Weekend Reading for Financial Planners (Aug 5-6)

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 August 5th/6th:

RIA Industry Hits New Records, But AUM Growth Slower Than S&P (Christopher Robbins, Financial Advisor) - According to the latest 2017 "Evolution Revolution" report from the Investment Adviser Association and NRS, the world of RIAs in the aggregate grew by 5.8% last year, up from $66.8T to $70.7T. Notably, though, this includes all types of investment advisers - and in fact, the small subset of RIAs that act as sub-advisors for most actively managed mutual funds, separate account managers, private equity funds, and hedge funds, comprise the overwhelming bulk of the $70T of RIA AUM. The independent financial advisor community that serves individuals are "just" $8.9T of the total of RIA assets, although those firms actually constitute the majority of SEC-registered investment advisors, having regulatory AUM (RAUM) between $100M and $1B and fewer than 10 non-clerical employees. The fastest growth category, though, are investment advisers providing services "exclusively through an interactive website" (i.e., robo-advisors), which grew by 16% last year (albeit from a small base of "just" 126 firms rising to 146 firms this year, and nearly half of those appear to just be "shelf registrations" with no actual assets yet); private equity funds are on the rise as well, though, hedge funds showed stagnant growth this year.

Advisors Lead Race To Bottom In Fund Expenses (Christopher Robbins, Financial Advisor) - In its latest Fund Distribution Intelligence report, Broadridge reports that the fund universe (including both mutual funds and ETFs) enjoyed $566B of net asset growth in the first half of 2017 (a 5.5% increase), but over 3/4ths of this total ($433B) went into lower-fee passive products. The shift to lower cost funds is prevalent across industry channels, as even wirehouses and independent broker-dealers added $190B into institutionally-priced active mutual funds (of which $159B were conversions from load funds), while RIAs are the largest users of ETFs. Although notably, the data also shows that low-cost active funds are still growing; for instance, while equity mutual funds in total had $69B of outflows in the first half of 2017, those with an expense ratio of 20bps or less had $93B of inflows over the same time period. In the meantime, the "online retail" channel - i.e., robo-advisors and cyborg advisors - are showing the fastest growth (albeit from a small base), with the human-based digital solutions from Vanguard and Schwab leading growth thus far.

How To Avoid A Sudden Increase In Medicare Costs (Laird Johnson, Advisor Perspectives) - Most retirees pay their Medicare Part B premiums directly from their Social Security checks, and as a result benefit from the "hold harmless" rules that prevent Medicare premiums from ever rising faster than the annual dollar increase in their Social Security checks. However, for higher-income individuals, they are not only ineligible for the hold harmless rules, but can potentially face a substantial "income-related monthly adjustment amount" (IRMAA), which effectively applies a surcharge on Medicare Part B (and Part D) premiums based on Adjusted Gross Income from 2 years prior (i.e., 2017 Medicare premium surcharges are based on 2015 AGI). At the extreme, the surcharges can increase Medicare Part B premiums from $134/month to as high as $428.60/month (plus another $76.20/month surcharge on Part D) for individuals with more than $214,000 of AGI (or married couples over $428,000 of AGI). And notably, the income thresholds for IRMAA are "cliff" thresholds; in other words, with the first surcharge kicking in at $85,000 of AGI (for individuals; $170,000 for couples), the entire surcharge will apply as income reaches $85,001. As a result, strategies that manage AGI become very appealing for those nearing the IRMAA thresholds, especially if income can be manipulated to come in just below one of the tiers. Potential strategies to achieve this include: do partial Roth conversions up to (but not above) the first/next AGI threshold, to reduce potential taxation of IRAs (or taxable RMDs) in future years; complete Qualified Charitable Distributions (QCDs) to satisfy RMDs and have the RMD income entirely excluded from the tax return (which means it's not included in AGI for IRMAA calculations); and purchase a non-qualified deferred annuity to limit annual exposure of taxable growth, and then control taxable liquidations to coincide with lower income years (and/or to fill up to but not beyond the next IRMAA threshold).

The declining growth rate of college tuition, per WSJ article & Labor Department statistics

In Reversal, Colleges Rein In Tuition (Josh Mitchell, Wall Street Journal) - Over the past 30 years, college tuition has risen a whopping 400% (an average annual growth rate of about 5.5%, with growth at 6%/year since 1990), sparking an emerging student loan crisis as young adults struggle to afford tuition. Now, however, the tide may be starting to turn, with tuition at college and graduate schools (after scholarships and grants) up just 1.9% last year, moving in-line with the general level of inflation. The problem appears to be a combination of the sheer challenges of affordability, and the fact that the number of two-year and four-year colleges rose 33% from 1990 to 2012, even as college enrollment has declined by 4% from its peak in 2010; in other words, there may be a supply-demand shift underway, as a growing number of colleges compete for fewer students, driving them to offer more discounts and even cut prices in some cases. And Congress hasn't increase the amount that undergraduates can borrow from the Federal government since 2008, which further limits buying capacity. The situation is exacerbated by shifting demographics as well, with the number of new high-school graduates up 18% from 2000 to 2010, but rising only 2% in the first 7 years of this decade, as the large base of baby boomer children age out of the college cycle and are following by the smaller generation of Gen X children. And consumers themselves appear to be getting more picky about colleges based on their pricing as well, with one recent study from Sallie Mae finding that high prices are a major factor for students eliminating schools from their searches. On the other hand, many schools are facing budget crunches of their own, and the recent decline of for-profit schools could give other schools more pricing power. Nonetheless, given these ongoing shifts, the growth rate in college tuition has been declining steadily since 2005 (though it remains positive at 1.9%), which raises the question of whether it's time for financial advisors to rein in their standard assumption of college costs rising at 6%/year in the indefinite future.

The Beauty Of Trusts For Real Estate Investing Clients (Martin Shenkman, Financial Planning) - When it comes to owning one's primary residence, there are substantial tax advantages for owning the home directly; in the case of investment real estate, though, Shenkman points out that there are both (income and estate) tax and asset protection benefits for owning properties inside of (irrevocable) trusts instead. Notably, though, it matters where the trust itself is based, as state laws for trusts vary from one state to another, and the "situs" of the trust (where it is trusteed and administered) impacts which state's laws will apply first. Leading states with favorable tax and legal environments for trusts include Alaska, Delaware, Nevada, and South Dakota. And notably, even though the most robust protections come from irrevocable trusts, many states are being more flexible about allowing irrevocable trusts to be merged, or "decanted", into new trusts (effectively shifting out of an "irrevocable" trust into a new one), and some states will even allow "non-judicial modification" where an irrevocable trust can be altered if the living grantor, all trust fiduciaries, and all beneficiaries agree to the change. Other benefits of using trusts (at least in states with favorable rules) include: the ability to have a "quiet trust" (where beneficiaries do not receive information and reporting for the trust, so the beneficiaries don't have to know they're trust beneficiaries); shifting trust income to states with lower state income tax rates (at least for retained profits being held in trust, as the income generated by a property itself in a particular state generally has to be taxed in that state, regardless of the trust situs); and creating a "directed trust" where an investment adviser makes investment/real estate decisions, and a second trustee serves as "general trustee" and handled all the other powers to administer the trust (especially appealing for real estate developers who can initially make themselves the investment-only trustee while still keeping trust assets out of his/her estate). Bear in mind that investment real estate itself should still be owned in an LLC (or ideally, a separate LLC for each piece of real estate) for further asset protection, though it is possible to create a "Master LLC" that rolls up all of the underlying LLCs to make it easier to manage gifting and tax reporting.

What Advisors Need To Know About Annuity Mortality Credits (Joe Tomlinson, Advisor Perspectives) - One of the fundamental benefits of using a lifetime annuity is that payments are pooled together for all participants, such that the dollars not used by those who die early are effectively reallocated to those who live a long time. These "mortality credits" apply to any type of contract that makes bona fide lifetime payments, including single premium immediate annuities (SPIAs), as well as deferred-income annuities (DIAs, also known as longevity annuities), including DIAs owned inside of retirement accounts (known as Qualified Longevity Annuity Contracts or QLACs). The benefit of mortality credits is that they make it possible for the group in the aggregate to receive higher payments than what anyone could spend on their own; for instance, a $100,000 purchase of a SPIA for a 65-year-old female today would buy $6,520.09/year in payments, despite the fact that today's low interest rates could not realistically sustain a 6.52% payout. Of course, initially, the payments simply help the buyer recover his/her own $100,000 contribution, which means the true Internal Rate of Return (IRR) varies with time, but can be substantial in the later years – for instance, by age 80, Tomlinson estimates that the annuity buyer's mortality-adjusted return would be 5.85%, a 2.25% mortality credit premium over what the IRR alone would have implied (and by age 90, the mortality credit premium is more than 8%/year!). In fact, for those who live materially past life expectancy, the mortality credit risk premium of surviving can even approach the value of the equity risk premium! Notably, different types of annuity products (e.g., SPIAs vs DIAs) have different payout structures and timing, though as long as the annuity remains actuarially fair, the mortality-adjusted risk premium of mortality credits is not substantially different from one to the other, and the contracts should instead be chosen based on how they coordinate with the rest of the overall portfolio and planning goals.

The Other Career Track (Philip Palaveev, Financial Advisor) - In most advisory firms, the focus on establishing a "Career Track" is all about how new paraplanners can eventually elevate themselves to be senior advisors and even partners. But Palaveev notes that, particularly as advisory firms grow in size and necessary infrastructure, the contributions of operations and administration staff are equally crucial, even if they're not as "outwardly visible" as client-facing financial advisors. And managing the development of operations and administrative staff can be especially challenging, because their productivity is not as easily measured as that of advisors (with standardized metrics like number of clients, amount of revenue, and client retention rates). Nonetheless, growing advisory firms have an ever-growing range of non-advisory positions, from client service administration and investment operations, to technology, human resources, marketing, accounting and finance, and compliance and legal, as well as general administration and management of the office and staff itself, which in a large advisory firm (e.g., 50 employees) may comprise nearly half the staff. So what are the career opportunities for non-advisory staff? Ultimately, the goal should still be the same as it is for advisors – the opportunity for growing the individual's scope of responsibility, status, and income – which means not just giving people elevated/inflated titles over time, but real growth in responsibility. Of course, the challenge in smaller advisory firms is that there isn't enough depth to have multiple tiers of management and growing levels of responsibility, but the good news is that if the firm is growing, the deepening of the firm's organizational chart will create those higher-tier higher-responsibility positions over time. In general, though, it's still possible to evolve a series of responsibility tiers over time, including senior specialists (over "just" the entry level position, though their responsibilities would include training new entry level staff), team leaders or directors, and then ultimately department leaders. Which in large enough firms, can even lead to non-advisor partners (e.g., COOs who have opportunities for ownership based on their level of responsibility), and a non-advisor CEO whose job is to run the business as a business (while the advisors continue to serve the clients).

Performance vs. Tenure: A Lesson in Employee Evaluation (Caleb Brown, Investment Advisor) - It is common for advisory firms, like many businesses, to promote the most senior employees that have the longest tenure of the firm. Of course, the reality is that it's usually necessary for someone to be in a position for a number of years to learn and master the skills of the current position, and be ready to move up. But Brown cautions that tenure alone should not be the sole, nor necessarily even the primary, criterion for deciding when/whether to promote someone. Instead, he suggests that an individual's career development plan should focus on the tasks and skills that he/she needs to master in order to progress. For instance, the path forward for an Associate Financial Planner might not just be about getting 3 years of experience to be promoted to a Senior Advisor, but instead, a series of task- and skill-based criteria, such as: after one week, be able to navigate the firm's CRM, portfolio management, financial planning software, and filing system; after 90 days, understand the core processes and procedures of the financial planning department; after 180 days, be able to give anyone in the firm a summary of the client with relevant/key information; after one year, have completed 12 full financial plans; after 2 years, be an in-house expert on the firm's planning software, and be presenting 25% - 50% of the agenda items in client meetings; after 3 years, be able to train new team members in financial planning software, and be presenting the majority of agenda items in client meetings. The idea of having this hierarchy of progression is that, if an employee doesn't reach those thresholds fast enough, they don't get promoted (or in the extreme, are at risk of being fired for poor performance), while those who excel and get there faster can be promoted faster (because they have, literally, mastered the elements that they were told they needed to master). In other words, the benefit of this performance-based (rather than tenure-based approach) is that promotions are now really in the hands of the employee, with clear expectations about what is requires of them to move up. From there, it's up to the employee to step up and achieve.

Why Everything Breaks When You Reach 25 Employees (Lighthouse) - As businesses grow (whether an advisory firm or in another industry), existing challenges are overcome, and new challenges emerge, and one of the most common "walls" that businesses hit is when they try to grow past 25 employees. The problem that comes around 25 employees is that, even with a co-founder or two, there are still too many people for the founders alone to manage effectively, and neglected employees can begin to feel unappreciated and risk becoming unengaged, leading to employee turnover. In addition, the business gets large enough that not everyone can be involved in everything anymore... which means communication begins to break down, as no one employee really knows all of what is happening in the overall organization. And as the org chart begins to deepen, and it's no longer about the excitement of being a startup, employees begin to care about their own career tracks, and want to know what their personal opportunities for growth are. In the meantime, the firm's culture starts to solidify, as there's increasingly a "standard way of doing things" that new employees pick up quickly from those around them... which may or may not actually be productive habits for the organization. So what should founders do to work through this challenge? Suggestions include: start doing one-on-ones with your emerging leaders, spending a chunk of time with them on a regular basis, helping to develop and nurture them (and showing them how to do the same for those who report to them); over-communicate, and then over-communicate some more, because the larger the organization is, the harder it will be for the word to reach everyone; and find and recognize the "small wins", to ensure that employees feel appreciated and recognized (and avoid them feeling like they're getting "lost" in a large and growing organization).

An Evaluation Of The Risk-Taking Characteristics Of Households (Michelle Kruger & John Grable & Sarah Fallaw, Journal of Financial Planning) - The proverbial saying is that in order to make money, you have to take risks, and the upside of long-term equity returns are based on the concept that they enjoy an "equity risk premium" to reward investors for the risks they are taking in being investors. In this study, researchers evaluated whether affluent households actually do engage in materially different risk-taking (and other) behaviors, and found that indeed they do. Drawing on a data survey that tracked people's actual financial behaviors on a day-to-day basis for four weeks (and then related them to a comparison control group), the study found several key distinguishing factors of the affluent, including: they are much more likely to understand the nature of investments and their likelihood for risk and return, the appropriate level of risk to take, and reported that they were much more likely to take risks in investing (although they were not substantially more likely to invest in "high-risk" investments). In other words, the affluent were more likely to be aware of their risks and understand them, and then be willing to proceed with taking on a prudent level of risk. Notably, this suggests that for financial advisors, there is an important opportunity to help clients not only in their willingness to take risks, but helping clients to better understand and be educated about their risks, as a clearer understanding of the risks themselves appears to aid in the willingness to subsequently take those risks.

What Rich People Do That Poor People Don't (Cole Schafer, Medium) - As the studies of lottery winners regularly show, just giving someone a giant pile of money doesn't mean they'll be able to turn it into sustainable wealth, which requires a certain mindset beyond "just" being able to get the money in the first place (whether by lottery, inheritance, or the hard work of earning, saving, and investing). So what are the mindset habits of those who tend to retain their wealth? Key areas include: the rich are voracious readers (as Buffett is known to be a voracious reader, along with Mark Cuban, Bill Gates, and Elon Musk), because in the end it's all about expanding your knowledge business and benefitting from long-term compounding (which applies to knowledge just as it applies to investments themselves); be "relentlessly resourceful" by not just making excuses, but trying to figure out how to do whatever it takes to move forward and improve (in other words, if you're dealt a bad hand, don't blame the dealer, just figure out if there's a way to win); the rich don't save, they invest (because in the long run, it's the compound growth on investments that really generates wealth, not just the savings themselves); believe in positive energy and people (as the famous saying goes, "you are the average of the five people you surround yourself with", so surround yourself with people who are successful to be inspired and driven to succeed more yourself); have big expectations, but with easily-definable goals (as if you don't know where you want to end up, it's hard to figure out what steps to take in order to get there, or build the habits it takes to sustain the path of success); and learn from other people's mistakes (as at a minimum, you should try to only make a mistake once and not repeatedly, but ideally you should try to learn from the mistakes of others so you don't have to make as many mistakes in the first place!).

Do You Have A Money Mind? (Todd Wenning, Monevator) - At the recent Berkshire Hathaway annual meeting, Warren Buffett discussed how his eventual successor must have a "money mind", recognizing that there are some very smart people who still make very unintelligent money decisions. But what exactly does it mean to have a "money mind"? Wenning suggests a number of key points, that those with a "money mind" just seem to intuitively get, including: understanding opportunity costs (where each choice isn't just about whether the opportunity presented is appealing or not, but also whether it's appealing given the opportunity costs that may be involved in pursuing it); have high emotional intelligence, which authors Bradberry and Graves define in their book "Emotional Intelligence 2.0" as self-awareness, self-management, social awareness, and relationship management (as it's crucial to be able to recognize our own biases, be able to act against them, and have an understanding of the emotions of other investors); be able to think and act long term (as while most people will claim they're not short-term focused and act with the long-term in mind, few actually do); judge opportunities based on value and not on price (recognizing that sometimes big opportunities have big stakes, and that it's important not to fixate on price alone); and be insatiably curious and contemplative (for instance, a good manager/leader should always be reading to seek out new ideas and opportunities, no matter how successful they already are).

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 Bill Winterberg's "FPPad" blog on technology for advisors as well.