Weekend Reading For Financial Planners (Feb 18-19)

SEC Proposes Expanding Adviser Custody Rule To All Discretionary Advisers

(Mark Schoeff | InvestmentNews)

The Securities and Exchange Commission’s (SEC’s) Custody Rule is designed to provide for the safekeeping of investor funds and securities, and to prevent such funds and securities from being misused or misappropriated by investment advisers. First adopted in 1962, the rule essentially called for segregated bank deposits, client notification about the location of their funds and securities, mailed quarterly account statements (from the adviser), and an annual surprise exam by an independent public accountant. Because of these additional compliance burdens, in practice most investment advisers try to avoid custody and simply rely on the use of third-party custodians (e.g., Schwab or Fidelity) instead.

The custody rule has been amended throughout the years, including changes in 2003 (that introduced the concept of a “qualified custodian”) and in 2009 (when, in the wake of the Bernie Madoff scandal, the SEC increased reporting obligations and required an “internal control report” from qualified custodians that were related to advisers, among other measures).

This week, the SEC issued a proposal that would amend the custody rule for the first time since the 2009 changes. The proposal would extend custody obligations beyond securities and funds (subject to the current rule) to encompass all assets in a client’s portfolio, including private securities, real estate, derivatives, cryptoassets (that are not securities), and other assets. As the SEC is increasingly concerned that some advisors may be avoiding the intended scope of the custody rule (to ensure additional compliance oversight where advisers have direct access to and control over client assets) with the rising use of alternatives and private markets and crypto. The amendments also would require advisers to enter a written agreement with a qualified custodian to protect client assets, and would require advisers to hold private assets with a qualified custodian unless they can show that doing so would not be reasonable.

Of more direct impact to the traditional financial advisor, though, is that according to an SEC fact sheet on the proposal, an investment adviser who can make trades on behalf of a client (i.e., has discretion) would be deemed to have custody of the client’s assets. Which could substantively shift a very sizable portion of the wealth management RIA community under the custody rule. Though it remains to be seen whether or what exact custody rule compliance requirements would be introduced for advisers who have custody through discretion, but are still otherwise using third-party qualified custodians.

The proposal will be open for a 60-day comment period, after being published in the Federal Register in the coming weeks. If enacted, RIAs with under $1 billion in assets would have 18 months to come into compliance with the regulation, while larger firms would only have 12 months to do so.

And so, while RIAs are used to managing client stocks, bonds, and funds through custodians, the proposed rule would significantly broaden the range of assets that would need to be managed through a qualified custodian (particularly notable at a time when private and alternative investments have become increasingly popular), and would for the first time scoop up all investment advisers who manage with discretion (which has become increasingly common in recent years as advisers operate more and more often using centralized model portfolios). Still, though, it remains to be seen exactly what additional requirements will be expected of RIAs that have discretion-based custody… and/or whether the RIA industry will be able to push back for an exception when third-party qualified custodians like Schwab, Fidelity, or the broad range of other popular RIA custodians, are already being used to protect client assets themselves.

Florida Court Strikes Down DOL’s FAQ Guidance That Was Making One-Time Rollover ‘Advice’ Fiduciary

(Mark Schoeff | InvestmentNews)

In December 2020, the Department of Labor (DOL) adopted Prohibited Transaction Exemption 2020-02 (“PTE 2020-02”). This exemption allows investment advisers and broker-dealers to receive otherwise prohibited compensation, including commissions, 12b-1 fees, revenue sharing, and mark-ups and mark-downs on certain principal transactions, as long as the recommendation is otherwise in the best interest of the client. However, in order for this Best-Interests requirement itself to apply, the investment adviser or broker-dealer must be giving ‘advice’ that is subject to the DOL’s rules in the first place, which traditionally was determined under a “five-part” test going back to ERISA’s origin in 1975 (that it’s advice or recommendations about investments… for a fee, on a regular basis, pursuant to a mutual understanding, that the advice will be the primary basis for the client’s decision, and is individualized to their circumstances).

However, in 2020 the DOL also significantly changed its interpretation of the “five-part fiduciary test” in an update to the exemption’s preamble, and asserted in an April 2021 Frequently Asked Questions (FAQ) document that even a one-time recommendation to roll retirement assets from a company plan to an Individual Retirement Account (IRA) would trigger fiduciary duty requirements under the Employee Retirement Income Security Act (ERISA), notwithstanding the original 5-part test requirement that the advice must be provided on a “regular” (which is generally interpreted to mean repeated or ongoing) basis.

And so this week, the U.S. District Court for the Middle District of Florida ruled that the DOL was “arbitrary and capricious” in its interpretation of the “five-part fiduciary test” (and its re-interpretation of ‘regular basis’), and vacated the policy referenced in the FAQ document. The ruling noted that while a rollover recommendation might represent the beginning of an ongoing advice relationship, advice given following the rollover would no longer be applied to retirement plan assets, and would therefore be outside the purview of ERISA requirements.

The ruling was cheered by the American Securities Association, which brought the lawsuit against the DoL (and represents, among others, small and regional broker dealers that would have faced a higher fiduciary burden for recommending rollovers under the DOL guidance), though the DoL could appeal the ruling.

Notably, though, the DoL is in the midst of proposing a new ‘fiduciary rule’ that could expand the definition of a fiduciary under ERISA (not via guidance but pursuant to a formal rulemaking process) and, if enacted, potentially moot this week’s court ruling (though a new fiduciary rule will likely face a barrage of lawsuits from the broker-dealer and insurance industries similar to those that led to the Fifth Circuit Court of Appeals ultimately vacating the prior DoL fiduciary rule in 2018).

Ultimately, the key point is that this week’s ruling (at least temporarily) lowers the bar for one-time rollover recommendations from workplace retirement accounts, particularly for broker-dealers and their registered representatives who are not subject to other fiduciary requirements (e.g., the SEC’s fiduciary rule for RIAs). Though notably, because the ruling was targeted specifically at the guidance regarding one-time rollover recommendations, other disclosure and conduct standards included in PTE 2020-02 remain in force, and proposed higher standards could be on the way in the form of a new DoL ‘fiduciary rule’!

Vanguard Going All In On Direct Indexing, CEO Says

(Ron Day | ETF.com)

Amid growing interest in direct indexing (whose use cases and potential users have expanded well beyond its original focus on tax management for high net worth individuals), competition has heated up among asset managers to provide direct indexing services to their clients. For instance, in 2022 Charles Schwab introduced its Schwab Personalized Indexing platform, available to advisors and retail clients with a $100,000 account minimum, and Fidelity introduced a new direct indexing platform for advisors, the Fidelity Institutional Custom Separate Managed Account (SMA), as well as its Fidelity Managed FidFolios offering for retail clients.

Further, asset management giant Vanguard made waves in 2021 when it acquired direct indexing platform JustInvest (Vanguard's first-ever external acquisition), announcing its entry into the direct indexing space. And this week, Vanguard CEO Tim Buckley said at the Exchange ETF conference that the firm will “invest heavily” in direct indexing. This is notable, as wider adoption of direct indexing (where investors purchase shares of individual companies directly rather than through a fund) has the potential to eat into the funds allocated to mutual funds and ETFs (Vanguard is the market leader in mutual fund assets and is in second place for ETF assets). But rather than taking a hostile approach to direct indexing, Buckley said Vanguard sees it potentially benefiting investors broadly and will be looking to take advantage of the opportunity it presents.

Altogether, the major asset managers have signaled continued interest in developing their direct indexing offerings. Though given differences in the range of direct indexing platforms, advisors can choose the option that best meets their (and their clients’) needs, whether it is a tax-focused offering that best tracks gains and losses of all the individual positions in the portfolio, or platforms for creating personalized indexes that offer a user-friendly client interface!

How RIAs Are Dealing With Hiring And Compensation Challenges

(Brandon Kawal and Rebecca Daves | Wealth Management)

Amid a continued tight labor market, the competition for advisory firm talent has heated up. And while firms have long faced a competitive market for experienced advisors (who need to be induced, through additional pay or other benefits, to leave their current firm), many firms are now experiencing a shortage of applicants to fill entry-level roles (e.g., client service associates), according to a study by consulting and transaction advisory firm Advisor Growth Strategies.

Conducted in the fourth quarter of 2022, the survey of RIAs found that the competition for entry-level talent has put upward pressure on wages, with roles that might have previously had a starting salary of $40,000 to $45,000 now being offered salaries $15,000 or more above those levels. In addition to salary, the study found that benefits packages are becoming more important as well. The survey found that 29% of firms cover 100% of employee health benefits (with a majority of firms contributing to premiums for family coverage) and more than three-quarters of firms offer dental and vision coverage. And when it comes to retirement savings, 94% of RIAs surveyed said they provide a match for employee 401(k) contributions and 29% of firms add profit-sharing into 401(k)s on top of the match. To help employees with their own financial planning needs, discounted planning or investment management services were offered at 29% of firms.

Firms that want to attract and retain talent can also consider how new hires are trained, developed, and advance within the firm. For instance, Advisor Growth Strategies found that the firms with the lowest turnover rates are those that demonstrate a career path for new hires and compensation increases that reflect their progression. And while providing training and development opportunities for new hires can come with an upfront cost to a firm, it can pay off both in having more capable staff down the line and in making it less likely that the employee will want to leave (which would result in another costly hiring and training process).

Ultimately, the key point is that firms that are hiring can make themselves more attractive to jobseekers by taking a holistic look at what they offer their employees. From salary and benefits to work culture and opportunities to develop, firms that can offer the most competitive compensation packages (which go beyond just salary) to candidates could see the most success in hiring in the current tight labor market!

Business Hygiene Vs Business Health

(Brett Davidson | FP Advance)

There is no shortage of tactics that financial advisory firms can consider to improve their profitability. But according to David Maister, author of the book Managing The Professional Service Firm, firms sometimes focus on actions that promote short-term profitability (‘hygiene’) rather than those that will increase the fundamental profit potential of the organization (‘health’). And just as a person who meticulously brushes their teeth (showing good hygiene) but only eats fast food might have poor overall health, if a firm focuses its energy on the ‘hygiene’ elements, it can find that its long-run ‘health’ issues are undermanaged.

For Maister, raising prices offers the most potential impact on profit ‘health’. In order to attract and retain clients while charging higher fees, firms that invest in providing new (higher value) services, speed up the skill-building process for its staff, and add more value through specialization. Another tactic that can improve firm ‘health’ is reducing the delivery cost for each engagement, which can potentially be accomplished by finding ways to have work completed by more junior staff (who are less expensive) rather than by senior advisors and by developing methodologies to avoid duplication of effort. On the opposite end of the spectrum, finding ways to lower overhead costs (e.g., reducing support staff or equipment costs) is more of a ‘hygiene’ tactic in that it could boost profits in the short run by reducing costs but might not improve the long-term health of the firm (particularly if reducing support staff means that more-expensive senior advisors have to take on an increasing burden of planning work).

Overall, the key for firms is to identify the practice management tactics that will lead to healthy long-run profitability rather than a short-term boost to the firm’s bottom line. From raising prices (whether by raising fees or by bringing in higher-fee clients) to building the skills of junior staff members (who can take planning tasks off of the plate of senior advisors), these tactics might feel challenging to implement (e.g., introducing a fee increase to current clients) or come with a dollar cost (investing in training for staff members), but doing so can pay off for the long-term success of the firm!

Stock Pullback Has More Advisors Diversifying Away From Asset-Based Fees

(Jeff Benjamin | InvestmentNews)

Assets Under Management (AUM) fees have long been the dominant fee structure for fee-only financial advisory firms. But recent years have seen the growth of alternative fee-for-service models, such as retainer, hourly, or project-based planning, which can reach potential clients who might not meet a firm’s minimum assets (but do have the income to pay planning fees) and can help insulate a firm’s revenue in case of a market downturn (which can reduce asset-based fees, even as the firm provides a similar level of service). And recent data from Advyzon suggests that an increasing number of firms are offering more than one fee structure.

Advyzon found that 92% of firms on its advisor platform used multiple fee schedules in 2022, up from 81% the previous year (notably, both large and small firms used multiple fee structures, with 90% of firms with less than $100 million in AUM and 95% of firms with more than $100 million in AUM doing so). Flat-fee models have also gained in popularity, with 39% of firms using them in 2022, compared to 26% in 2021 (44% of large firms and 35% of small firms offered a flat-fee option, according to the data).

The study also identified changes in when firms bill their clients, finding that the number of firms offering monthly billing has increased (though, notably, the number of firms offering quarterly billing also increased, suggesting that firms are offering more billing flexibility overall). And while billing on the client’s average daily portfolio balance remains the least common of the options for firms with an AUM model, advances in advisor technology making it more feasible could see its popularity increase in the future (as it reduces the risk that fees will dramatically increase or decrease based on sudden market moves at the end of the billing period, potentially offering a smoother ride for both advisors and their clients).

Altogether, Advyzon’s data reflect similar results from the recently released Kitces Research report on How Financial Planners Actually Do Financial Planning, which found that while 82% of advisors surveyed get the majority of their revenue from AUM fees, 74% use more than one charging method. So while AUM continues to hold a dominant position among advisor fee structures, firms appear to be offering flexibility both in the way they charge clients (e.g., quarterly or monthly) and in terms of the fee models they offer!

Redefining The Retirement Income Goal

(David Blanchett | Enterprising Investor)

One of the most common questions that clients nearing or in retirement ask of their advisors is how much they can afford to spend each year without depleting their assets during the remainder of their lifetime. And thanks to financial planning software and related tools such as Monte Carlo simulations, advisors can help clients better understand whether they are on a sustainable spending path. At the same time, many of these tools assume that clients will have relatively fixed spending (perhaps adjusted for inflation) throughout retirement (particularly if the plan is being made on a one-time basis, rather than making adjustments over time). This can lead to conservative outputs for sustainable spending, as a Monte Carlo analysis will treat a simulation that falls $1 short of the client’s target spending as a failure (and assumes that the client would not be willing to reduce their spending).

However, a survey of 1,500 defined contribution retirement plan participants between the ages of 50 and 70 conducted by Blanchett and PGIM found that in reality, these individuals are willing to be more flexible with their spending that planning software programs might assume. For example, in response to a question about how a 20% spending drop would impact their retirement lifestyle, 45% of respondents said that such a reduction would require some changes, but could be accommodated, while 31% said it would require few changes (only 2% said such a decline would fundamentally change their lifestyle). Looking at a couple specific categories, only 12% of respondents said they would not be willing to cut back on food away from home and 14% said they would not be able to reduce spending on vacations and entertainment (and on the opposite end of the spectrum, 20% said they could reduce spending in these categories by 50% or more).

Ultimately, the key point is that when incorporating spending flexibility into a plan, advisors can find that sustainable spending levels for clients in retirement can be higher than when assuming a fixed spending rate. So whether an advisor is incorporating risk-based guardrails or another strategy that incorporates potential spending reductions, the key is to understand each client’s tolerance for potential spending reductions and communicating clearly the implications of future changes in their portfolio value for their sustainable spending!

A Ten Point Medicare Primer

(Tony Isola | A Teachable Moment)

Given that healthcare costs are a major concern for many retired clients, financial advisors who help clients make Medicare coverage decisions can not only provide them with greater peace of mind, but also potentially save them significant money by choosing the most appropriate coverage for their needs. In addition, helping clients understand the basics of Medicare can make them feel more confident in their decisions.

Medicare is composed of four parts: Part A covers hospital costs, Part B covers outpatient visits and related services, Part C (also known as Medicare Advantage) is an optional private plan that provides both Part A and Part B benefits, and Part D is an optional prescription drug plan. Seniors can also choose to use a Medigap plan, which covers costs not included in Parts A and B (with a range of coverage levels available). Advisors can support their clients both in their initial Medicare election (made in the months leading up to their 65^th birthday) as well as in navigating the annual open enrollment period (which runs from October 15 through December 7 and allows participants to make changes to their coverage).

Advisors can also help explain to clients the Medicare coverage costs (and potential healthcare costs, depending on the plans chosen) they will face. For instance, the premiums for Part B vary by income (due to Income-Related Monthly Adjustment Amount [IRMAA] surcharges), from $164.90 in 2023 (for those with Modified Adjusted Gross Income [MAGI] less than or equal to $97,000 for individual filers and less than or equal to $194,000 for joint filers) to $560.50 (for individual filers with MAGI of at least $500,000 and joint filers with MAGI above $750,000). Notably, advisors can also help clients manage their income to minimize the IRMAA surcharges to be paid (with those whose incomes are already near the thresholds most likely to benefit).

In the end, because Medicare is quite complicated, advisors can add significant value for their clients by helping them make appropriate coverage choices both initially and during the annual open enrollment periods. Which can not only save clients money, but also ensure they have the appropriate coverage for their healthcare needs!

Are IUL Insurance Policies Good Retirement Income Tools?

(Andy Panko | Rethinking65)

Indexed Universal Life (IUL) insurance policies have been hot products for life insurance companies, growing from 4% of life insurance sales (as measured by new annualized premiums) in 2008 to 28% of sales by the third quarter of 2022 (though the pace of sales slowed in the third quarter amid weak stock market returns and inflationary pressures on consumers’ ability to pay policy premiums). These policies are often marketed as a way for policyholders to earn higher returns than previous universal life policies (where the crediting rates were pegged to bond rates) by providing a participation mechanism that delivers a portion of the upside price return of the stock market while simultaneously protecting against losses (though upside gains are often capped as well).

In addition to being a way to potentially earn higher returns than other permanent insurance policies, IUL policies also can be structured and funded to be used for income in retirement. This can be accomplished by putting into the policy, as early as possible, as much premium as possible without triggering Modified Endowment Contract (MEC) rules, letting the cash value sit and grow over the years, and eventually taking out loans against the policy to cover living expenses (while incorporating certain features to protect the policy from lapsing).

But for an advisor who has not previously worked in insurance sales, these policies can be confusing, particularly because they are sometimes marketed in ways that obscure the fact that they are insurance policies (e.g., as ‘tax-free retirement accounts’ or ‘private reserve accounts) and are subject to possible changes over the life of the policy (e.g., to the levels of interest that will be paid). But when Panko, the owner of RIA Tenon Financial questioned how these policies work and whether they can live up to some of the marketing messages (e.g., one salesperson referred to them as “can’t lose money assets”), he was often rebuffed by insurance salespeople.

So Panko has now taken matters into his own hands, purchasing an IUL policy for himself to see how it performs in real time. Further, to help advisors and consumers better understand the policies, he has started a website that includes his policy documents and where he will track its terms and performance. Which could ultimately support advisors with clients with IUL or other permanent life insurance policies help them decide whether to hold it or cancel it, or, if it has a sizable loan, whether to ‘rescue’ it!

Things To Be Grateful For Every Day

(Darius Foroux)

In the hubbub of daily life and the quest for ‘more’ it can be easy to overlook some of the things that make life easier or happier. But taking a moment each day to practice gratitude can help you recognize the various ways in which you are well-off, and perhaps feel better about your situation.

For instance, while life is not fun when you are sick, it can be easy to take good health for granted when you are not ill. But being grateful for good health when you have it (and recognizing that continued good health is not guaranteed) can encourage you to put maintaining a healthy lifestyle among your top priorities. Another area that can be easy to overlook is the presence of good people in your life. Whether they are awesome coworkers or friends you haven’t seen in a while, taking a moment to recognize the importance of these relationships for you can be a good reminder that they require attention to continue to thrive. Other areas that are sometimes taken for granted include freedom (as many of the privileges enjoyed by those in the United States are not universal), the Internet (perhaps including your favorite source of financial planning information, wink), and the fact that you are who you are and have made it to this point in your life (as many others are almost certainly in more precarious positions).

Ultimately, the key point is that even on a bad day, there are many things for which to be grateful. And so, maintaining a habit of gratitude (whether for good health or for those who have helped support your business) can not only help you recognize these areas, but also help nurture them so that they continue into the future!

One Good Day

(Philip Pearlman | Prime Cuts Newsletter)

A common topic of buzzy articles on the Internet in recent years has been to outline the daily routine of high-performing individuals. These often entail early wakeup times (4:00am?!), a regimen of ‘healthy’ activities (from meditation to exercise to the latest food trend), several hours of work, and, often, late bedtimes, before doing it again the next day. But while this schedule might work for some individuals, Pearlman suggests that such an extreme and ‘optimized’ routine is not necessary to live a healthy, productive life.

Rather than optimize every aspect of his routine, Pearlman instead focuses on having “One Good Day”, which typically includes: morning sun, body movement, focused work, strong nourishment, family dinner, and rest. He then tries to have another ‘good day’ the following day. With this routine, he can worry less about optimizing his exercise routine, the exact number of calories he eats, or productivity during each hour of work, but instead focuses on hitting the ‘big ticket’ items and enjoying the benefits of compounding when he is able to string together several ‘good days’ in a row. This strategy also allows him to listen to internal cues; for example, if he is feeling particularly tired one day, he might not force himself to stay up working until a certain time and instead get more rest in order to make the next day a better day.

At a time when there are both countless things that can be done in a day and a wide range of technological tools to help measure everything from exercise to productivity, it can be tempting to optimize every aspect of your life. But sometimes, stepping back and making sure you get the ‘big things’ right can help ensure you have ‘good days’ today and into the future!

Are You Living The "Deferred Life Plan"?

(Khe Hy | RadReads)

A common conundrum in personal finance is striking the right balance between spending today and saving for tomorrow. For some lower-income individuals, the answer is set for them, as they have to spend nearly all of their income just to make ends meet. But higher-income individuals have a choice: do they align their spending and work habits to get the most out of today, or to save for an indeterminate future?

Some individuals decide to go down the path of maximizing their earnings, with less regard for their current happiness. For example, an investment banker might make $400,000 per year but have to work 80-100 hours per week. Given the challenges of fitting in personal interests with that kind of schedule, individuals who operate at this pace are likely on a “deferred life plan”, focusing on earning and saving income today for some time in the future (retirement?) when they will actually start ‘living’. But given that there are no guarantees that an individual will be in good health by the time they actually decide to step back from work and spend their money, this ‘plan’ can be very risky.

Many advisors have likely seen this concept play out amongst clients, the wealthiest of which can often be worried that they have not saved enough and need to work longer (perhaps because they are extremely risk averse or possibly because they are comparing themselves to peers who are even wealthier). And so, whether it is working through a structured process like life planning, helping clients consider whether they might take a sabbatical along the way during their working career, or just starting an open-ended conversation about their interests and goals outside of work, advisors can help clients actually enjoy their wealth!

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