Weekend Reading for Financial Planners (Nov 30-Dec 1)

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 November 30th/December 1st:

SEC Panel Approves RIA Fee, Uniform Fiduciary Proposals - The big news that came late last Friday was the conclusion of an ongoing SEC advisory committee that recommended the best way forward on the fiduciary issue was for the SEC to appeal to Congress for the authority to collect user fees from advisors to enhance RIA oversight (as opposed to delegating RIA oversight to FINRA or a new Self-Regulatory Organization), and that the SEC should act in adopting a uniform fiduciary standard for RIAs and brokers to close "the 'regulatory loophole' that holds financial professionals who provide similar services to different standards" according to Barbara Roper of the Consumer Federation of America. Ultimately, the outcome of the advisory committee is simply a recommendation on how the SEC should proceed, and not an SEC action itself; nonetheless, as new SEC Chairwoman Mary Jo White has indicated that resolving the low levels of investment adviser oversight and implementing a uniform fiduciary standard will be priorities for the SEC in the coming year, the panel's recommendations provide some guidance as to likely (but not definite) directions that the SEC may proceed in 2014.

Will the SEC Create Two Kinds of Fiduciaries? - At the recent Schwab IMPACT conference, Brian Graff (executive director of the American Society of Pension Professionals and Actuaries) suggested that we may soon see the SEC create "two kinds" of fiduciaries with its rulemaking next year. The issue is that under the existing Investment Advisers Act of 1940, RIAs generally do not accept commissions, while Section 913 of Dodd-Frank (which directed the SEC to study the fiduciary issue) declares that if the SEC establishes a fiduciary rule it "cannot make the receipt of commissions, in and of itself, a violation of the fiduciary duty." Accordingly, there is a risk that ultimately there is one fiduciary standard for investment advisers under the 1940 Act, and a second "broker fiduciary" standard that applies "transactionally" when brokers offer investment advice to retail customers as a solution. Another version of the "two kinds of fiduciary" outcome could occur if the SEC authorizes a fiduciary standard but carves it out to be different than the existing common law legal standards for fiduciary status, and/or differentiates where RIAs are always subject to the fiduciary standard but brokers are only subject at the time of giving advice under a "two-hats" kind of standard. Ultimately, the fundamental question is simply whether/how the existing fiduciary standard can be adapted and applied to the broker-dealer transaction-based business model, and/or whether some portion of broker activities need to be carved in the future so that a fiduciary standard can uniformly apply to the rest.

UK Wealth Manager Number Drops 20% After Regs - At the beginning of the year, the UK implemented their Retail Distribution Review (RDR) reforms to financial advisors, including most significantly an outright ban on commissions from product providers and a requirement to charge up-front fees. Thus far, the results seem to be "mixed" as the initial outcome has been characterized as making things "transparent, but not simple" for consumers as different firms adjust their pricing and services. Overall, the most notable "unintended consequence" is that the advisory industry in the UK has already shed about 20% of its advisors, although the majority of the losses seem to be within large institutions (that may have been disproportionately commission-focused?); the number of bank advisors has slumped 44%, while wealth managers are only off 8%. Institutions have suggested the challenges are not merely the loss of commissions, though, but also complying with RDR's different tiers of new reporting and oversight, which has resulted in regulation that is claimed to be more complicated and more costly. To say the least, it will be interesting to see how the changes continue to play out in the coming year in the UK (and also Australia, which recently enacted similar reforms), as a prospective template for regulatory reform here in the US!

Court Eases Use of Annuities to Avoid Medicaid Spend-Down - In an environment where state Medicaid agencies have become increasingly aggressive at trying to restrict asset transfers by those applying for Medicaid, a recent court case - Hughes v. McCarthy  - has provided a notable Medicaid planning victory for the use of the Medicaid annuity strategy. The basic approach of the strategy is where a married couple annuitizes assets using a "Medicaid compliant annuity" in the name of the community spouse (i.e., the spouse not going into a Medicaid facility); under current rules, the purchase is treated as a permissible investment and not an invalid transfer, even though the income paid to the community spouse becomes excluded (assets of a community spouse are included for Medicaid, but not the community spouse's income). The key requirement, though, is that the annuitization must be done based (at least) on the community spouse's life expectancy, and the state is named as the remainder beneficiary of the Medicaid annuity. In this case, the annuity was purchased by the wife after four years of paying her husband's nursing home expenses (but before the husband had applied for Medicaid), and the Ohio Medicaid agency challenged the timing of the transaction; because the annuity was compliant with the Deficit Reduction Act rules, though, the court found in favor of the couple, declaring that a state cannot make its rules more restrictive than the Federal Medicaid laws prescribe.

New Research on How Much Clients can Spend in Retirement - On Advisor Perspectives, this article by Wade Pfau looks at some of the research on how to adopt more dynamic spending approaches in retirement than the "traditional" safe withdrawal rate research, which assumes clients will maintain stable inflation-adjusted spending throughout their lifetimes. While clients may not wish to go to the opposite extreme - an annually calculated percentage of wealth each year, similar to the IRS' RMD methodology for retirement accounts, which would produce very volatile spending patterns - Pfau notes several studies that have provided an intermediate level of "dynamic" approach that may be appropriate. For instance, Guyton and Klinger in 2006 (a follow-up to Guyton's previous 2004 study) suggested a series of decision rules for clients, including a portfolio management rule (liquidate from asset classes with the greatest growth), an inflation rule (only increase withdrawals by inflation if total returns were positive), and a capital preservation and prosperity rule (adjust spending upwards or downwards by 10% if the current withdrawal rate moves more than 20% from its original starting point). An alternative approach by Frank, Mitchell, and Blanchett suggests doing ongoing recalculations based not on the current withdrawal rate, but by continuously updating the Monte Carlo probability of failure (with annually updated life expectancy estimates) and adjusting spending as necessary to keep the probability within an acceptable range (they suggest 30% probability of failure as a point to retrench). A subsequent study by Blanchett extended this further, refining the thresholds and suggesting that the best targets were a 20% probability of failure and to use a (continually updated) planning horizon equal to the client's remaining life expectancy plus 2 years. Ultimately, Pfau notes that the Guyton approach is easily understood by advisors and clients, while the others are more closely linked to actuarial models that may be a bit harder for advisors to implement and explain, though Blanchett's more recent work attempts to simplify this a bit. On the other hand, Pfau also ultimately notes that while these methodologies may specify what can be spent, ideally most client retirement plans will be built from the budget of what they wish to spend to determine feasibility/sustainability, and/or adjust accordingly.

Efficient Retirement Income Strategies and the Timing of Annuity Purchases - From the Journal of Financial Planning, this article by Dr. Sam Pittman looks at, for those who wish to annuitize some or all of their wealth to meet their retirement income needs, what the timing of such annuitization decisions should be. Building on the earlier work of Wade Pfau, which found that the most "efficient" frontier of retirement income products appear to be a combination of an all-equity stock portfolio paired with partial immediate annuitization (where, in essence, annuitization substitutes for the bond component of the portfolio), Pittman finds that for those who are going to annuitize, annuitizing some of the funds immediately at retirement and the remainder after 20 years (the maximum delay that Pittman studied) have almost the same efficiency as Pfau's prior research, but significantly improves bequest and liquidity goals during the interim time period. Notably, Pittman also found that if equities are slightly less volatile going forward, the delayed annuitization strategies are even more efficient (presumably, the same would also be true if equities have better returns than the conservative 7.25% nominal equity return Pittman assumed); in essence, the more negative the equity outlook, the greater the upfront annuitization, and the better the long-term equity outlook, the more it would pay to delay annuitization.

What Do Annuity Buyers Want? - In this cover story to Research Magazine, financial planning professor Michael Finke looks at why it is that annuities seem to be "theoretically" and academically optimal for retirement, yet so few buy them; in fact, Finke observes that remarkably few annuitization scholars have even been able to convince their own mothers to purchase an annuity. This "annuity puzzle" has challenged economists for years, given that annuities are so effective at smoothing income with little risk of outliving it, yet Finke concludes that ultimately the real problem is that most people aren't economists; they have more complex and nuanced goals, and irrational biases, not typically captured in standard economic models. Yet notably, for the inflation-adjusted annuity that everyone has by default - their Social Security payments - people exhibit the opposite irrational extreme; when asked what lump sum would be necessary to give up $500/month in Social Security payments in 2008, the average respondent in the Health and Retirement Study responded $250,000 - equivalent to an assumed longevity of 130 years with a 0% discount rate. Our unwillingness to sell something for a fair price once we own it is known as the endowment effect, which explains the overvaluing of Social Security payments and our unwillingness to convert them to a lump sum, but Finke notes that the endowment effect is also likely what causes us to overvalue our liquid retirement sums and become unwilling to convert them to an annuity. Accordingly, Finke suggests that one of the best ways to consider addressing the issue is by "reframing" their retirement assets as income instead of wealth; for instance, the Department of Labor is considering an approach where retirement plan sponsors would illustrate retirement assets based on the income they would buy rather than just their future lump sum value (especially since most people have no idea how to translate one to the other intuitively). Another challenge is dealing with loss aversion - even if it's unlikely, we fear the losses associated with dying shortly after purchasing an annuitized stream of income; Finke notes that while economically obtaining a cash refund guarantee is less optimal, in that it reduces income, if it helps to manage the loss aversion fear, this "imperfect alternative" may still be a better course of action.

The Asset Location Decision Revisited - In the Journal of Financial Planning, Dr. William Reichenstein and William Meyer takes a fresh look at the "asset location" decision, about whether it's better to place equities in taxable accounts and bonds in IRAs, or vice versa. While many studies have shown that the asset location decision depends upon specific assumptions about returns and tax rates in determining which location produces greater after-tax wealth in the end (including research by yours truly), this study examines asset location by first adjusting the allocations to reflect their after-tax equivalents up front rather than merely adjusting at the end (since assets held in a retirement account essentially have a portion 'earmarked' for taxes, or are "tax-deferred partnerships" as Reicheinstein and Meyer characterize it) . This in turn impacts not only how wealth compounds but also the "after-tax risk" of the investments (as losses in each account type also have different characteristics). In the case of tax-deferred accounts, the government takes a portion of the entire account (principal and interest) but the taxpayer effectively enjoys the full growth rate on his/her after-tax share; by contrast, with a traditional investment account, the government effectively bears a portion of the risk (in the form of taxable losses). Accordingly, Reichenstein and Meyer find that when stocks in an IRA (with "full" risk) are compared to stocks in a brokerage account (with "shared" risk), the optimal allocation is virtually always to hold the stocks in the brokerage account, not merely for asset location tax efficiency, per se, but because the stocks-in-the-brokerage-account results in a more favorable mean-variance-optimized portfolio (because it effectively has a lower after-tax standard deviation). (Michael's Note: While I greatly respect Reichenstein and Meyer's work, I do dispute some of their findings and conclusions in this study; stay tuned for a further blog post with some discussion on this issue!)

Colleges Struggling to Mint New Advisors - This lead story from Financial Planning magazine looks at the challenges of the financial advisory world to mint enough college students to meet the demand for new advisors. While many schools are having no trouble placing students - William Patterson places the majority of its students, and Texas Tech boasts a whopping 95%(!) placement rate of its students into jobs! - they're still not putting forth enough students to meet the demand, as the U.S. Bureau of Labor Statistics forecasts a 32% growth rate in demand for advisors from 2010 to 2020 (some 66,400 new jobs), yet Cerulli projects that the actual number of advisors is scheduled to decline by 25,000 positions in the new four years, driven by the ongoing retirement of baby boomer advisors and an insufficient volume of younger advisors to replace them. In fact, the demand for advisors - and the already-present shortage of experienced advisors available for hire - is a heavy factor driving the high placement rates of financial planning college students, as New Planner Recruiting partner Caleb Brown notes RIAs are being encouraged by their custodians to build out a "farm team" of junior advisors. Even at the student level, there are often more job and paid internship opportunities than there are students to fill them, yet due to poor awareness of financial planning as a career (and its underdeveloped career track), the programs are struggling to attract as many students as they'd like. In addition, the reality is that even amongst the students coming out of the programs, some are far better than others, and firms trying to hire the top talent are struggling to find, attract, and retain them. Nonetheless, the demand trends for financial planners in the coming years paints a bullish picture for financial planning programs, and many are trying to expand their programs to ensure graduates have the skills that planning firms want, and are eagerly looking to partner with local firms to hope convey the value of financial planning to potential students and support them on finding jobs after graduation. For those interested, check out the accompanying "30 Great Schools for Financial Planning" article as well.

Facebook's five-star ratings: The end of business pages for advisers? - Earlier this month, Facebook appears to have started to 'experiment' with a Morningstar-style 5-star rating system that can be applied to Facebook business pages; the new system does not appear to have been rolled out to all Facebook business pages yet, but their potential arrival may spell doom for the use of Facebook business pages for advisors. The reason is that clients who rate the advisor-controlled business page with 5 stars may be deemed to be giving prohibited testimonials; alternatively, even if the selection of a star rating doesn't constitute a testimonial, it would certainly be prohibited for advisors to solicit star ratings, which means if a few bad ratings show up (even from non-clients or malicious visitors) there's no way to invite clients to counterbalance the results by providing favorable ratings. In addition, at this point it doesn't appear there's a way to easily turn off the star ratings, although marketing consultant Kristen Luke walks through the process that advisors can follow to disable their map and check-ins, which also manages to disable the star ratings as well (but at a 'cost' of losing the mapped business location and the ability of clients to check-in socially in the first place).

Why People Don’t Want Your Financial Planning Service And It’s Not Because They Don’t Need You, Don’t Trust You, Or Don’t Believe You - From the blog of Dutch financial planner Ronald Sier, this article draws on research in psychology and persuasion to take a novel look at why it's often difficult to convert prospects into financial planning clients. The key is our tendency as human beings towards consistency - once we commit to something, we tend to want to see it through, and may even change our views to try to justify our position (for instance, bettors are often more confident that their horse will win after they place a bet, as they now want to convince themselves to support their prior decision). In the context of working with a prospective financial planning client, this is manifests itself in the form of all the individual's prior financial decisions; in other words, if someone agrees to become your client and change their financial behaviors going forward, it may be tantamount to admitting their prior decisions were mistakes (including the decision not to hire an advisor sooner!?)... which is something we're very loathe to do! Fortunately, most of the time it's good to be consistent - in fact, our culture values it highly, as we attribute negative connotations to behaviors like "flip-flopping" on decisions - but in the context of appealing to a new client, it can be a significant blocking point. So how can you work through this? Sier provides three suggestions: 1) invite people to substantiate their decisions (e.g., asking "are you responsible for the financial future of your family" can then encourage them to follow through on the decision to see/work with you); 2) help people to write something down or give them a tactile experience (signing something - like a pre-engagement letter - can help them follow through on working with you); and 3) help people to understand that if the facts and circumstances have changed, it's more (socially) acceptable to change their mind and engage you.

How Mobile Phones Can Solve the Retirement Savings Crisis - This article by behavioral finance researcher Shlomo Benartzi takes an interesting look at the ongoing "retirement crisis" of baby boomers, noting how decades' worth of potential remedies from tax incentives to financial education campaigns have had limited impact in encouraging retirement savings, and suggests that we need to look at more behaviorally-driven solutions. For instance, Benartzi's "Save More Tomorrow" program (discussed previously on this blog) where workers commit in advance to automatic increases in their savings that align with their compensation raises (so they don't actually have to cut their spending to save more) have already doubled the savings rates of 4 million Americans, and research is showing that auto-enrollment or even just simplifying the enrollment process with pre-filled forms can lead to dramatically higher retirement savings rates. But these interventions alone aren't enough given that not everyone participates - or even has access to - in employer retirement plans in the first place (and without those systems, it's much harder to accomplish the auto-enrollment and automatic increase provisions in a self-directed IRA). Accordingly, Benartzi suggests that what we need is a retirement savings "app" on our smartphones, that draws on our known information to make enrollment and saving simple and automated with a single click. The idea is not unprecedented; for decades most people in Kenya have been "unbanked" but when Vodaphone started a simple commercial bank-by-phone system, banking activity exploded, and now 70% of Kenyan adults use it to transfer money, make payments, and save. Another key part of the app would be to take advantage of our impulsivity for the good; just as when we're sometimes flush with cash we have a tendency to make impulse purchases, the retirement app would allow us to make impulse savings, finally truly making it as easy to save as it is to spend. And of course, one ancillary benefit of such a mobile-app-based retirement approach is that it would ultimately give us a lot more data about how people save, which may help lead to further research and how to help ourselves even more in the future.

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, including his "FPPad Bits And Bytes" weekly advisor technology update!

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! And click here to sign up for a delivery of all blog posts from Nerd's Eye View - including Weekend Reading - directly to your email!