Weekend Reading for Financial Planners (August 30-31)

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 30th/31st:

Is Vanguard Hiding Behind Low-Cost Structure To Evade Taxes? (Trevor Hunnicutt, Investment News) - An attorney and former Vanguard corporate legal counsel named David Danon has filed a whistleblower lawsuit against the company, accusing Vanguard of operating as an illegal tax shelter and using its corporate structure to abuse the tax code to the tune of about $1 billion in Federal taxes and $20 million in New York state taxes. The key issue - as acknowledged in Vanguard's own marketing materials - is that because Vanguard's fund shareholders are the effective owners of the company, the company deliberately runs its business "at cost" and does not generate profits for its shareholders; instead, it simply returns any potential profits it would have earned as cost savings to the investors, allowing Vanguard to be not only a low-cost investment provider but the low-cost investment provider (now approaching $3 trillion of AUM!). The key distinction is that if Vanguard simply charged "at-market costs" and then paid those profits back to shareholders, it would be taxable income for which Federal and New York (and other) state taxes would be owed, but its direct ownership model that implicitly rebates its profits avoids the tax burden. Danon also points out that Vanguard has accumulated $1.5 billion in a "contingency reserve" from "profits" (revenue from its funds in excess of expenses, notwithstanding its low costs) that it has generated over the years, but unlike other businesses has not paid taxes on that income either. Danon also alleges that when he raised these issues internally as a corporate lawyer for Vanguard, he was reassigned, given negative performance evaluations, and eventually fired him last summer after he filed the then-sealed whistle-blower complaint.

The Decline and Fall of Fund Managers (Jason Zweig, Wall Street Journal) - As Vanguard approaches $3 trillion of AUM and index and ETF funds continue to gather assets, widely regarded industry guru Charles Ellis is declaring the world of stock-picking as dead and that active management is no longer able to earn its keep. Expanding upon the theme in a recent article for the Financial Analysts Journal, Ellis points out that as fund managers have geared up with sophisticated analytical tools, electronic trading, and instantaneous access to news, the competitive environment for active managers is grinding down the available alpha and leading to "a mutually assured destruction of outperformance" as the market gets more efficient and harder to beat. The trend is arguably exacerbated by the current low-return environment; while typical 2% fund expenses weren't perceived as a big deal in the 1980s and 1990s when equities averaged 18% annual returns, with stocks averaging just 4% annually since 2000, even a 1% fee is a significant chunk of the return. Skeptics do point out that if "too many" rush into passive funds, the markets may become less efficient again and active could see a resurgence. And notably, Zweig concedes that even with their rising popularity, it's still unlikely that all investors will index; some will never stop hoping to find the next Warren Buffett, and some managers will beat the market over time (perhaps by skill though many probably by luck alone) even in the hypercompetitive environment (notwithstanding the fact that few investors have figured out how to pick those managers ahead of time). But Zweig's conclusion is perhaps the most striking - that it may be time to get out of the business of managing investments and into the business of managing investors, where the decline of fund managers may align with the rise of financial planners.

An Emerging Price War In The World Of Investment Advice (Ron Lieber, New York Times) - For those who have decided that they would like to just own a passive portfolio of index funds and just need a solution to find the right mix and rebalance them, a price war is emerging amongst the available solutions. In the "traditional" camp include both a number of financial advisors, and a wide range of traditional and discount broker-dealers from Fidelity and TradeKing to Merrill Lynch's Merrill Edge program, with fees that typically vary between 0.5% and 1.1% or so. By contrast, the emerging crop of "robo-advisor" solutions like Betterment, FutureAdvisor, and Wealthfront are offering the same thing for a mere 0.15% to 0.50%, with the caveat that there's no local storefront or retail branch to visit face-to-face. Given the significant impact of compounding fees (to which investors seem to be paying more attention than ever?), Lieber raises the question of how long establish players will be able to keep charging 2-4 times the upstarts. Some large companies appear to be trying to roll out more competitive solutions - Schwab chief executive Walt Bettinger recently announced that Schwab is working on its own online advisory solution, though it remains to be seen what the product will ultimately be and whether/how it can co-exist with the rest of the Schwab line-up of solutions, and Vanguard launched their Personal Advisor Services offering for investment advice plus (limited) financial planning for a mere 0.3% AUM fee. Other established companies are relying on the fact that many consumers do still want to talk to a human being face-to-face, both for service and just to inspire trust and confidence in the company, though today's younger generation raised on technology seems to have more confidence in online solutions that prior generations. In  the end, it's not clear whether the new lost-cost providers will really persist and succeed - none are actually even profitable yet - but to say the least, the pressure is on for the establishment to demonstrate that its good advice is worth the cost.

Active Versus Passive Is the Wrong Question (John Rekenthaler, Morningstar) - Over the past decade or two, index-fund managers have framed the great investment debate as being one of active versus passive, a battle that the indexing advocates are currently winning as investors pour into index funds, Vanguard approaches $3 trillion of AUM, and articles portend the death of stock-picker fund managers. However, Rekenthaler makes the case that the real issue is not necessarily about active versus passive, per se, but about cost; clearly, an expensive actively managed fund is likely to be problematic, though an expensive index fund is as well. What happens if we just look at the subset of inexpensive active versus passive funds though? To test this, Rekenthaler looked at three groups of active funds: "expensive" funds with expense ratios over 1.5%, "cheap" active funds with expense ratios of 0.50%, and a subset of cheap active funds that are offered by Vanguard itself (which does have active funds in addition to passive ones!), all of which are compared to Vanguard's passive index funds. The results are striking; while the majority of expensive active funds underperform, the category of cheap active funds finishes almost dead even with Vanguard index funds (based on their average total-return rank over the trailing 15 years), and the Vanguard active funds actually beat the Vanguard passive funds (though it varies by category, with international active doing especially well and taxable active bond funds lagging their passive comparables)! Notably, because the analysis looks at trailing performance of existing funds, there is some potential for survivor bias (even Vanguard has merged/liquidated a few of its active funds, so it may be that only a subset of the best have survived to be analysis), but it nonetheless raises the interesting question of whether the focus has been too much on active versus passive and not enough the overriding role that cost plays in both categories, for worse and for better.

The Power and Limitations of Monte Carlo Simulations (David Blanchett and Wade Pfau, Advisor Perspectives) - The idea of using Monte Carlo projections is to improve upon the 'traditional' approach of using time-value-of-money calculations that are implicitly based on an assumption of zero-volatility straight-line (i.e., "linear") returns, or what Blanchett and Pfau call "deterministic models"; by contrast, the Monte Carlo approach is intended to incorporate randomness into the modeling process (also known as "stochastic modeling"). By incorporating volatility, the advisor can show a range of potential outcomes, and also account for the fact that actual dollars compounding in a volatile manner will produce less wealth than the linear expected return implies (this is known as "volatility drag" or "variance drain" and is also embodied in the difference between arithmetic and geometric returns). However, the typical use of Monte Carlo in financial planning, where the advisor enters assumed means, standard deviations, and correlations for various return and inflation inputs, has faced a great deal of criticism in recent years. As Blanchett and Pfau point out, though, much of the criticism is not entirely valid; for instance, while one complaint of stochastic tools is that they do not incorporate "fat-tailed" distributions, the reality is that Monte Carlo can certainly be designed to do so, and any failure to capture fat tails in the model is a result of how the particular software/tool was built, not a flaw of Monte Carlo itself. Another challenge is that Monte Carlo may fail to take into account how present conditions impact at least near-term returns. For instance, rising rates may eventually allow bonds to generate their average long-term return around 5%, but clearly when the 10-year Treasury only yields about 2.5% now, the compound return is very unlikely to be 5% over the next 10 years; however, this too is not actually a flaw of Monte Carlo, but simply something that requires additional factors to be incorporated into the model (e.g., making the model "autoregressive" to capture the relationship between the data points over time). Finally, Blanchett and Pfau note that most Monte Carlo models do not incorporate the randomness of life expectancy itself, though yet again this is merely a constraint of how most Monte Carlo tools are designed, not Monte Carlo as a modeling technique unto itself. The bottom line: perhaps it's time to stop criticizing Monte Carlo so much, and instead spend more time pushing for the next generation of improved Monte Carlo software tools!

Jumbo Reverse Loans Revived for U.S. Seniors (Alexis Leondis, Bloomberg News) - Since the 2008 financial crisis, most lenders backed away from the reverse mortgage marketplace, which became dominated almost exclusively by the Home Equity Conversion Mortgage (HECM) program insured by the Federal Housing Authority (FHA), which limits the equations that determine the maximum borrowing amount to be based on no more than $625,500 of home value. However, this week two of the biggest players in the reverse mortgage space - Urban Financial of America, and American Advisors Group - announced that they will be rolling out "jumbo" reverse mortgages for those with more valuable homes who want to utilize the product (in the past 5 years, the only other lender in the space has been Generation Mortgage Company, which acknowledged it will likely have to change its own jumbo reverse mortgage to remain competitive with the new offerings). The push appears to be coming both due to rising home values since the financial crisis, the ongoing wave of baby boomer retirement, and the fact that "traditional" HECM reverse mortgage volume has fallen significantly since more restrictive reforms were put in place last fall to cut down on abuse. Although the final solutions are not quite available yet, the Urban Financial offering is anticipated to have a maximum loan amount as high as $2M with a 7% interest rate, and the American Advisors Group may offer proprietary jumbo reverse mortgages for as much as $6M in borrowing and a 6%-8% interest rate; notably, though, it remains to be seen whether more affluent investors will really utilize the new loans, or if they will decide instead that even with ongoing payments, a cash-out refinance with a traditional mortgage at a significantly lower interest rate may be more appealing.

No Need To Worry About Social Security (Andy Landis, Marketwatch) - This article provides a great overview of the latest Social Security Board of Trustees Annual Report that was delivered to Congress on July 28th, which highlights that despite the negative media, Social Security is far from "going broke". As it currently stands, the Social Security program has $2.76 trillion invested in government bonds, and is using a combination of Social Security payroll taxes and interest from its government bond portfolio to pay benefits; by 2020, the benefits obligations will be significant enough that the Social Security trust fund will have to begin to liquidate its bond portfolio (rather than just spend the interest), and that by 2033 the account balance will be depleted. However, even at that point, Social Security will still be able to pay 77% of its scheduled payments for most of the remainder of the century just from ongoing payroll taxes. And notably, this is far from "the worst" that Social Security has faced; in the late 1970s and early 1980s, Social Security was also running deficits that were depleting the trust fund, with "insolvency" looming in July of 1983, and that's what spurred the Social Security reforms in April of that year that have carried us forward ever since; in fact, in 1983 the reforms were anticipated to provide for another 50 years of full solvency, which means the trust fund depletion projected for 2033 is right on track after 30 years! Obviously, if we don't want to experience a "mere" 23% benefits cut in 2033, the program will still have to be reformed further, but Landis points out that the numbers have already been crunched on a huge number of viable solutions; the program is not figuring out how to solve the remaining shortfall, but simply getting Congress to agree on the desired combination of benefits adjustments/cuts and revenue/tax increases, just as was ultimately done in 1983.

In Financial Data, Small Is The New Big (Ellen Uzelac, Research Magazine) - While there's been a great deal of buzz lately about the rise of "big data", in both financial services and other industries, this articles notes that for most advisors, they don't necessarily have enough clients and volume to harness much insight from big data, but may be able to significantly leverage the "small data" of what's contained in their own in-house software. For instance, advisors can evaluate the average age of their clients, average revenue, distribution of revenue by age group, how clients are finding the firm, and more. Advisors can also get a better handle on who their top clients are, and then look for insights and commonalities, from their gender and age, to income and assets, to what kinds of services the clients do and do not utilize. Other areas of focus could include the operations of the firm, and metrics ranging from time being spent in meetings and calls, to the frequency of demands by various clients. Notwithstanding the focus on small data within firms, there are firms trying to solve big data problems as well; for instance, BrightScope is trying to harvest information about 680,000 advisors registered with the SEC and FINRA to help match consumers in need, such as being able to answer the request "show me all advisors within a 25-mile radius of my zip code who specialize in retirement planning." By contrast, WealthEngine tries to cull data on high-net-worth individuals directly and provide big data insights to advisors to help them prospect and make connections to potential new clients.

Saving Your Practice from HR Headaches (Richard Dragotta, Journal of Financial Planning) - One of the challenges of being an independent advisor is that you have to wear the "human resources (HR) hat" which entails both managing the upside potential of employees, and avoiding potential employee HR headaches. Tips to minimize the latter include: have a formal application for everyone you interview, that can be compared to their resume for inconsistencies and get them to sign off regarding additional information/background checks you may conduct (and keep the document, along with their resume, as the foundation of every employee's personnel file); deliver new hires a formal "letter of understanding" that provides a description of their roles and responsibilities, sets expectations, and makes it clear they are an "employee at will" (this is not an employment contract, but more like the "offer letter" you provide when making the offer to hire); automate accountability (e.g., use a CRM to track workflows, which can also capture workflow mistakes/errors/omissions); keep it personal but professional (it's great to make a fun work environment and relate with employees, but remember you're the boss first); be flexible but consistent with established policies (and if you don't have them, create policies as part of an employee handbook, covering the basics like company computer usage, personal phone calls, dress code, holidays, jury duty, bereavement, and more, so you don't have to make up everything on the fly); confront problems in the present (the longer you allow things to fester, the worse they'll usually get!); and provide formal documented employee reviews (it's extra work, but it's important for employees to receive positive feedback for a job well done, and important for the employer to clearly document problems that may come up along the way).

Step by Step: Tips for Onboarding New Staff (Lisa Crafford & Shaun Kapusinski, Financial Planning magazine) - No company wants to have high turnover and low productivity, yet this article makes the case that for many advisory firms, the lack of a clear strategy and process for onboarding new staff can cause these outcomes. According, the authors (both business managers/managing directors at their own advisory firms) explain their own multi-month systematic process for onboarding. Before the hire, key steps include creating a written job description (explaining not only the details of the position, but the title, department/area of the firm, supervisor the person will be working for, and compensation), having (or building if you don't have yet!) a checklist of all the things that need to be done the moment the employee starts so they can hit the ground running (employment/HR paperwork to be signed, phone and email access and key software logins established, necessary office supplies and business cards, etc.), and if you're in a more formal office space, sort out issues like building parking and access. In the first week, key issues include: schedule time for new employees to meet with managers, co-workers, and subordinates, and have someone assigned to discuss the firm's history, vision, and strategy, along with the organizational chart and career path, so they understand the opportunity and get engrained early into the culture; make sure all the appropriate HR paperwork gets done (from tax forms to health insurance to employment/confidentiality agreements and delivering an employee handbook and compliance manual); and begin to get the employee acclimated to processes and procedures around the firm. Over the next several weeks, up to the 3 month mark, key additional onboarding tips include: training on key software and systems (CRM, portfolio management software, etc., where the best "super-user" in the office for each software tool delivers the training); coach other employees to recognize that part of their role is to become teachers as well; and sit down to review everything, including the firm's vision/strategy again and where the new employee fits in after 90 days, because no one is going to remember it all the first time! The article suggests a framework for teaching tasks, that includes: 1) explain the task; 2) demonstrate the task; 3) have the employee imitate the task (with your supervision); and 4) have the employee practice the task (on their own).

Seeing the Glamorous Side of Finance (Kenneth Silber, Research magazine) - This article focuses on the work of Virginia Postrel, author if "The Power of Glamour: Longing and the Art of Visual Persuasion"; Postrel defines glamour as "nonverbal rhetoric... that leads us to feel that the life we dream of exists, and to desire it even more." In other words, images that can inspire and persuade us to push towards goals. In this context, Postrel notes that the financial services industry does a mixed job of providing effective visual communication and persuasion; for instance, our typical images of retirement (families on beaches, hiking on trails, sitting by pools, etc.) paints a somewhat glamorous and positive image of leisure and family time, but it's not differentiated from one firm to the next. Of course, advisors should be cautious not to mix glamour with effortless results; the point is not to suggest that working with the advisor will automatically lead to an easy and glamorous life. Nonetheless, the reality is that our culture is becoming increasingly visual, especially with the explosion of visual sharing platforms from YouTube to Facebook, not to mention the incredible popularity of infographics and demand for skilled people who can convert data into compelling images. Of course, most advisors are not necessarily visual by nature, and we tend to be communicators with written or spoken words instead, and often focus more on numbers than images, which means it may be necessary to hire a graphic designer to help out. Nonetheless, Postrel suggests there's a lot of opportunity for advisors to improve in this regard, especially those who can figure out how to walk the line between demonstrating credibility but also establishing distinctiveness.

The Pitchforks Are Coming… For Us Plutocrats (Nick Hanauer, Politico) - This article is written by "zillionaire" Nick Hanauer, one of the "0.01%ers" who has founded or funded more than 30 companies (including being the first nonfamily investor in Amazon, and the founder of aQuantive which was sold to Microsoft in 2007 for $6.4B in cash). As Hanauer himself notes, he's not the smartest guy or the hardest working, but he does have an ability to spot future trends a little sooner than others, which was why he saw the investment potential for Amazon (it didn't hurt that Jeff Bezos was an early friend of his!), and what he sees now are pitchforks, in light of the broadening gap of income inequality between the "haves" and the "have-nots". Not that all inequality is bad or avoidable; Hanauer suggests it's the intrinsic outcome of any high-functioning capitalist economy, but the concern is that it's as extreme as it is, and just getting worse. In fact, it's hard to find any historical example of such extreme and rising inequality that didn't end badly, whether the end point is a police state, an uprising, or some other type of fall. Accordingly, Hanauer "warns" his fellow .01%ers that some kind of disruptive change is inevitable, likely to start slowly but then advance suddenly, as most "revolutions" do. To address the issue, Hanauer suggests a return to the great insight of Henry Ford - by increasing the wages for his autoworkers (to a then-exorbitant $5/day), he realized that with more money they'd be able to afford his Model Ts. Or in other words, waiting for trickle-down policies to work isn't working, and it's time to just outright raise the minimum wage instead, as part of an approach that Hanauer calls "middle-out" economics instead, where the foundational principle is that if workers have more money, businesses have more customers, growing the middle class... and ironically, also allowing the rich to potentially become even richer, but built on the back of a strong and thriving middle class rather than today's struggling-middle-class environment. And Hanauer notes that a wide range of reforms over the years have supported this; from first instituting a minimum wage, to paying women equal amounts, to establishing child labor laws, every time the case was made that businesses would be destroyed, and instead as the workers were treated and paid better the businesses did better too; in fact, the two cities in the nation with the highest rate of job growth by small businesses are now San Francisco and Seattle, which also "happen" to be the two cities with the highest minimum wage in the country. Ultimately, Hanauer notes that while some companies may do this voluntarily, others will not, which means in the end there is a role for government to play in pushing for the change... but at the same time, recognizing how "broken" Congress is right now, Hanauer suggests that change will have to start in the states and work its way up.

Finance is a Strange Industry (Morgan Housel, Motley Fool) - As Housel puts it, "Finance is a strange industry", with an interesting list of examples. For instance, the financial services industry has cultivated an incredible ignorance about its own costs; ask someone what they pay for their cell phone or a gallon of gas and most know (sometimes down to the penny!), but ask them what they pay in advisory fees and most have no clue whatsoever, thanks to the fact that most fees are deducted directly from accounts; a situation that's especially tragic when you recognize that some people will agonize over whether their household can afford an $8.99/month Netflix subscription but never see that their 401(k) is costing them 50 times that amount! Similarly, Housel also points out the tragic harm that while doctors must attend medical school and lawyers must pass the bar - and even becoming a taxi driver in London requires passing a test that can take years of practice - in financial services, "managing money requires little more than a desire to manage money"! Or viewed another way, it takes extensive training to be a firefighter, but just a nice suit and a sales pitch to manage the firefighters' retirement fund (and perhaps a basic sales license like a Series 6, but that's still a bar radically lower than most other industries!). Other strange realities of finance include the fact that schools teach investing as though it's all math-based when in the real world it's very psychology-based, and that finance people can survive incredibly long periods of time despite poor results, from the now-regularly-mocked monthly doomsday forecasts of Marc Faber (who's nonetheless still in business after a 44-year career), to the fact that in 2012 there were 894 mutual funds in business since 1998, but only 275 beat their benchmarks, which means over 600 funds stayed in business for a decade and a half despite their underperformance! Perhaps the saddest point, though, is that despite all of this, a large portion of consumers continue to show an unwillingness to take a greater role in educating themselves, which may be what allows all of the other strange oddities of finance to persist.

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!