitled “The October 1987 Market Break” to conduct a postmortem on the event, and one of the SEC’s observations was that the damage may have been mitigated if market markers could have turned to a single “product” for trading baskets of stocks, which might have served as a buffer for the circular trading sell-off that occurred when stocks and stock futures crashed together that day. At the time, the American Stock Exchange (AMEX) product managers decided to capitalize on the idea (and differentiate themselves from the more popular NYSE and Nasdaq exchanges), inferring that if the SEC suggested such a solution, they would be likely to approve the new product relatively quickly. The starting point was reaching out to Vanguard, and proposing a market-traded index mutual fund solution tied to Vanguard’s funds, which was actually pitched to Jack Bogle at the time, and was rejected (primarily because he was concerned that investors would trade in/out of the fund, rather than sticking to the index fund as a long-term investment). Yet Bogle’s rejection and criticism drove the AMEX product developers to determine how to create a product that could allow investors to trade a fund throughout the day, without driving up the underlying trading costs; what emerged was the exchange-traded fund, and its in-kind creation/redemption process. Ultimately, SEC approval was more difficult than expected, and AMEX’s 1989 application took four years to get through, as the SEC scrutinized the proposed product trying to evaluate its ramifications (and notably in the meantime, Canada actually launched its own version first, called Toronto Index Participation Shares, in 1990). Of course, the irony is that in today’s environment, ETFs have become so successful that now regulators are now concerned about the trading activity in ETFs as well, particular given their problematic trading last Monday, August 24^th, where the S&P 500 fell 5.3% at the market open, trigger 1,278 trading halts, of which 80% were ETFs (and many of which subsequently traded at drastic and somewhat disruptive ‘temporary’ discounts). ETFs remain on the SEC’s short list for “examination priorities” in 2016.

Everything You Need To Know About Whether Money Makes You Happy (Robert Wiblin, 80,000 Hours) – The cliché is that “money can’t buy happiness”, yet surveys indicate that “financial security” is a primary career priority for most, and when people are asked what would most improve the quality of their lives, “money” is the most common answer. A growing base of research finds that the “right” answer seems to be something in between. Increasing income does appear to have at least some relationship to higher life satisfaction, based on large international surveys of hundreds of thousands of people, but the effect is modest and diminishing – doubling your income was associated with life satisfaction by about 0.5 points on a 1 to 10 scale, but then another 0.5 point increase requires doubling income again from there (up 4X from the original income). Yet while higher wealth seems to be associated with higher overall life satisfaction, on a day to day basis, the relationship is less clear; one leading study found that day-to-day self-reported happiness was similar for everyone above about $75,000 of annual income (although overall, people in richer countries still tend to be happier on a day-to-day basis than those in poorer countries). In addition, it’s not entirely clear how causal the relationship is. For instance, some of the most high-paying jobs are very unsatisfying, while many low-paying jobs provide significant personal fulfillment (which is why they can ‘get away’ with being low paying), which means pursuing job changes for more income may not result in much change in happiness at all (trading off the better happiness of more money for the reduced satisfaction of a more money-centric and less personally fulfilling job). And the so-called “hedonic treadmill” plays a role as well – we adapt so quickly as humans, that when we spend more, we get used to that standard of living, and then just want even more. Ultimately, though, the key point of the research is that these money effects on happiness are quite small compared to other things that do more to make us happier; for instance, the happiness boost produced by marriage would require a 767% increase in income to match it, the increase in happiness from improving health would require a 6,531% increase in income to match, and even just shortening your commute has a rather significant impact on happiness!

Get 5% Better (Shane Parrish, Farnam Street) – Achievement-oriented individuals often have a drive for continual improvement, focusing on weaknesses and trying to turn them into strengths. The caveat, of course, is that real change is hard, and we often struggle to follow through on the things we know will make us better. Parrish suggests that part of the problem is our failure to understand how change really happens. Most expect that change will happen quickly – we set our minds to do something, and then we do it that way forever. Yet the reality is that change is not sudden, and typically takes long, repeated effort to get there. In other words, we change not all at once, but through a process of ongoing refinement. For instance, just getting 5% wiser and better every year will make you twice as wise in 15 years, and more than 4X wiser or better (or whatever you’re trying to improve) in 30 years. Or viewed another way, compounding is just as relevant in the world of personal improvement as it is in portfolio investing. Ultimately, the key takeaway is simply to recognize that personal improvement is not a single sudden event, but an ongoing incremental effort that compounds in meaningful ways over long periods of time.

I hope you enjoy the reading! Let me know what you think, and if there are any articles you think I should highlight in a future column!

In the meantime, if you're interested in more news and information regarding advisor technology I'd highly recommend checking out Bill Winterberg's "FPPad" blog on technology for advisors. You can see below his latest Bits & Bytes weekly video update on the latest tech news and developments, or read "FPPad Bits And Bytes" on his blog!