Weekend Reading for Financial Planners (Apr 26-27)

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 April 26th/27th:

$600,000 Legal Tab in CFP Board Lawsuit? - Last month, the lawyers for Jeff and Kim Camarda filed a motion to compel the CFP Board to move forward on providing documents for discovery for their case with the organization, claiming that the CFP Board had not been moving forward in a timely manner. Yet the case remains at a standstill, as earlier this month, the CFP Board responded with its own motion asking for more time, noting that the organization is working through some 60,000 documents, is preparing to hand over 25,000 documents, and has already logged more than 2,000 hours of legal work leading up to its motion. Notably, though, 2,000 hours with a Washington DC law firm that may be charging upwards of $300/hour means the CFP Board could already be in more than $600,000 of legal fees, a non-trivial amount relative to its "only" $23M annual budget (of which only about half is actually part of its operating budget, with the remainder allocable to its public awareness campaign), and raising the question of whether the case has been a worthwhile 'investment' for the organization; notably, both sides in the matter have requested that the court order the other side to pay its legal fees, which means ultimately the CFP Board may be off the hook for its costs if it prevails, but facing a significantly higher pricetag if it does not. In the meantime, the case itself (and the associated costs) continues.

Investing for Retirement: The Defined Contribution Challenge - This article by researchers at GMO takes a great overview of the current landscape for retirement investing, with a focus on the optimal glidepath to be used in retirement in an increasingly defined-contribution-centric world (where retirees have to confront such asset allocation decisions). The first part of the article makes the familiar case that good investment decisions for retirees are not just about maximizing returns (or even wealth) for a given level of risk; instead, the goal is to minimize the Expected ShortFall (ESF) a retiree might face (i.e., to reduce the risk of running out of money and having a shortfall of retirement wealth). When viewed from this perspective, the general outcome is that equities would decline in the years leading up to retirement, and then decline a bit further in retirement, though each precise glidepath would vary based on the details of the individual (such that there can easily be a mismatch between a retiree and a typical target date fund). However, the GMO paper goes further to note that the target date fund glidepaths generally assume all future return environments are the same in the long run; in other words, they fail to account for valuation. This matters because while a valuation measure like Shiller P/E 10 is not very effective at predicting short-term returns, it can be very good at predicting the long-term returns over which retirement occurs. Once adjusted for valuation, the optimal retirement glidepath begins to look very different - it moves up and down (inversely) with market valuation, where stock exposure could be extremely low in the years leading up to retirement if valuation is high, with equity exposure subsequently rising significantly in retirement if equities become cheap. At the end, the authors examine Monte Carlo scenarios (with valuation adjustments factored in) that similarly show that more dynamic asset allocation in retirement can lead to lower failure rates and reduced shortfall risk. The bottom line - similar to the April 2009 issue of The Kitces Report on "Dynamic Asset Allocation and Safe Withdrawal Rates" - is that more dynamic asset allocations that are adjusted based on long-term market valuation can improve sustainable retirement income.

Are Boomers Headed for Retirement Disaster? - In Research magazine, Texas Tech professor Michael Finke looks at the current landscape of baby boomers approaching retirement, and suggests that the situation might not be as bad for most boomers as the media suggests... but that unfortunately, those who are in the greatest danger are also the ones least likely to see a financial advisor to get help for it. The backdrop for this challenge is that we're also in the midst of a "brave new experiment" for self-funded retirement income (at least, for those who want anything to live on beyond the limited payments from Social Security), though to be fair even in its heydey in 1980 the proportion of American workers participating in a defined benefit pension plan was only 38%; accordingly, the share of near-retirees with defined contribution assets rose from 12% in 1983 to over 60% today. Parsing the data further, though, reveals an emerging group of "haves" and "have-nots"; amongst the top 10% of wealth the average account balance is $200,000, compared to only $22,000 for a middle class employee, and the median for workers with an income over $100,000 is savings of about $100,000 but an average of $360,000 (suggesting a small subset of high-income workers with very large account balances pulling up the average, in part perhaps because they also receive the greatest benefit from our current retirement tax incentives). Exacerbating the problem is that the top income quintile of workers are actually more likely to still participate in one of the few pension plans that are left (58% of them) than those at the bottom end of the spectrum (where only 25% participate in pensions). So which groups are most at risk? Lower middle class workers who might have had a (union-negotiated) pension in the past but don't anymore, and higher-income private sector workers who simply don't save enough; notably, the broad middle class may be in less danger as Social Security actually does replace a healthy chunk of their income (so if they do have a shortfall, it won't be severe). On the plus side, recent research suggests that helping retirees get a 'reality check' by actually going through a process of estimating what they'll need for retirement can help motivate savings behavior, and more recent research has suggested that retirees may not spend as much throughout their retirement as is commonly assumed (which means they may need less than traditional financial plans have suggested and not actually be as far behind).

2 Schools Of Thought On Retirement Income - This article by retirement researcher Wade Pfau in the Journal of Financial Planning looks at the landscape of retirement planning strategies and theories, and breaks them into two categories: the "probability-based" approach, and the "safety-first" approach. The probability-based approach is generally linked to traditional investment concepts (e.g., Modern Portfolio Theory), where portfolios are diversified to reduce risk, managed on a total return basis, and withdrawals are taken systematically from the portfolio at a withdrawal rate low enough to be "safe" and have a high probability of success. By contrast, the safety-first approach - sometimes framed as an "essential versus discretionary" income strategy - typically uses bonds with fixed maturity dates or annuity guarantees to "ensure" essential expenses are funded, and then a mix of more volatile investments with greater upside (and downside) are used to fund discretionary. Pfau dates the probability-based approach back to the first safe withdrawal rate studies by Bill Bengen in the 1990s, while the safety-first school has older roots stemming from both the academic models of lifecycle finance decades ago and also the insurance industry's traditional use of annuities. Notably, the safety-first approach often focuses more heavily on segmenting and prioritizing spending (to match to the safety-first floor), while the probability-based approach often works simultaneously towards the entire goal. Pfau also notes a third approach - essentially a compromise/combination of the two - which he labels as "time segmentation" where separate pools (e.g., "buckets") of investments are set up based on time horizon to fund goals, with conservative assets for near-term goals and riskier assets for long-term goals (given its basis around portfolios, Pfau suggests this is probably closer to probability-based than safety-first).

Do Small Cap-Value Stocks add Value in Retirement Portfolios? - Since Fama and French showed that small-cap value stocks have produced superior returns in the early 1990s, much debate has emerged about whether this outperformance will persist in the future and whether investors should tilt their portfolios accordingly; in this article, financial planner and actuary Joe Tomlinson extends the issue one step further, to look specifically at the role of small-cap value stocks in portfolios trying to deliver sustainable retirement income. Looking at historical returns through recent times, Tomlinson notes that the small-cap value return premium appears to remain (at least so far), and although it's accompanied by a higher standard deviation the risk-adjusted returns (as measured by the Sharpe ratio) as still superior to large-cap stocks. Yet while the pure investment performance shows superior risk-adjusted returns, Tomlinson raises the question of whether the results would still be superior when taking into account the sequence risk that a retiree faces (which is generally exacerbated by higher levels of volatility). Notwithstanding the volatility, Tomlinson finds that small-cap value stocks do add 'value' to a retirement portfolio (so much that the "ideal" retirement portfolio would be almost 100% small-cap value!); an alternative scenario assuming lower bond returns, a small equity risk premium, and a smaller small-cap value premium were still generally supportive small-cap value dominating the equities portion of the allocation (i.e., mostly small-cap and not much large-cap, to the extent equities are held in the first place), and the same was generally true with starting withdrawal rates anywhere in the 3% to 5% range (with either set of return assumptions). Overall, Tomlinson's conclusion is that, at least based on this research, retirees should generally have small-cap value allocations of at least 30% of their portfolio.

Lifetime Expected Income Breakeven Comparison between SPIAs and Managed Portfolios - This article by retirement researchers Larry Frank, John Mitchell, and Wade Pfau, looks at comparisons of lifetime cash flows between single premium immediate annuity (SPIA) contracts, and using managed portfolios, with a focus on if/when it's best to annuitize with a SPIA to improve retirement outcomes and at which asset allocations SPIAs may be more appealing than a managed portfolio alternative. The managed portfolio approach is assumed to continually recalculate a reasonable withdrawal rate relative to the account balance and age of the individual at the time, and is compared to available SPIA rates at those age points. The results generally find that retirees willing to hold even just moderate equity allocations (e.g., 50%) have superior outcomes to SPIAs, and in some cases even at lower equity allocations. To the extent that SPIAs are favored at all, it is generally only in situations with no concern for final account balances (e.g., an inheritance), very pessimistic market return assumptions and highly optimistic longevity assumptions, and even then the optimal SPIA starting point is beyond age 70 (and at more moderate longevity assumptions, beyond age 80). Overall, the study finds that, especially in today's low interest rate environment, retirees should be wary about annuitizing at the start of retirement.

Does Rebalancing Really Pay Off?? - This Advisor Perspectives article by Michael Edesess looks at the research on the benefits of rebalancing, which he suggests are actually quite meager despite how popular the approach is, dating back to what is now an 18-year-old article written by William Bernstein on his website entitled "The Rebalancing Bonus". In fact, Edesess points out that Bernstein's original article itself is actually flawed; it compares a rebalanced portfolio to the average of the returns achieved by the component parts over the 1926 thru 1994 time horizon (showing a 0.49%/year "rebalancing bonus"); the problem is that over a multi-year time period, that's not actually the return of the buy-and-hold (i.e., don't rebalance) alternative, and once a proper buy-and-hold benchmark is used, the rebalanced portfolio actually underperforms the long-run buy-and-hold portfolio by 0.83%! In point of fact, Bernstein has separately acknowledged that a buy-and-hold portfolio will beat rebalancing when the expected return of one asset is significantly more than the other, but it will come at the 'cost' of greater risk as the compounding returns increase the allocation to the higher return (and ostensibly higher risk) asset. However, Bernstein also makes the case that if the returns are expected to be equal, that the rebalancing bonus will remain, and has done so historically... yet in practice, most advisors and clients hold multi-asset-class portfolios that do not have all equal returns! Nonetheless, in theory the research suggesting that markets tend to mean-revert should alone create a rebalancing bonus... yet again, Edesess notes that research is also showing markets exhibit momentum effects, for which active rebalancing can be a detriment! In fact, when Edesess conducts his own empirical study, this is exactly what he finds; most often, rebalancing wins (about 70% of the time), but the margin when it wins is less than half the size of how much it loses in the other 30% of cases, and overall the net result in the long run was almost negligible. In other words, rebalancing will really only "work" if it's timed to an environment where the returns of all the asset classes were relatively similar in the first place, and if the timing is off, rebalancing can actually be harmful.

Do Commodities Belong In Your Allocation? - In this article from Advisor Perspectives, Geoff Considine looks at whether there's really much value to holding an allocation to commodities, especially given how severely commodities have lagged over the past five years due to both low interest rates, low inflation, slow economic growth, and a raging equity bull market. Of course, the fundamental starting question is whether or why commodities should provide any real return in the first place, beyond simply trending with the general level of inflation. Keynes laid the foundation for the modern view of this, which is that the commodities futures markets should provide some expected real return by paying more to sell the commodity now than in the future as a reward for the risk that the price might fall precipitously during the intervening time period; in situations where commodities markets are in contango (current spot price is lower than the futures price), the real reward is to incentivize buyers to build and maintain storage facilities to hold the commodities for the future (though this benefit may be somewhat less certain). The empirical research suggests that this has held true historically; in a 2005 paper going back almost 50 years, the fully-collateralized zero-leverage commodities portfolio produced near-equity-like returns. However, another paper found that for any particular commodity, the real compounded return over time really was close to 0%; instead, it appears that most/all of the commodities returns were actually driven by the rebalancing effects amongst the diversified commodity components (and with a return that had little correlation to equities and thus appeared to be a strong diversifier in that regard). On the other hand, more recent criticism suggests that the prospective returns are generally less when commodities markets are in contango, and that as long as heavy speculator interest remains (as appears to be the case today), the natural returns predicted by Keynes may be unrealistic. Ultimately, Considine tests various allocations to commodities with some of his own models, and concludes that much of the inflation-hedge benefits can be replicated similarly or better by owning REITs and/or TIPS, and that at best perhaps a 10% allocation to a diversified collateralized futures strategy may add a little value, but only a little over the other inflation-hedging alternatives.

ETFs and the Rise of the Tactical Allocator: 5 Questions - Managed ETF portfolios are one of the most rapidly-growing segments of the investment marketplace, having grown by nearly 40% and crossed the $100B threshold in 2013. They managed ETF portfolio strategies span a wide range; Morningstar alone tracks over 600 strategies from 150 firms, which has led it to divide them into strategic, tactical, and "hybrid" (some strategic and some tactical) subcategories. A number of the biggest tactical players each have $10B to $20B of AUM now, in light of their excellent relative returns through the tech crash and the financial crisis (or in one case, based on their simulated hypothetical returns!). Given the variability in the space, the article recommends 5 core questions to do some due diligence on tactical managers, beyond just looking at short-term performance, including: 1) what role with the strategy play in the client's portfolio (is this about enhancing returns, or diversification, or reducing risk? Is it a supplement to the core holding, or meant to be the core?); 2) what is the strategist's investment "edge" and is it sustainable (Are they sector driven? Momentum based? Macroeconomic/fundamentally focused? Is there a reason to expect their results to persist?); 3) How does the firm establish the inputs to its models (given that most tactical firms use models, are the inputs purely quantitative or also qualitative? If there's a qualitative component, how is that judgmental overlay determined and applied?); 4) How is the strategy implemented (what investment instruments are used, what's the turnover, etc.); and 5) how has the strategist performed in different market environments (don't just look at total compound returns, be certain to look at performance separately in bull and bear markets to see if value is added consistently or just at certain points). Ultimately, the goal is to try to discern between sustainable value from an active manager, and one that might have just been a one-hit wonder.

The Surprising Number One Driver of New Clients - This article by Dan Richards on Advisor Perspectives discusses some recent survey research from Cerulli that found, contrary to the prevailing view, getting referred to an advisor is not nearly as much of a driving factor in choosing an advisor as is commonly thought. In fact, according to the Cerulli report, just 11% of affluent investors cited referrals as the key reason for selecting on advisor, and 8-out-of-9 affluent consumers chose advisors by other means. Instead, the number one factor that ranked (slightly) above referrals was actually reputation, as getting referred on its own just isn't enough anymore in a world where affluent individuals often solicit multiple referrals and interview several advisors (which means the referral alone just isn't the decision-making driver it once was). So what can advisors do to build their "reputation" in this regard? Richards suggests trying to allocate 3 hours a week to enhance your profile and reputation, and strategies include: 1) take a leadership role in a charity organization (giving back to charity just for the sake of doing so is great, but to accomplish the reputation goal as well, it's necessary to take a leadership position); 2) get articles published (ideally, targeted specifically to a key publication that your target audience reads, even if you need to hire a freelance/ghost writer to help you produce it); 3) get quoted in the media (read up to find authors that write on topics in which you have expertise, and then contact them to share positive feedback and perhaps something they "missed" you could be helpful on in the future); 4) write a book (the writing is difficult, but the good news is that technology has made self-publishing it much easier and more cost-effective than in the past!); and 5) build an online brand (focus on becoming recognized as a "thought leader" in your target market by producing content that makes you "findable" by those you want to reach).

The Re-education Of A Brash Young Stock Picker - This article from Ron Lieber of the NY Times tells the story of Randy Kurtz, a money manager who launched a stock-picking firm 8 years ago where clients would pay him nothing if he underperformed the S&P 500, and 1/3rd of his (relative) outperformance if he beat the benchmark (rather than just taking a flat percentage of the whole portfolio every year like a 'typical' investment manager, regardless of whether the account performed well or not). Despite having had some success and beaten his benchmark in 6 out of 8 years, Kurtz has "capitulated" (in his words) from being a stock-picker to investing primarily in index and exchange-traded funds. The challenges Kurtz notes includes the fact that because he was only investing in large-cap US stocks, it was often difficult to get clients to carve out just a portion of their accounts for him to manage. In addition, Kurtz acknowledged the ongoing tax drag given rates and his holding period. But the biggest problem was perhaps simply the realization that even if he was helping people with their large-cap US stocks, he often saw the rest of their portfolio was an (undiversified) mess, too. Accordingly, despite some reasonable success as a stock-picker, Kurtz has shifted from US stock-picking to a globally diversified portfolio spanning the asset classes, selecting active managers where he believes they are appropriate, and charging 0.95% on the first $100,000, 0.75% up to $500,000, and  0.5% on everything above that amount for his pure investment services.

King For A Day - In this article from Financial Advisor magazine, financial planner Roy Diliberto engages in a thought experiment of what he would do if he were "king for a day" to advance the financial planning profession. Key changes that Diliberto envisions for full recognition of the financial planning profession includes: 1) Being regulated AS a profession, not as "investment advisers" who happen to provide advice in other areas as well (after all, in addition to investments, we give estate, tax, employee benefits advice, and more, but we're not regulated as estate planners, tax professionals, or employee benefits specialists, so why are we [predominantly] regulated as investment advisers!?); 2) the only people who can hold themselves out as financial planners would be those who are registered/regulated as such, have demonstrated competency of the requisite knowledge (e.g., attaining the CFP certification), and actually engage in the financial planning process with clients; 3) the media will stop focusing on the fees and compensation that planners earn, and focus instead on the value that financial planning brings to the table; 4) more planners will structure their fees in a manner besides just a percentage of assets under management; 5) planners must have a robust client discovery process to ensure they are focused holistically on clients, and not just their investment portfolios; 6) financial planning education will be widely available in undergraduate and graduate school programs, and will teach both the emotional aspects of planning/money in addition to the technical knowledge; 7) all financial planners will be required to be fiduciaries, and can be stripped of their ability to practice for repeatedly failing to meet the standard of care; 8) industry publications will no longer rank "top" financial planning firms by AUM, and focus instead on the quality of advice/care; 9) career paths will be more clearly defined for new financial planners to enter the profession; and 10) high school students throughout the country will be required to take courses in basic personal finance (taught by CFP professionals). Can I get an "Amen!"?

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 as well!