Weekend Reading for Financial Planners (Oct 2-3)

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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Franklin Templeton To Buy O’Shaughnessy’s Direct Indexing Platform ‘Canvas’ (Justin Baer, The Wall Street Journal) - Direct indexing platforms offer advisors the opportunity to eschew owning an index mutual fund or ETF, and instead own all the underlying stocks of the index. Historically, such direct indexing strategies provided an opportunity to benefit from tax-loss harvesting opportunities on the underlying stocks (even if the index was otherwise up). But once the technology to replicate an index built with the underlying stocks is built (the first generation of direct indexers), it also becomes possible to modify the index – whether for factor tilts, ESG preferences, building around a client’s existing concentrated stock position, or some other aspect of client-specific personalization (the second generation of more ‘custom indexing’). Large asset managers have increasingly taken note of the potential of direct indexing as a threat to mutual funds and ETFs, with Vanguard, JP Morgan, and other major players all making acquisitions of direct indexing platforms over just the past 12 months. And now, Franklin Templeton has jumped into the pool with its acquisition of O’Shaughnessy Asset Management and its Canvas direct/custom indexing platform, one of the ‘second-generation’ direct indexing platforms that have been increasingly going beyond ‘just’ tax-loss harvesting benefits and into more ‘custom indexing’ instead. Franklin currently manages $130 billion in client assets within Separately Managed Accounts (SMAs), and the acquisition allows them to turn OSAM’s Canvas into an SMA-style custom indexing strategy, where advisors personalize portfolios for their clients through the technology, and Franklin implements it. In fact, Canvas was launched in late 2019 and distributed its solution primarily to advisors, amassing more than $1 billion in assets in its first year (and nearly $2B by the end of its second year), providing the portfolio construction technology to allow advisors to build client portfolios and implementing the trading of what can be hundreds of stocks at one time on their behalf. These opportunities are particularly appealing to advisors seeking to differentiate their services in an increasingly crowded marketplace with the ‘ultimate’ level of differentiation – portfolios customized down to the individual client level. In the end, if direct indexing technology becomes the new building block for advisors, it threatens the entire mutual fund and ETF complex that is powered by advisors today – a potential multi-trillion-dollar opportunity, which helps to explain why so many ‘traditional’ asset managers, including now Franklin Templeton, are acquiring the technology providers to deliver it!

RIA Disciplined For Charging 81 Clients As ‘House Accounts’ Without Providing Services (Jeff Berman, ThinkAdvisor) - Employee turnover is a regular part of the financial advisory business, making established processes and written procedures (that are actually implemented!) for how to transition clients when their primary advisor departs an important part of a firm’s compliance program. Nonetheless, this practice is not universally implemented, as evidenced by a recent Securities and Exchange Commission (SEC) order that between 2015 and 2021 a Michigan RIA failed to provide advisory services to 81 clients whose original advisor left the firm and failed to disclose conflicts of interest arising from compensation received from an affiliated portfolio manager. The firm and two of its executives agreed to pay almost $950,000 to settle the charges. According to the order, under an informal firm policy the accounts of clients whose advisors left the firm would become “house accounts,” with two principal executives taking responsibility for managing the accounts and dividing up the advisory fees from the accounts in proportion to their ownership stake in the firm. Yet in practice, not only did the executives not provide any services to some of the accounts, but many of the clients were not even informed that their original advisor had left the firm! Notably, while the actions described in the order represent a blatant disregard for industry ethics – charging clients advisory fees while literally not even assigning an advisor to service them – the concept of “reverse churning” (where advisors charge an ongoing investment fee but fail to provide any substantive ongoing investment services) has caught the eye of both US and foreign regulators that want to ensure clients are receiving (sufficient) services for their advisory fees. The issue is especially pertinent for those charging ongoing retainer or subscription fees, where regulators want to ensure there is no “fee for no service” scenario, and want to see the firm document that deliverables were provided as agreed upon for the fee that the client paid. Though even for AUM firms managing portfolios on an ongoing basis – and especially for those adopting increasingly passive approaches where there may not be much of any trading from year to year –firms need to consider ways to document their value beyond making trades, whether it be through creating a client service calendar or other methods!

FINRA Plan Sets Annual Fee For Members Who Use CE To Reregister Lapsed Series Licenses Within 5 Years (Melanie Waddell, ThinkAdvisor) - Employees who decide to take extended time away from their current job—whether to explore a new career path, care for family members, or other reasons—can find it difficult to break back into their previous field. In the financial services industry, the issue is especially problematic, as employees who lose their securities licenses (or other designations) potentially face the daunting task of retaking qualification exams and other measures to regain their prior status. To help reintegrate previous registrants, the Securities and Exchange Commission (SEC) on September 21 approved amendments to Financial Industry Regulatory Authority (FINRA) rules to allow individuals who terminate their registrations to reregister after an extended period, without retaking qualification exams (e.g., their Series 6 or 7 exams), as long as they maintain their continuing education (CE) requirements during the period. In turn, FINRA’s board subsequently approved a plan (subject to SEC approval) to charge a $100 annual fee on individuals who take the CE path to reregister within five years after terminating their registration, effectively turning the existing 2-year window (after which FINRA licenses lapse) into a 5-year window for a nominal fee. Notably, the 5-year window is similar to the CFP Board, which also offers certificants the opportunity to reinstate their certification within five years of relinquishment without retaking the CFP exam if outstanding CE requirements have been met. FINRA touted the potential of these measures to improve the environment of inclusion in the financial services industry, by easing the process for employees to reintegrate back into their previous fields, and the extension could also prove useful to individuals who were laid off early in the pandemic. On the other hand, allowing registrants five years to reregister could also have the unintended effect for broker-dealers of leading more employees to try going independent, who might not have otherwise under the previous two-year rule but would be comfortable knowing that they’d have five years to see if the independent RIA channel worked out before needing to decide if they’re going to go back to the broker-dealer world!

Tax Moves Advisors Should Make Before Year End (Jeff Stimpson, Financial Advisor) - The final quarter of the year is often an active period for financial advisors helping their clients make tax planning decisions for the current year and the year ahead. This year, however, the possibility of significant changes in clients’ tax situations brought on by the proposed reconciliation bill currently being negotiated in Congress means there could be especially high value in proactive end-of-year tax planning. For example, because the bill would increase the top ordinary income tax rate from 37% to 39.6% for individuals earning over $400,000 starting in 2022, a client who is expecting a year-end bonus could benefit from accelerating that income to this year (e.g., by asking for it to be paid in December 2021 instead of January 2022). Additionally, the fact that most capital gains realized after September 13, 2021, would be subject to a higher top capital gains tax rate of 25% under the bill means it will be even more important to consider the tax consequences of performing year-end rebalancing in HNW clients’ taxable accounts… especially given the potential for large unrealized gains in those accounts after a year of strong market growth. Furthermore, with the proposed bill reducing the estate tax exemption amount by 50% effective on the day of enactment, couples with taxable estates over $11.7 million may have only a small window to gift away excess assets to avoid having them be subject to estate tax (especially given that a number of popular estate planning strategies, from GRATs to IDGTs, would also be shut down if/when the legislation is enacted). Ultimately, though, we may see changes to the legislation before it is passed, which makes it difficult to take action now. Nonetheless, the limited time window before the bill’s provisions would take effect, combined with the potential downside of waiting too long to act, means it would be better to have these conversations with clients that may be impacted sooner, rather than later.

Richest Americans Use GRATs To Avoid Estate Tax (Pierre Paulden, Wealth Management) - The Grantor Retained Annuity Trust (GRAT) is an estate planning technique that has existed since the early 1990s as a strategy for wealthy individuals to pass on assets to their heirs while minimizing their exposure to gift or estate taxes. In fact, in a world where many ultra-HNW estate planning strategies have a significant amount of ‘grey’ area, GRATs are unique in being explicitly blessed under the Internal Revenue Code (ironically implemented as a crackdown on a prior estate planning strategy of the 1970s and 1980s, that in turn spawned a new one). And while the increase in the estate tax exemption over the past 20 years – from $1 million per person in 2002 to $11.7 million in 2021 – has made GRATs less common among affluent and even many high-net-worth individuals in that time, declining interest rates (which support the estate-shifting potential of a GRAT) has kept the strategy incredibly popular among the ultra-wealthy, according to a ProPublica investigation on the use of GRATs among the United States’ 100 wealthiest people. In fact, according to their analysis, over 50% of those ultra-wealthy individuals made use of GRATs and other trusts, though the report notes that it is likely still undercounting that number (i.e., the usage of GRATs amongst the ultra-wealthy may be even higher than 50%), due to the fact that only documents that explicitly referenced GRATs were counted, while in reality the trusts can be named whatever the donor wants them to be (and less-clearly named trusts could therefore have been left out of the analysis). Coincidentally, this report comes at a time when Congress is debating curtailing the ability to use these (and other) trusts to transfer intergenerational wealth without estate tax, and the current American Families Plan bill being debated in Congress would largely eliminate the effectiveness of GRATs by making all of their assets includable in the grantor’s estate at death. Notably, however, this provision would only apply to trusts created after the bill’s enactment, meaning that the GRATs included in the ProPublica report – along with any more that are created between now and the day the bill is signed into law – would remain valid as they are under current law.

Tech Millionaires Fear Their Favorite Tax Break Will Be Chopped (Ben Steverman and Kaustuv Basu, Financial Advisor) - The capital gains exclusion for Qualified Small Business Stock (QSBS) has been a boon to tech industry entrepreneurs and investors for more than a decade, by providing a valuable tax break to those who invest in early stage high-growth companies. Designed to encourage seed investment in startup businesses, the QSBS exclusion allows investors in certain corporations with under $50 million in assets to exclude up to 100% of their first $10 million of capital gains when they ultimately sell the stock. And with venture capital money flooding Silicon Valley and startups soaring to high valuations, the tech industry has been by far the largest beneficiary of QSBS’s tax advantages, with investors in early stage startups that eventually become successful being able to reduce their tax bills by millions of dollars. But the proposed American Families Plan reconciliation legislation being debated in Congress would sharply reduce that benefit, allowing only 50% of the eligible QSBS capital gains to be excluded in the first place (i.e., at the maximum eligible $10M of capital gains, only $5M would be excluded, and if capital gains were only $5M in the first place then 50% or $2.5M would be excluded). Of course, a 50% capital gains exclusion is still a substantial tax break, but the difference from the current law could result in millions of dollars in additional taxes for investors in highly appreciated stock of companies they invested in years ago. And furthermore, the proposed changes would be effective for any stock sold after September 13, 2021, meaning that, if the bill is passed as written, investors would be ‘locked into’ the lower exclusion, even if they originally invested into the company years ago (long before the bill’s enactment) in anticipation of the future tax benefit. However, given the wealth and influence of the tech industry and the billions of dollars at stake, there is certain to be a lobbying blitz to preserve the exclusion, or at least change the provisions to be more favorable to those who already hold highly appreciated QSBS (and therefore would be the most impacted if the exclusion were reduced) and perhaps only limit the gains for new companies created after the legislation is enacted.

More Than One Target Client? Here's How To Make It Work (Julie Littlechild, Absolute Engagement) - There are many benefits for financial advisors to building a business around a clearly defined target market or niche. For one thing, it allows the advisor to narrowly focus their expertise and client experience around the needs of a specific clientele, allowing the advisor to deliver higher-value service to those clients while improving efficiency through a standard approach specialized to those clients. Also, defining a niche has clear advantages for building a marketing strategy, allowing the advisor to tailor their messaging to differentiate themselves from other advisors who may be offering otherwise-similar financial planning services. So given the benefits of defining a single target market, could it be possible to multiply those benefits by serving multiple targets (or simply help manage risk by not going ‘all-in’ on just one target clientele?)? While such an approach is possible, Littlechild suggests that the specialized expertise and processes required to serve a narrowly defined niche mean it is most likely to be successful for a firm with enough scale to have separate teams and processes for each niche served. In other words, an advisory firm could have teams to serve multiple niches, but any one advisor at the firm would still be focused on a single specialization. And advisor firms serving multiple target markets must still take care that their niches complement each other and that the marketing messages for each remain clear and distinct from each other… after all, the primary advantage of marketing to a single niche is that a prospective client can immediately understand that an advisor’s services are for them, and anything that distracts from that message (e.g., a long list of different niches) risks undermining the sense of ‘exclusivity’ that niche advisors work to cultivate. Above all, though, in order to be successful, an advisory firm serving multiple target markets needs to serve each individual target as well as if they were serving that target exclusively, meaning the decision to serve multiple target markets should be a natural outgrowth of the advisory firm’s desire and ability to serve those markets.

How To Exceed Client Expectations (Stephen Wershing, The Client Driven Practice) - Getting client feedback helps financial advisors gauge their clients’ satisfaction with their services and focus their attention on areas that need improvement. But the kinds of questions that advisors ask to get that feedback can make the difference between a useful response and a generic one. Because, while most clients may be generally satisfied with their experience (otherwise they would have probably moved on to another advisor!), simply asking them about their satisfaction misses the point of understanding what they expected to get in the first place. Which is important, because in the end we don’t just judge an offering by the quality of the service, but its quality relative to what we expected it to be in the first place… which means there’s no way of knowing how their clients are really evaluating the advisor (which could be completely different from how the advisor evaluates themselves) without knowing what they expected in the first place! Perhaps even more valuably, asking clients about their expectations can help the advisor gauge how those expectations change over time: For example, a client who hires an advisor to help them plan for retirement will initially expect the advisor to help them set up and implement that plan, but once the client actually retires, their expectations (and accordingly, the type of advice that the advisor must deliver in order to meet those expectations) may be entirely different. Furthermore, having these conversations with the client not only gives the advisor valuable feedback, but also helps to remind the client how their expectations may have evolved over time (perhaps as a result of following the advisor’s guidance and improving their own outlook on the future!). Ultimately, there may be no higher goal for a financial advisor than to have altered a client’s future expectations for the better… but there is no way of knowing for sure without asking the client’s expectations to begin with.

Keeping Your Advisory Firm Alive And Relevant In A More Digital Era By Making Your Expertise Visible (Elizabeth Harr, Advisorpedia) - Throughout the COVID-19 era, professional service firms have become increasingly reliant on their digital presence to drive new business. But while digital presence is the pipeline through which a firm can reach its potential clients at any time, relevance is what actually draws the eyes of those clients and separates a firm from its competitors. Because, in an era where every advisor has a digital presence of some kind, it is not enough to have just visibility (but no meaningful demonstration of expertise) or just expertise (with no visibility to bring that expertise to a wide audience)… a firm needs the combination of visibility and expertise to achieve high growth through digital means. This means having strong skills in digital marketing areas like social media, audience research, and Search Engine Optimization (SEO), while using the available marketing channels (such as blog posts, newsletters, and podcasts) to promote the advisor’s expertise. And while more traditional, non-digital marketing techniques like speaking and networking might also be incorporated, the primary goal of these techniques might be simply to draw more people toward the advisor’s digital presence (where that expertise can be demonstrated on an ongoing basis beyond a single event or meeting). But whatever the channel, what’s most important is that the advisor’s message is clear and relevant to the audience that the advisor wants to reach, and that all of the marketing channels complement each other to create a self-reinforcing structure that resonates with potential clients and stands out in the digital crowd.

As More Workers Go Solo, The Software Stack Is The New Firm (Seema Amble, D’Arcy Coolican, & Alex Rampell, Andreessen Horowitz) - Applications for new businesses have soared during the pandemic, as former employees seize the opportunity to start their own businesses. But while opportunities for “solopreneurship” abound – including in the domain of being a(n independent) financial advisor – replacing the infrastructure of a larger company can be challenging. Areas that must be replaced include operational support (such as finance and legal functions), marketing for customer/client generation, and networks of community support. And while technological solutions currently exist for these areas, the software for each often does not integrate with the others. An alternative would be an integrated software stack where each tool works together; for example, the booking tool would sync with the calendar and the Customer Relationship Management (CRM) software. This integration allows the solo firm owner to spend more time on what they produce rather than on business operations. It is also an opportunity for software companies themselves to ensure that the use of their product remains sticky. As an industry with a long tradition of solo firms, financial advisors have no shortage of technological tools to choose from – covering operational support, new client lead generation, and network building, and many other areas. In turn, as the “software stack” grows for new firms in the financial services domain, advisors who decide to set out on their own have the option of picking software options a la carte or leveraging a network of advisors to take advantage of a bundled tech stack. The ironic endpoint is that even as more and more large financial services firms insist that size and scale will be essential to survive and thrive, the ongoing evolution of the advisor technology space (as with other industries noted in the article) is making it increasingly feasible for smaller and smaller firms to survive and thrive, creating the potential in the midst of waves of mergers and acquisitions for a “golden age” of solo advisor productivity and profitability as well!

The Promise And Perils Of Decentralized Finance (The Economist) - The rise in popularity of cryptocurrencies like Bitcoin has ignited a debate over their value and usefulness. While some see crypto as a fad whose primary use is for criminal activity (e.g., black market transactions, inter-country money transfers, and money laundering), others see the potential for a multitude of use cases to improve the way money itself is used. One of these latter ideas is Decentralized Finance, or DeFi. Financial activity taking place on DeFi networks includes trading on exchanges, as well as issuing loans and taking deposits using “smart contracts”. This has the potential to offer users trustworthy, transparent, and fast transactions… and consumers have started to take notice. In fact, the value of transactions that the Ethereum network verified in the second quarter of 2021 reached $2.5 trillion, around the same value of transactions Visa processed during the quarter. What remains to be seen is how DeFi transactions will interface with the “real world”. From the volatility of the cryptocurrencies underlying the DeFi space, as well as the need to take security measures to protect crypto holdings and blockchains (networks of computers that keep an open, incorruptible common record of transactions and update it without the need for a central authority), questions remain about the scalability of DeFi into mainstream use cases. Further, the US government has been eyeing DeFi’s rise warily, as new Securities and Exchange Commission (SEC) Chairman Gary Gensler has indicated that DeFi activities can be subject to financial services industry regulation. Ultimately, as crypto prices rise and fall, financial advisors will no doubt continue to field questions from curious clients, and DeFi could represent a future area of interest. Though with the ability to trade stocks on DeFi networks gaining momentum, the use cases for advisors could extend into more direct investment management as well, potentially becoming the RIA custodians and broker-dealer platforms of the future!?

AI Should Augment Human Intelligence, Not Replace It (David De Cremer & Garry Kasparov, Harvard Business Review) - Humans have a long history of harnessing technology to improve productivity. Yet, the increasing use of technology can come with downsides, particularly for those whose jobs are lost to automation. Nonetheless, even as artificial intelligence (AI) expands further into the realm of knowledge workers (including financial advisors!) opportunities exist for positive-sum, rather than zero-sum, interactions with this new technology. As while AI-based tools are fast, accurate, and rational, humans still have the advantage when it comes to intuition, emotions, and cultural sensitivity. Thus, rather than operating separately, combining the strengths of AI and humans can lead to greater productivity than either side operating alone. One field where this has proven to be the case has been chess, where “cyborg” teams of humans and computers working together have regularly defeated humans or the best computers playing alone. Similarly, cyborg advisors can combine human and technological strengths to provide better service to clients than a human or “robo-advisor” could do alone. For instance, while a computer can compute an optimal investment portfolio or run thousands of Monte Carlo simulations to determine a plan’s chances of success, human advisors have the emotional intelligence and communications skills to understand a client’s needs, aid them in exploring scenarios they hadn’t analyzed because they didn’t know it was possible, and help them to actually implement financial plans as an accountability partner. Ultimately, the key point is that embracing the power of technology can allow a cyborg advisor who augments themselves with technology to go deeper with clients and to provide a level of service that neither another human advisor, nor an AI tool, could possibly do alone.

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.