Executive Summary
Enjoy the current installment of "weekend reading for financial planners" - this week's edition kicks off with a look at the top "watch list" priorities from FINRA in the coming year, including new scrutiny on floating-rate bank loans, alternative mutual funds, and the dramatic increase in recent years of "securities-based lending" where affluent investors are using their portfolios to get access to faster, "cheaper" money to buy everything from real estate to luxury items (and raising concerns of what happens if there is some market volatility and the loans must be repaid quickly!).
We also have a number of investment-related articles this week, from an interesting defense of the benefits of the "maximize shareholder value" philosophy from AQR's Cliff Asness, to some thoughts from Howard Marks about the lessons we can draw about the recent volatility in oil prices, a look at the use of municipal bonds in portfolios, an overview of the coming money market reforms (and how some clients may end out in money markets with floating NAV if they're not paying attention!), and a look at where the next market meltdown and advisor debacle may come from (think non-traded REITs and risky bond funds).
From there, we have a few technical planning articles, including: a review of the FAFSA (Free Application for Federal Student Aid) and some planning opportunities and issues for those sending children to college; a look at the emerging rise of "deferred income annuities" and their potential role in a retirement portfolio; and a nice in-depth explanation of the Social Security earnings test, how it works, and how it can impact the decision about the optimal time to begin Social Security benefits.
We wrap up with three interesting articles: the first looks at how spectacularly bad the 2014 economic predictions were about everything from interest rates to the price of oil, yet notes that people will continue to seek out such predictions anyway... not because they want the accuracy of the prediction, but because they're seeking the reassurance that it implies; the second gives an interesting look at how "time perspective" (one's orientation/focus about events in time) can impact financial planning decisions, and raises the question of whether planners should do more to understand their clients' time perspectives when providing advice; and the last gives an interesting overview of the regulatory advocacy efforts of the FPA of Florida state coalition as a template for how financial planners can and are having some success in lobbying and advocacy.
Enjoy the reading!
Weekend reading for January 10th/11th:
FINRA to Examine Securities-Backed Lending Practices (Matthias Rieker, Wall Street Journal) - In an era of tight credit where getting a mortgage can be a pain (even for affluent individuals), higher net worth investors have been increasingly using their portfolios as collateral for a growing volume of securities-backed borrowing to purchase anything from homes to luxury items (egged on in part by many large brokerage firms incentivizing their advisors to deploy such strategies). The activity has grown to the point where FINRA is adding the practice to its watch list for 2015, as while this hasn't been an area with a lot of disciplinary issues and abuses, concerns have been raised that the extent of the borrowing and leverage against portfolios could exacerbate market volatility in a time of crisis (although securities-based lending is not used to buy more securities, like a margin loan, a market decline could still trigger a call on the loan and/or amplify the selling pressure). Other issues on the FINRA watch list for 2015 include floating-rate bank loans (given their difficulty to value and relative illiquidity, in addition to credit and call risk) and also alternative mutual funds (where FINRA is urging that offerings be more transparent about the details of their strategies). FINRA also noted that in 2014, fines were almost double the pace of 2013 (with $127M in penalties), and restitution payments more-than-tripled (to $32.3M), although the number of disciplinary actions were down 11% (to 1,365 actions against firms and their brokers).
Shareholder Value Is Undervalued (Cliff Asness, AQR) - Recently, the idea that corporate management should focus on maximizing shareholder value has been under attack, being blamed for everything from underinvestment to inefficiency to exacerbating income inequality (including a popular piece from GMO's James Montier covered previously in Weekend Reading). Yet Asness points out that many of the critiques are fundamentally flawed; for instance, it is common to criticize the shareholder value approach as being too focused on the short-term and maximizing "today's" share price instead of long-term value, yet Asness points out that markets price stocks based on the long-term forecast of what the stock will be worth, which means even "short-term" stock price should still be a reflection of long-term impact. The caveat, of course, is that this mechanism only "works" if markets are actually at least relatively efficient in the long run; if stock prices consistently make big errors that fail to reflect the impact of management decisions on long-term value, then outcomes could be distorted, but while markets are clearly not always perfectly efficient (Asness acknowledges they can be "too short-term" from time to time), they're not necessarily that consistently bad either (which means maximizing shareholder value is still a reasonable mechanism). Asness also critiques other critiques, including: while focusing on stock price is not a strategy, it does result from a strategy and still encourages corporate management to strategize; while there are some flaws to options-based compensation, that doesn't mean maximizing shareholder value is bad, just that options-based compensation perhaps deserves a fresh look; management trying to manage the "expectations game" is actually a sign that markets are relatively efficient, and theoretically supports the case for maximizing shareholder value; and corporations may be encouraged to focus on shareholders but not other stakeholders (e.g., the environment?), but Asness again notes that conflicted companies should still have such concerns reflected in their share price. The bottom line: maximizing shareholder value may not be perfect, but it's better than we give it credit to be (and if it's not, you're making the case that markets are wildly inefficient), and many of the criticisms about it aren't actually flaws with the shareholder value approach, just other things we should separately try to fix.
The Lessons Of Oil (Howard Marks, Advisor Perspectives) - For much of 2014, the obsession of investors was around interest rates and the potential impact of the Fed as it tapered its bond buying and began to talk about raising rates again at some point... yet despite the belief that rising interest rates were only a matter of "when" and not "if", rates declined significantly in 2014 and the consensus was wrong. Similarly, Marks notes that while there was little focus on the price of oil last year, suddenly in December oil became the market's new obsession, as its price plummeted near (and since below) $50/barrel. Marks characterizes this as a "failure of imagination", where most forecasters were sticking far too close to the then-current $100+/barrel prices earlier in the year, and underestimated the potential for a significant price change. The greater difficult, though, is that even though the price change has now occurred, most still struggle with the "failure of imagination" to consider all the ramifications and "second-order" consequences that may occur. For instance, lower oil prices will reduce revenue for oil-producing nations, contracting their GDP and driving up their budget deficits; earnings decline at many energy companies, but rise for airlines; cheaper gasoline leads people to drive more, boosting lodging and restaurant industries, and buy bigger cars (which boosts the auto industry, but increasing consumer willingness to buy gasoline-powered cars can slow the trend towards alternatives and eventually benefit the oil industry); etc. The latter in particular is important, because it highlights the fact that many of the impacts of a big price change are ultimately self-correcting (lower gas prices = people drive more + decline in drilling for supply + decline in product = lower supply and higher demand eventually producing higher gas prices again). In turn, though, the real "risk" in the investing sense is when the second-order effects are not self-correcting but ultimately disruptive, leading to broad-based selling or highlighting a previously unrecognized "fault line" in the market that sets off a major tremor. The bottom line, as Marks quoted economist Rudiger Dornbusch: "In economic things take longer to happen than you think they will, and then they happen faster than you thought they could... [and they go much further than you thought they could."
When Municipal Bonds Get Exciting (Michael Finke, Research Magazine) - The classic appeal for municipal bonds is their tax-free nature, and as a result municipal bonds that have the same yield as (Federal) government bonds will provide a better after-tax return, especially for high-income investors. Of course, since this is "known" market knowledge, the prices of municipal bonds can and normally do adjust to provide equivalent after-tax yields to Treasury bonds of similar duration; however, in practice Finke notes that this is usually only true for shorter-term munis, and that at longer durations the after-tax yield is better than what would be expected by investor after-tax expectations alone. In fact, this "gap" between what longer-term muni bonds "should" pay and what they do pay has long been a puzzle of the finance world. Traditionally, researchers assumed that the difference must be attributable to the slightly higher default risk of muni bonds, or the fact that many munis are callable, or the fact that it's often hard to recover residual assets when a muni bond does default (think Detroit muni bondholder fiasco); nonetheless, given that only about 0.5% of municipal bonds defaults in the U.S. in the last half of the 20th century, munis haven't actually been very risky. Another possibility is the fear that the Federal government could someday change the tax treatment of munis and begin to tax them (which a 1988 Supreme Court ruling has made possible), but that seems unlikely (and any changes might well grandfather existing investors anyway). Yet another theory is that muni bonds pay better because of their illiquidity (which also presents a challenge for investors who wish to buy them), though as transaction costs fall and more pooled investment vehicles become available, this too is less of a concern than it once was. And ironically, the relative illiquidity and therefore potential inefficiency of muni bonds means it may be one area where an active manager could actually provide value.
Prepare Now for the Coming Money Market Reform (John Frownfelter, SEI Practically Speaking) - Over the years, consumers have increasingly considered money market funds to be synonymous with cash, offering daily liquidity, principal stability, but offering a better yield; yet the reality is that money market funds are not FDIC insured, and can lose money, as was witnessed during the financial crisis when the Reserve Primary Fund "broke the fund" and its NAV fell to $0.97 after Lehman Brothers declared bankruptcy. To reduce the risk of another tumultuous money market event, on July 23 of 2014, the SEC adopted new money market rules, with a 2-year time window (until October 14, 2016) for firms to adjust. Key aspects of the new rules for advisors to be aware of include: there will now be a distinction between "retail" funds and "institutional" funds (to be retail, all shareholders must be natural person human beings, and if there is even one non-natural-person investor, the fund is "institutional"); institutional money market funds will have a floating NAV (out to four decimal places) that changes daily, unless it invests at least 99.5% of its assets in government securities; for all money market funds, if the fund's weekly liquid assets falls below 30%, the board can suspend redemptions for 10 days and may impose a redemption fee of up to 2% (and if the fund's weekly liquid assets fall below 10%, non-government money market funds are required to impose a 1% redemption fee unless the board decides not to). For advisors, it will be important to know going forward whether a client's money market fund is retail (stable NAV) or institutional (floating NAV), and whether it holds only government securities (liquidity fees and redemption gate optional) or can hold other bonds as well (liquidity fees and redemption gate apply by default). Although the rules don't require firms to comply until late 2016, expect to see many money market funds begin to reform themselves starting this year to come in line with the new requirements.
The Next Great Market Meltdown (Bob Veres, Financial Planning) - Veres makes the case that after Congress and regulators failed to fix compensation and sales incentives after the financial crisis, the seeds of the next debacle have been sown, and will soon come to bear. The key flashpoints are anticipated to include non-traded REITs (which Veres has warned all along were problematic given the combination of opacity, illiquidity, large selling concessions to brokers, and generous "due diligence" fees to broker-dealers, and now seem to be imploding before our eyes), and "high-income" bond funds (that are loading up on unrated private bond issues, low-quality debt, higher-duration bonds, all of which will be creamed when interest rates tick up and/or risk spreads widen, with the potential Puerto Rican bond default just the tip of the iceberg). Veres cautions that because these vehicles are used so widely by many "advisors", that when the tide turns, it will be damaging not only to the reputation of large financial services firms, but the reputation of financial advisors in the aggregate as well, and that true advisors may find themselves trying to emphasize once again the difference between what they do and those who are still primarily focused on sale of (sometimes questionable) financial services products.
Gateway To College Aid (Jerilyn Klein Bier, Financial Advisor) - It's January, which means it's time for those who have children heading to college to begin preparing the Free Application for Federal Student Aid (FAFSA) to be considered for Federal and state financial aid (many private colleges also require students to complete the CSS/Financial Aid Profile application as well). Technically, the FAFSA isn't due until the end of next school year, but many individual schools have much earlier deadlines, and for some financial aid is awarded on a first-come first-served basis, so waiting can be a losing proposition. Experts suggest that parents should go through the application process even if they think they won't qualify or have been denied in the past; one recent study found that even amongst parents who earned $100,000 or more, 11.3% received need-based grants (especially likely if they have more than one child in college at the same time) and 18.9% received non-need and merit-based grants. Some key planning issues to consider this year include: if the FAFSA is filed "early" (before the 2014 tax return is done), remember to submit an updated FAFSA once the tax return is finalized; same-sex couples legally married must now file as a married couple this year; if a student's parents co-habitat, they are now treated as married, even if they are legally divorced or were never legally married; and distributions from grandparent-owned 529 plans are now being reported as untaxed income (although the asset itself is not included, but this treatment can actually be worse for the student, so it's best to use such funds for senior year after all college aid applications are done). Unfortunately, completing the FAFSA does take time, though the online version is a bit easier because the software has built-in logic to skip questions that aren't relevant based on prior responses, and popular financial aid expert Mark Kantrowitz provides helpful guidance material at Edvisors.com.
Taking A Closer Look At Deferred Income Annuities (Wade Pfau, Journal of Financial Planning) - A deferred income annuity (DIA) is perhaps most easily understood in contrast to its counterpart the immediate annuity; with an immediate annuity, a lump sum is paid in exchange for payments (often for life) that begin immediately (or at least, within one year), while a deferred income annuity is purchased with a lump sum to receive payments (again often for life) but not beginning until some point in the future. For instance, a 65-year-old might purchase an immediate annuity with payments for life beginning now, or a deferred income annuity where payments won't begin until age 85. The advance of such an arrangement is that it leverages the potential mortality credits of the contract, effectively providing greater payments over time for those who really do live long enough to enjoy them, and more generally it ensures that consumers get "lifetime" income they cannot outlive, but requiring a small lump sum to purchase than an immediate annuity beginning today. DIAs can also provide a form of "dementia insurance" by effectively automating payments and eliminating potentially-self-destructive decisions in the later years. On the other hand, the illiquidity of a DIA still limits its ability to be accessed earlier if circumstances should change, funds are no longer invested in markets that may provide a greater return (albeit at the risk of producing a worse one), and the inflation-protection options for DIAs are more limited (payments can be guaranteed during the payment years, but not the intervening deferral period). Nonetheless, studies are beginning to explore strategies that may integrate together DIAs and portfolios - where the portfolio covers the early retirement years (e.g., with a 20-year TIPS later), and the DIA covers the later years, often with at least comparable overall payments but avoiding the risk of outliving the portfolio. With recent new Treasury Regulations authorizing so-called "Qualified Longevity Annuity Contracts" (QLACs, essentially a form of DIA) to be purchased inside retirement accounts, there are also more options than ever about how to fit a DIA into a retirement plan.
Social Security’s Earnings Tests: A Primer for Financial Planners (William Reichenstein & William Meyer, Journal of Financial Planning) - The Social Security Earnings Test potentially reduces Social Security benefits for those who receive payments prior to full retirement age. The test applies once income exceeds a threshold; in 2015, the threshold is $15,720, above which benefits are reduced by $1 for every $2 of earnings. In the year the individual reaches full retirement age, the income threshold is higher - at $41,880 (in 2015) - and the reduction is $1 of benefits for every $3 of earnings over the line; notably, in the year of full retirement age, the $41,880 threshold only applies from January 1st until the exact date that full retirement age is reached (and for the remainder of the year, no amount of income would trigger a reduction in benefits). In addition, if Social Security recipients have volatile income, where it's higher in some months and lower in others, the earnings test can be applied on a monthly basis instead for the first year (and if the monthly income threshold is exceeded, benefits are simply not paid for that month). And if spousal or dependent benefits are being paid based on a worker's benefits and that worker is over the earnings test, it can reduce all benefits being paid on that worker's benefit (i.e., the retirement and associated spousal and dependent benefits). For the purpose of the earnings test, it's also notable that only earned income applies, which means wages and (net) earnings from self-employment; distributions from retirement accounts, investment income, pensions and annuities, and Social Security benefits themselves do not count. And earnings count based on when they were actually earned, not paid, so a payout of accumulated vacation or sick pay, a bonus, severance, or deferred compensation will generally not count towards the earnings test when paid given that it was earned previously. Notably, applying for benefits before full retirement age causes a reduction in benefits, but any benefits not actually paid due to the earnings test will trigger a re-calculation of benefits at full retirement age, un-adjusting out the previous early reduction; thus, in practice, the earnings test is effectively the equivalent of simply forcing the recipient to not elect early and instead receive the (unreduced) full benefit at full retirement age.
Lessons From a Year of Market Surprises (Jason Zweig, Wall Street Journal) - The Wall Street Journal's January 2014 economic forecasting survey had a spectacularly bad track record last year: 48 out of 49 economists expected the 10-year Treasury to exceed the 3% by year-end (with an average forecast of 3.52%), but instead it ended around 2.2% (and spent only 3 days all year above 3%); economists expected oil to finish around $95 per barrel, but finished around $50; despite Ebola hitting the markets hard in the fall and knocking them back almost 10%, the S&P 500 finished with a total return in excess of 14%; and active managers had one of their worst relative performance years in decades. Given such a bad year, Zweig raises the question of why, despite the track record, we still continue to focus so much energy on financial pundits and their predictions. His answer is that in the end, the point is not really that people want accuracy, but that they want reassurance, as admitting that the future is completely unknowable is just too frightening. Nonetheless, if you're going to rely upon - or even pay attention to - forecasts, try to follow those that are being tracked and tested and evaluated; Zweig recommends sites like Simple Forecasting, and forecasting expert Philip Tetlock's Good Judgment Project.
Time Perspective and the Practice of Financial Planning (Robert Albright & John McDermott, Journal of Financial Planning) - Recent studies in the field of psychology by famed researcher Philip Zimbardo has found that people vary in their "time perspective" and that their orientation around time can have a major impact on their attitudes and behaviors, including the tendency to engage in risky behavior. The five time perspectives include: past-positive (focusing on positive prior events); past-negative (focusing on negative past events); present-hedonistic (focused on enjoying the present); present-fatalistic (focused/worried on the future with a helpless/hopeless attitude); and future (a general future orientation with a strong tendency to pursue future rewards). This research paper examines the time perspective construct in the context of financial planning, and whether/how awareness of both the client's and the planner's time perspective could impact financial planning recommendations. The researchers found that planners themselves are disproportionately more likely to have a Future focus (not surprising given their line of work!), and are far less likely to have a past-negative or present-fatalistic perspective, and future research aims to explore how client attitudes may differ, and the kinds of investment/client dysfunctions that can arise from problematic time perspectives. The implication is that in the future, advisors might try to identify a client's time perspective (or outright give them a measuring tool to evaluate it), and use that information to better anticipate and understand where challenges may arise.
Planners Are Succeeding At Regulatory Advocacy (Dan Moisand, Journal of Financial Planning) - Advocacy to get legislation passed is difficult these days, when even measures with strong bipartisan support often get buried, and it's especially challenging for relatively "small" populations like the financial planning profession. Nonetheless, Moisand notes that financial planning is making progress. For instance, it was 10 years ago that the 9 FPA chapters in Florida decided to band together to create the Florida Cooperative of FPA chapters for state advocacy, and after years of building, the group has built strong relationships in the state capital of Tallahassee, and is now gaining access to meet with the state's Department of Business and Professional Regulation, its Office of Financial Regulations, and the Florida Insurance Consumer Advocate. The efforts in Florida, particularly around supporting consumer protections, has yielded several successes, such as the "Safeguard our Seniors" legislation that ensured those who were banned from the securities industry couldn't get a state insurance license to continue abusing seniors (which in turn has led to a dramatic reduction in complaints and investigations into annuity sales abuses), and more recently established an "unaffiliated insurance agent" license to give consumers access to insurance advisors not specifically in the business of selling insurance products. The FPA of Florida successes have been significant enough, that other states are now looking to emulate the model, including a recently formed coalition of state chapters in California, and FPA has a new state council task force examining how to adopt the approach in more states as well.
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!
In the meantime, if you're interested in more news and information regarding advisor technology I'd highly recommend checking out Bill Winterberg's "FPPad" blog on technology for advisors. You can see below his latest Bits & Bytes weekly video update on the latest tech news and developments, or read "FPPad Bits And Bytes" on his blog!
