Weekend Reading for Financial Planners (Sept 18-19)

Authors:

Ben Henry-Moreland

Team Kitces

Ben Henry-Moreland is a Senior Financial Planning Nerd at Kitces.com, where he specializes in writing and speaking on financial planning topics including tax, practice management, and technology. He also co-authors the monthly Kitces #AdvisorTech column. Drawing from his experience as a financial planner and a solo advisory firm owner, Ben is passionate about fulfilling the site’s mission of making financial advicers better and more successful.

Read more of Ben’s articles here.

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Adam Van Deusen, CFP

Team Kitces

Adam is a Financial Planning Nerd at Kitces.com. He previously worked at a financial planning firm in Bethesda, Maryland, and as a journalist covering the banking and insurance industries. Outside of work, he serves as a volunteer financial planner and class instructor for local and national non-profits.

Read more of Adam’s articles here.

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Analyzing Biden’s New “American Families Plan” Tax Proposal (Jeffrey Levine and Michael Kitces, Nerd’s Eye View) - With the release of the House Ways and Means Committee’s text of the proposed legislation, President Biden’s “American Families Plan” (running in parallel to congressional Democrats’ goal of a major infrastructure package) took one step closer to becoming law on Monday. And while many elements of the bill were anticipated – including higher taxes overall on households earning over $400,000, a reduction of the estate tax exemption amount, and an extension of the expanded monthly Child Tax Credit payments – the bill also contained some surprises for financial advisors and their clients. Of particular importance to advisors are: a potential prohibition on the popular ‘backdoor Roth’ strategy by eliminating the ability to convert after-tax dollars altogether; a new “Required Minimum Distribution” for high-income individuals with retirement accounts worth over $10 million that would force out 50% of any excess above that amount every year to prevent the accumulation of ‘mega’ IRAs; and rules designed to curtail discounts on Family Limited Partnerships (FLPs) holding nonbusiness assets and the use of ‘intentionally defective’ grantor trusts for estate planning purposes by causing any grantor trust to be included in the grantor’s estate for estate tax purposes (effectively eliminating the “defective” trust altogether). And while most provisions of the proposed legislation would take effect on January 1, 2022, giving advisors just over 3 months to help their clients prepare, the rules regarding limiting discounts on FLP trusts would be effective on the day the bill is signed, giving advisors very limited time to engage proactively with HNW clients on their estate planning. In addition, it’s notable that in the case of the new higher capital gains tax bracket, the change would be retroactive to September 13, effectively locking taxpayers into the new rate for any capital gains taken for the remainder of the year (if the bill is enacted). Notably, at this point the legislation is simply proposed, and has yet to be passed by Congress or signed into law, which means it may still change further in the weeks to come. Nonetheless, the significant changes in the legislation compared to proposals earlier this year indicate that compromises are already underway in Congress… increasing the likelihood that the current legislation, or something substantively similar to it, may in fact pass in the weeks to come, such that advisors should start discussing it with their clients now to develop a strategy for its eventual (and likely) enactment.

ETFs Risk Losing A Key Tax Edge In Proposed Legislation (Sam Potter, Katie Greifeld, and Elaine Chen, ThinkAdvisor) - One of the key differentiators of ETFs from mutual funds (and a large factor in their rise in popularity in recent years, particularly in taxable brokerage accounts) is the tax deferral treatment they receive on capital gains realized by the funds themselves (typically incurred when selling assets to pay investors redeeming their shares in the fund). As while mutual funds are required to distribute accumulated capital gains to their shareholders each year – thereby generating (often-unwanted) taxable income for the investors – ETFs are currently able to avoid these distributions by redeeming shares ‘in-kind’ via an intermediary. However, draft legislation (separate from the bill discussed above) released by Senate Finance Committee Chair Ron Wyden would, if enacted, remove that tax advantage for ETFs as of January 1, 2023. And though the goal of the bill appears to be applying the same set of rules to ETFs that already apply to mutual funds, as a means to remove a ‘potential tax shelter for wealthy investors’, it would also impact smaller investors with whom ETFs are also popular – perhaps even disproportionately so, given that a single person earning $45,000 and one earning $400,000 currently pay the same tax rate on capital gains, with the latter being far more likely to have funds outside of their portfolio to actually pay those taxes. Not surprisingly, the draft legislation faces a mountain of opposition from fund providers and asset managers, but regardless it may ultimately have little chance of passing based on the fairness arguments alone (given that in practice it is not as targeted to ‘wealthy investors’ as its justification suggests). Still, with fund companies such as Vanguard and DFA, which had traditionally focused on mutual funds and only just become more heavily involved in the ETF space in recent years, it is notable to see proposed legislation that would dramatically affect the value proposition of ETFs relative to mutual funds… and potentially cause wealthy investors to start looking for other types of tax-advantaged assets instead?

How The Step-Up In Basis Got Crushed (Alan Cole, Full Stack Economics) - With the release of the latest version of President Biden’s tax agenda from the House Ways and Means Committee on Monday, one of the key elements of the President’s agenda that didn’t make it into Monday’s proposed legislation was the elimination of the step-up in basis of assets at death. The President’s original American Families Plan contained a detailed proposal for a step-up elimination, coupled with an exemption for up to $2.5 million of capital gains per couple. But even that relatively moderate version was left out of the proposed bill, and the reaction of many financial advisors upon the bill’s release (along with, for many, a sigh of relief) was: What happened? One theory is that the Democrats’ Congressional majorities are too thin to withstand almost any defection from a party-line vote, and the pressure from lobbyists and rural-state legislators (where capital gains at death is a major issue for family farms and other small family businesses) was enough to keep the step-up elimination out of the bill. Another potential explanation is that, while eliminating the step-up has been championed for years by progressives as a way to reduce inequality by curtailing tax-free inheritance of high-value, low-basis assets (particularly via the ‘Buy-Borrow-Die’ strategy recently detailed in the Wall Street Journal, where owners of low-basis, highly appreciated assets avoid incurring capital gains both during life by borrowing instead of liquidating and after death via step-up in basis), Democrats failed to press that message. As a result, Republican opponents were able to effectively make their case that eliminating the step-up would be unfair to those family farms and businesses and their inheritors who may not have enough liquid assets to pay the (capital gains) tax bill if gains on those entities were taxed on death. Finally, one of the main arguments in favor of the step-up is that while assets are currently not subject to capital gains tax at death, they can still be subject to estate tax. And one of the other Democratic priorities that did make it into the proposed bill was a reduction in the estate tax exemption amount, which if combined with the elimination of the step-up, would have made more assets subject to both estate and capital gains tax at death, so Democrats risked a public backlash to this perceived “double-taxation” had they included the step-up elimination in the bill. Ultimately, while more political than financial in nature, the story of the step-up provides lessons on how tax policy is shaped not necessarily by the soundness of its logic but by the power of narrative framing, the luck of circumstances, and the direction of political winds.

Are ETFs and Mutual Funds Still The Future? (John Rekenthaler, Morningstar) - For decades, mutual funds have represented a convenient way for investors to achieve diversification. More recently, Exchange-Traded Funds (ETFs) have become another tool for financial advisors and investors, thanks to their tax efficiency and generally low cost. Together, mutual funds and ETFs control 25% of the U.S. stock market capitalization, up from 4.5% in 1985. However, for those seeking the professional management of funds and more control of the underlying investments, Separately Managed Accounts (SMAs) have historically been the primary option for more affluent investors. Rekenthaler suggests that SMAs remain a relatively small player compared to mutual funds and ETFs, because of their higher cost, and the rising popularity of indexing compared to active management. In turn, this has left the door open for the recent rise of direct indexing, where investors can customize an otherwise passively constructed portfolio, with lower asset minimums and lower costs than SMAs. Potential additional benefits include harvesting capital losses, compensating for (i.e., building the portfolio around) a concentrated position, or filtering out companies based on ESG or SRI factors. The biggest players in the investment market have also seen the potential of direct indexing, with Vanguard, Morgan Stanley, Blackrock, Fidelity, Morningstar, and JP Morgan all making acquisitions of direct indexing platforms. It’s unclear whether direct indexing can go mainstream, but the money pouring into the field suggests there will be growing opportunities for investment advisors (and dangers if a DIY consumer platform gains popularity?) in the years to come, presenting a threat to the continued growth of ETFs (and mutual funds) even as mutual funds themselves are still reeling from the growth of ETFs already.

The Lazy Investor’s Guide To Getting Stuff Done (Jason Zweig, The Wall Street Journal) - Inertia is a powerful force when it comes to making (or rather, not making) changes, from exercising more to finding a better job, and financial decisions are no exception. One study found that 68 out of 100 retirement savers said they were not saving enough, but only 24 planned to increase contributions to their 401(k) in the next few months, and only three actually did so! Zweig suggests that one way for individuals to get unstuck is to break up big financial moves into smaller components. For example, an individual using dollar-cost averaging to try to reduce the risk of investing immediately before a downturn might be more likely to actually invest the funds than someone waiting for the ‘right’ time to invest a lump sum. Another option is to make a public commitment (i.e., tell others you’re planning to take the action), or join a group, both of which help to hold us accountable to others. Zweig also suggests using a birthday or the first day of Spring as a fresh start to take action on one’s finances. Fortunately, financial advisors are well aware of the difficulty of changing client behavior, but are well positioned to be the implementor and accountability partner Zweig describes. Of course, these strategies could also be useful for advisors themselves, when their entrenched habits could be preventing them from achieving the growth they desire!

When Do Investors Freak Out? (Daniel Elkind, Kathryn Kaminski, Andrew Lo, Kien Wei Siah, and Chi Heem Wong, SSRN) - The sudden market drop in early 2020 tested all investors’ nerves. While some held strong through the turmoil, and others were able to stay the course with the help of their financial advisor, some still turned to cash after the market began its freefall. Accordingly, the researchers of this study analyzed investor behaviors during prior events with significant market turmoil, and found that factors that would increase the likelihood of an investor ‘freaking out’ during a market decline included being male, older the 45, married, having dependents… and perhaps ironically, those identifying themselves as having excellent investment experience or knowledge! In other words, it appears that for those who simply don’t understand how markets work, they may be more likely to tune out volatility, while it’s those who had more investment knowledge that were more likely to overreact based on that knowledge! Of course, those that do exit the stock market on its way down still at least have an opportunity to get back in without missing out on the recovery gains. Yet the authors also found that those investors who panic on the way out are also more likely to wait too long to reinvest, causing them to miss out on significant profits when markets rebound. In fact, more than 30% of investors who panic sold during previous market crashes never bought back into the market after they cashed out! Which ironically means the ‘damage’ was not done by selling early, per se, but was primarily a result of buying back in too late (or not at all). When faced with clients looking to cash out during a market downturn or who are afraid to reenter the market, financial advisors have several potential strategies to use, including engaging clients in a collaborative process to create a statement of goals, having a conversation about why money is important in the first place, and discussing whether changes to their savings and investment goals are permanent. Though, as the research suggests, perhaps the most impactful strategy is not about dissuading clients from selling, but about setting a clearer agreement upfront about when they’ll get back in (which can minimize most or all of the damage anyway?). And with the 2020 market downturn in the rearview mirror, now could be a good time to have these conversations with clients, to be prepared for the next crash that will inevitably come someday!

How Offering "High Touch" Bill Pay Services Can Help RIAs Differentiate (April Rudin, The Rudin Report) - As the services offered by Registered Investment Advisers continue to expand beyond ‘just’ investment management – often driven by the need to differentiate one’s RIA from other firms who may offer similar portfolio management services – advisors are putting more thought than ever into deciding which services to offer. Because while offering more in-depth financial planning or tax preparation were once ways to stand out from one’s competition, those offerings are now increasingly standard, which in turn is leading more firms to turn to an even more ‘niched’ landscape to better reflect what its clients specifically value in order to seem truly different. And for firms serving ultra-high-net-worth clients, whose complex financial affairs can make any time savings for themselves particularly valuable, “high-touch” offerings like an automated bill pay solution can be an attractive differentiator. However, the nature of actually paying a client’s bills means that any RIA offering the service would have the ability to withdraw funds from client accounts – an action that, according to the SEC, gives the RIA custody over client funds. Which means that, though many RIAs have long preferred to avoid the administrative complexity of triggering the SEC’s ‘Custody Rule’ – which requires an annual ‘surprise’ examination of the RIA’s books and records by an accounting firm – firms that do want to offer bill pay simply need to get comfortable with the idea of having custody, and familiarize themselves with the processes and controls required. Because, along with the value a service like bill pay adds in its own right, putting the proper checks and balances in place to comply with the Custody Rule’s requirements is arguably just another way for an RIA to show its clients how it is protecting their wealth, building further trust and value into the relationship anyway?

How "Personal" Should Your Personal Service Be? (Tony Vidler) - As a client-facing occupation, being a financial advisor involves providing a personal service focused on meeting the needs and expectations of clients. But, as with other professions, financial advisors can offer varying degrees of ‘personalization’ in their personal services and, while it makes sense at times to take a highly personalized approach, sometimes a greater level of standardization might actually be preferable. Because in general, some services derive their value from the ability to address the client’s unique needs (and thus tend to be highly personalized to each client), but others really derive their value from the process that the professional follows to achieve a desired result (which in fact requires more standardization of that process). Therefore, advisors need to decide which approach best fits their practice based on (among other things) the degree of specialized expertise they offer, the type of client niche they serve, and the style of delivery (involving a high or low level of client interaction) that they prefer. Ultimately, however, the degree of personalization should match the solutions that the advisor offers, because professionals providing more transactional or execution-based services (like mortgage or insurance brokers) may ultimately need to adopt a standardized approach to match the mindset of clients seeking those services, while those offering more bespoke solutions like financial plans or estate plans would need to likewise offer a high degree of personalization to meet the needs and expectations of those clients – though of course there may be elements of even a hyper-personalized advisor’s approach that would benefit from standardization, such as the financial planning process itself which is a (standardized) framework within which the advisor can deliver their (personalized) advice!

Client Segmentation Is Not Evil (Matt Sonnen, Wealth Management) - The desire to be ‘all things to all people’ is a temptation for many RIA firms, particularly those in the early startup stage who just need more of any type of client in order to bring in revenue to meet business overhead and even just their own personal living costs. However, a firm that grows larger while maintaining a diverse range of clients can increasingly struggle to allocate its finite resources of time, people, and money in a way that delivers the best service across the entire ever-varying client base. One way to optimize this allocation of resources is through client segmentation, a method of dividing the client base into groups (often based on the amount of revenue generated by each client), and defining the service structure for each group. To some, this process of ‘ranking’ clients seems unfair, and is perceived as giving smaller clients a lower level of service when they are subjected to the same fee structure as everyone else (and given the tiered fees of many AUM-based advisors, may even be paying relatively higher fees as a percentage of assets). But another way of looking at it is that, while per-client profitability is (or should be) a concern for anyone running an advisory firm, the best argument for client segmentation is that it’s what allows a firm to keep serving a diverse range of clients, with the alternative scenario being that, for a firm providing the same level of service across all clients regardless of the revenue they actually generate, economic pressures will eventually force the firm to ‘fire’ its smaller clients, ultimately leaving them without any advisory services! And though many firms continue to ‘niche out’ and focus on a narrow range of clients, it can still make sense for some to reach out to a broader market – provided that the firm is ultimately able to use its resources in a way that avoids a one-size-fits-all approach and truly delivers its best experience to each of those varying clients.

Goodbye To The ‘Office Mom’ (Jessica Grose, The New York Times) - With the pandemic sending many office workers home to work remotely, some office traditions – cake to celebrate a birthday, or monthly after-work outings – have become harder to do. Some business owners are even worried that remote work will lead to the demise of ‘office culture’, and inhibit team bonding, mentorship, and casual ‘water cooler’ conversations. And while all employees can benefit from a strong office culture, research shows that the burden of maintaining it often falls to female employees. Women are more likely to volunteer for ‘office mom’ tasks like planning parties or resolving conflicts, and if a task needs to be assigned are more often ‘voluntold’ by management to take up the task. Despite its importance, though, this extra work generally is not a part of an employee’s performance rating. To help ameliorate this problem, advisory firm owners can consciously distribute the work among all employees, or make it a part of job descriptions so that it becomes a promotable task, rather than simply letting it fall to the ‘office mom’ by default! More generally, though, financial advisory firm owners should recognize there is a range of options to improve company culture in a remote environment, from reimagining team-building activities, to implementing a more output-based management style, and allowing employees to have workplace preferences.

How A Hybrid Office Could Make Proximity Bias Worse (Megan Rose Dickey, Protocol) - Many companies decided to go fully remote during the pandemic, but are now faced with a decision of whether to remain remote, go back fully to the office, or take a hybrid approach of allowing employees to choose whether to work remotely or in the office. In addition to considerations such as the cost of rent and the desire for clients to meet in person, creating an equitable office culture is another important factor in choosing a workplace structure. And while many employees might find a hybrid office environment convenient, managers should consider the potential effects of “proximity bias”, which occurs when employees who are located in closer proximity to teammates and company leaders are perceived as better workers, which helps them gain subsequent raises and promotions over their less-proximal peers. In addition to not being “seen” in the office, remote workers in a hybrid environment can also suffer when managers check in with them too often, or alternatively, are left out of impromptu in-office meetings altogether. For financial advisory firms that decide to take a hybrid approach, setting clear employee expectations for coming into the office (and for leaders to follow the rules they set for employees themselves!), and consciously including remote employees in meetings can help reduce the impact of proximity bias. Larger advisory firms might even consider hiring a head of remote operations, to ensure that remote workers are treated fairly, and that the company is prepared for a future crisis if/when fully remote work is ever required again in the future.

The New Frontiers of Hybrid Work Take Shape (Emma Jacobs, Financial Times) - With many employees realizing the benefits of remote work – including no commute time, more flexible work hours, and the ability to balance work and family needs – companies are adapting to match employee preferences with business needs. And while one survey found that more than 70% of workers want flexible work options to continue, 65% of workers also want more in-person time with their teams, too! Some firms see a potential win-win situation through a hybrid formula: allowing employees to do focused work at home, and collaborative work in the office. This approach would support employee work-life balance, without losing out on the benefits of in-person brainstorming, mentoring, and socializing. To do so, companies are considering how to adapt the physical office workspace, from creating new rooms for collaboration in large or small groups (if collaboration becomes the primary in-office function), to installing videoconferencing equipment in smaller rooms to allow remote workers to have more intimate conversations with their counterparts that are still located in the office. At the same time, if the office becomes the center of collaboration in the hybrid workplace, then aligning schedules within teams in an equitable manner will become more of a priority. In essence, hybrid workplaces require a more careful balance to maximize productivity, fair treatment, and employee satisfaction. Financial advisory firm owners have the added considerations of ensuring regulatory compliance, and considering client preferences for remote or in-person meetings. With this wide range of priorities in mind, flexibility might be the most important trait for advisory firms in this new environment! Nonetheless, though, the key point is to recognize the difference in functions between remote and in-office work, where the ‘focus’ work (e.g., analyzing and building financial plans) may be more conducive to remote work, but the ‘collaborative’ work – from working with teammates, to working collaboratively with clients themselves – may remain a more uniquely in-office activity (with advisory firm offices of the future adapted to meet that reality).

I hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of 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 Craig Iskowitz's "Wealth Management Today" blog, as well as Gavin Spitzner's "Wealth Management Weekly" blog.