Weekend Reading for Financial Planners (Dec 19-20)

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 December 19th/20th:

Congress Approves (Mostly Permanent) 2015 Tax Extenders Legislation For QCDs And More! (Michael Kitces, Nerd's Eye View) - This week, Congress came to an agreement on the so-called "Tax Extenders" legislation, as part of a broader series of negotiations on an Omnibus spending bill, which is expected to be signed into law early next week. Notably, though, this year's Tax Extenders legislation actually didn't just temporarily extended again, it actually made many of key provisions permanent. In particular, enhanced Section 179 expensing limits, the enhanced Child Tax Credit, the American Opportunity Tax Credit for students in college, and the State and Local Sales Tax deduction, are all retroactively reinstated for 2015 and made permanent in the future. In addition, the popular Qualified Charitable Distributions from IRA rules are also reinstated for 2015 and made permanent for the future. Provisions that were temporarily reinstated included the ability to exclude from income any discharged mortgage debt on the short sale of a primary residence (extended through 2016), the deductibility of mortgage insurance premiums (extended through 2016), the above-the-line education deduction for qualified tuition and fees (extended through 2016, though rarely claimed in practice as the American Opportunity Tax Credit is usually superior), and 50% bonus depreciation rules (extended at 50% through 2017, stepping down to 40% in 2018 and 30% in 2019 before expiring again). Other 'miscellaneous' changes include some enhancements to Section 529 accounts (including allowing computers, software, and even internet access costs to be eligible expenses for tax-free 529 plan distributions), and the elimination of the in-state residency requirement when selecting a 529 ABLE account (expected to roll out in 2016 for special needs beneficiaries). Also notable in the Tax Extenders legislation and related Omnibus spending bill was what it did not include: no crackdowns on GRATs, IDGTs, stretch IRAs, or the backdoor Roth IRA, and no intervention that might have limited the Department of Labor's new fiduciary rule (which is still expected to debut in early 2016).

CFP Board to Update Professional Conduct Standards (Jamie Green, ThinkAdvisor) - The CFP Board announced on Wednesday that it is forming a commission of practitioners and industry leaders to review and propose relevant changes to the CFP Board's entire Standards of Professional Conduct, which includes its Code of Ethics, Rule of Conduct, Practice Standards, and key Terminology (the latter including its controversial definition of a "fee-only" advisor). The 12-member commission will include former SEC official Robert Plaze, Barbara Roper of the Consumer Federal of America, former NAPFA chair Diahann Lassus, and Merrill Lynch's Allison Bishop, to ensure a wide representation of CFP practitioners and consumer interests (as well as including gender and racial diversity), and will be chaired by former CFP Board chair Ray Ferrara. The process for the new commission will include a series of public forums in January and February across the country, and proposals that will be put forth for public comment (and possibly a second public comment period if necessary), before ultimately being finalized by the Board. The last time the Standards of Professional Conduct were changed was back in 2007 (a 5-year process that had begun previously in 2002!), when a fiduciary obligation for CFP certificants engaged in financial planning was first introduced.

Snakes And Ladders: What To Expect In The Unexpectedly Triumphant Final DOL Fiduciary Rule (Duane Thompson, RIABiz) - With the news that this week's efforts to block the Department of Labor's fiduciary rule with a rider on the Omnibus spending bill had failed, it now appears 'certain' that the DoL will put forth its final fiduciary rule in early 2016. And Thompson notes that if anything, the DoL may be emboldened by the fact that even as Congress continues to rumble about "killing" the DoL's fiduciary efforts, more and more Democrats are siding with President Obama's pledge to support the rule (which makes it virtually impossible for Congressional legislation to stop or change the rule). But the question still remains about what exactly the details of the fiduciary rule will be, as the DoL has acknowledged it will make 'some' concessions and adjustments in response to its critics. The basic framework is still expected to remain intact, even after a whopping 2,300 substantive comment letters, including the requirement that advisors working with IRA rollovers will need to engage as fiduciaries under a "Best Interests Contract" with clients in order to receive product commissions or other third-party payments, and a carve-out protection for mere investment education. That being said, Thompson anticipates a few "streamlining" refinements, including: compensation disclosure arrangements may be eased (including an elimination of the point-of-sale disclosure of future anticipated costs, which conflicts with FINRA rules about projecting future investment performance); the best-interests contract exemption (BICE) will become negative consent (i.e., clients by default would be subject to the contract, and must opt out to avoid it, which reduces upfront paperwork requirements); a signed agreement will not be required before discussing investment recommendations with a prospective client; and the DoL will exempt or streamline the BICE requirement for level-fee advisors doing rollovers (e.g., existing RIAs who are already subject to a fiduciary standard). In addition, there is discussion of a potentially-much-longer implementation period, where enforcement might be phased in over as long as 3 years, though the rule itself it likely to take effect by December 31 of 2016.

Is the Bond Index Broken? (Michael Edesess, Advisor Perspectives) - The "standard" for benchmarking equity portfolios is to broad-based market indices like the Wilshire 5000 or the S&P 500, and the "standard" for benchmarking bond portfolios is a bond index like the Barclays Aggregate Bond Index (formerly the Lehman Aggregate Bond Index). Yet in recent years, there has been a growing base of criticism that the Barclays Agg is fundamentally flawed as a bond index. The first issue is that the bond index ends out overweighting heavily indebted issuers, which is problematic not just because the largest issuers end out with the largest weighting (a criticism of cap-weighted stock indices too, but still reflective of the reality of those companies' relative weightings of market capitalization), but because the largest bond issuers might be able to force issuance at market-distorted prices since indexers "must" buy it and there's no recently-traded price to reveal the mis-priced weighting. However, Vanguard founder John Bogle suggests that in practice, this criticism is rarely likely to manifest (as when companies over-issue debt, markets do adjust). The second criticism is the question of whether the bond index double-counts some bonds that are both considered directly and also as part of a packaged asset-backed security (given that securitized bonds are almost 1/3rd of the Barclays Agg); however, given that most securitized bonds are mortgage-backed securities (which don't appear elsewhere in the Agg), the portion that could even possibly be corporate bond and double-counted appears to be negligible. The last criticism, which is perhaps somewhat more credible, though, is that what's in the Barclays Agg isn't really representative of what the vast majority of U.S. fixed income investors hold, given that almost 70% of the Agg is government-issued securities that in reality are more-than-half owned by national governments (from China, Japan, and the UK, to the U.S. itself, often for reasons that bear no relationship to actual investing, such as funding government programs or facilitating and stabilizing currencies); thus, the Barclays Agg representation of the bond market includes a large slice that isn't actually owned by (non-governmental) bond investors. Accordingly, Bogle has actually suggested it may be better to establish a corporate-bond-only bond index to better reflect the actual bond market for investors (or perhaps with a 1/4th government bond mix).

Is Buy Term and Invest the Difference on Life Support? (Allan Roth, Financial Planning) - Earlier this year, retirement researcher Wade Pfau published a white paper sponsored by OneAmerica, entitled "Optimizing Retirement Income by Combining Actuarial Science and Investments" which concluded that it may actually be superior to just purchase whole life insurance (and merging it into a retirement distribution plan) versus buying a term policy and investing the rest in a retirement portfolio. The analysis compares a couple investing $15,000/year into their 401(k), and carving out from that an amount necessary to buy either $400,000 of term or whole life insurance. At retirement, the couple with the retirement account adopts a 3.5% spending rate, while the couple with the whole life policy purchases a single premium immediate annuity on the life of the husband; the outcome is that the couple with the retirement account can spend $58,556 annually from their 401(k) assets, while the couple with the whole-life-to-annuity scenario can spend $82,034/year instead (a 40% increase with the whole life strategy). As Roth notes, though, there are several critiques to Pfau's research methodology. For instance, the reality is that the couple could also have taken their 401(k) plan proceeds to buy a single premium immediate annuity at retirement as well, which would have produced income within 1% of the whole life scenario, which means in reality almost all of the 40% improvement in spending with the whole life policy had nothing to do with using whole life for accumulation, but simply the decision to annuitize versus a 3.5% withdrawal rate. Other issues with the research that Roth notes include: the 401(k) assets were assumed to invest in a target-date fund with an annual expense ratio of 1.59%, even though target date fund expenses can be as low as 0.17% from providers like Vanguard; the projected values for the whole life insurance were taken directly from the illustration, which is not guaranteed (to the extent of dividends); and the 3.5% spending rate was assumed to be inflation-adjusting, while the annuity purchase was not (which means the "40% difference" in income is also largest attributable to the difference between a flat versus low-initially-but-inflation-adjusted income stream). In fact, when the analysis was re-run simply using lower expenses and the whole life policy's guaranteed illustrations, the buy-term-and-invest-the-rest scenario provided 4% more income.

Positive Feedback Loops: The Other Roads to Ruin (Dirk Cotton, The Retirement Cafe) - A positive feedback loop occurs when a system feeds back on itself in a manner that enhances or amplifies the impact with each loop, causing the scenario to move away from its equilibrium state and making it more unstable (as contrasted with negative feedback loops that tend to dampen or buffer changes). In this context, positive feedback loops may sound "positive", but can actually become serious problems; a classic example is the "head-splitting screen" that fills an auditorium when the PA system experiences a positive feedback loop between the microphone and speakers. In the retirement context, an example of a positive feedback loop might be a retired couple who funds retirement with a large portfolio of mortgaged real estate plus a moderate amount of side investments, with the plan to live off the rental income; when both interest rates and the real estate market crashed in 2008, this couple would find themselves no longer able to afford their mortgage obligations, forcing them to sell some properties, except the loss of the income from those properties would make them unable to afford the rest, forcing them to sell more, and driving the couple to liquidate almost all of their real estate to reach a new equilibrium. The key issue is that while the diversified real estate holdings looked safe, the problem was that a disruption to a few didn't actually let the couple average out, but instead caused a cascade that drove the liquidation of most of the real estate, because the couple didn't have the flexibility to adjust spending (due to real estate mortgage obligations) during the downturn. More generally, Cotton notes that retirees with less flexible spending in retirement may be more prone to such shocks, and that spending shocks (e.g., unexpected medical expenses) can actually trigger an adverse positive feedback loop. In fact, given that markets typically only deviate "so far" in bear markets before recovering - and that retirees normally hold diversified portfolios - Cotton suggests that ultimately, it's almost always the spending inflexibility that actually triggers the cascade. Which in turn means it's also problematic that retirement projections fail to effectively illustrate scenarios where the retirees can (or cannot) adjust their spending dynamically along the way, which obscures the potential feedback loops that occur with market disruption and inflexible spending.

The Financial Aid Advisor (Lynn O'Shaughnessy, Wealth Management) - It's financial-aid season, which means millions of families filing their forms, and unfortunately many making mistakes. O'Shaughnessy suggests the most common problem is simply doing the filings correctly in the first place. For instance, with couples that are divorced or separated, the rules stipulate that the FAFSA should be filed not based on which parent claims the child on the tax return or provides child support, but for whichever parent has had the child living with them for the majority of the preceding 12 month (which means divorced or separated couples can improve their financial aid situation simply by having the child live the majority of the year with the lower-income parent). On the other hand, if the parents of the child are unmarried but living together, they must each share their income and asset information on the FAFSA (though if the parent co-habitates with a non-parent, only the actual parent must file and report on the FAFSA). It's also important to recognize that for nearly 230 schools (including many of the most prestigious colleges), the proper financial aid application is not the FAFSA at all, but the CSS/Financial Aid PROFILE, created by the College Board. Notably, CSS/Profile is also the aid application most commonly used for early aid deadlines with many first-come first-served financial aid programs. And some state aid programs have both their own deadlines, and are first-come first-served! Ultimately, O'Shaughnessy also notes that not all merit or financial aid awards are "final" offers; some schools will be willing to discuss granting a higher award if the parents can be specific in documenting what additional money they need and why, along with other higher aid offers from other schools (though typically not at most elite schools that already have ample qualified applicants for their freshman slots).

Don’t Make These Common IRA Distribution Mistakes (Ed Slott, Financial Planning) - While the standard rules for Required Minimum Distributions (RMDs) are fairly straightforward, with a required beginning date (RBD) of April 1st in the year after the year the client turns age 70 1/2, and RMDs due by 12/31 for each subsequent year, mistakes do still happen. When they occur, there is a 50% penalty for any shortfall of RMD not taken, though the IRS can (and often does) waive the penalty for good cause, presuming the individual quickly made up the missed RMD that should have been taken, and files Form 5329 to report the mistake and request the waiver. Nonetheless, Slott notes that ideally mistakes should be avoided in the first place, not just fixed after the fact. And several common mistakes that do occur include: don't forget that there is an RMD associated with every retirement account, though all IRAs (including SEP and SIMPLE IRAs but not Roth or inherited IRAs nor employer retirement plans) can be aggregated to calculate the RMD and determine whether the distribution requirement has been satisfied. When it comes to inherited IRAs (that will be stretched), the first RMD is due in the year after death, though the decedent's RMD for the year of death should be taken by the beneficiary if it hadn't been done before the original owner died (and should be reported on the beneficiary's tax return!); don't forget that inherited Roth IRAs have post-death RMDs, too. When it comes to employer retirement plans, the same general rules apply as well, but there is no aggregation rule (each employer plan has its own RMD calculation and the RMD must be taken from that plan), and remember the "still-working" exception, where RMDs are delayed for ongoing workers and don't begin from that plan until after the person retires, as long as the individual doesn't own more than 5% of the company (though RMDs must still occur from all other retirement accounts!). Other tips from Slott: Don't forget to check on the potential for a lump-sum NUA distribution (as once an RMD is taken, it can foul up the subsequent use of the NUA rule); for an inherited employer retirement plan, it's possible to do a trustee-to-trustee transfer to an inherited IRA to stretch, but should be done by the end of the year after death; and don't forget to check that clients with ongoing 72(t) substantially equal periodic payments continue those "required" distributions as necessary (until the later of 5 years or age 59 1/2!).

Your Most Valuable Asset Is Yourself (Carl Richards, NY Times) - While many successful professionals accumulate some large retirement accounts and nice real estate, their largest asset is typically themselves and their ability to earn money, a "human capital" asset that declines as you age and your working years get shorter. Yet as Richards laments, traditional financial planning spends almost no time on this issue, focused instead on how to maximize the portfolio asset and not the human asset. Accordingly, Richard highlights the work of financial advisor podcaster Joshua Sheats of Radical Personal Finance, who suggests that strategizing around maximizing human capital involves three key levers. First, push up your starting salary as high as possible from day 1, as that's the base upon which all future income growth will be built; that's why it's valuable to invest into your own education and training (even if the schooling costs more than the salary increase in the short term, it compounds later!). Second, focus on how to get better raises every year, as a bigger raise once compounded out over a working career again is highly material; for instance, can you learn some new skills, get a side gig, or do something else to bring in some extra income that accelerates the growth process. And third, of course, you can always control your human capital by deciding to work longer and add more years of working income in the first place, especially in a world where we increasingly acknowledge the personal value of maintaining meaningful work engagement anyway!

A Diversity Problem (Elizabeth MacBride, Investment News) - Despite the growing diversity in the general population of Americans, where only 63% of the U.S. population is white, the world of financial advisors remains overwhelmingly white at 79%, which means African-Americans, Asians, and Hispanics/Latinos that make up nearly 36% of the overall population are barely 20% of all financial advisors (by contrast, even accountants are 26.7% people of color, and financial analysts are at 27.7%). And notably, it's not for a lack of wealth in minority communities, where the wealthiest 1/5th of African-Americans (more than 3 million households) have $395,000 of wealth, the wealthiest 1/5th of Asians average more than $1M of wealth, and the top 1/5th of Hispanics average over $400,000. In fact, some advisory firms are looking to expand into serving minority communities, specifically by hiring minority advisors who may be more effective at connecting with people in those communities. From a societal perspective, the concern is that financial advisors also have a role in financial literacy, which means underserved minority populations end out with less financial literacy, and that in turn leads to bad financial behaviors that perpetuate the disparity. Yet a recent Investment News survey found that amongst 700 advisors, few believe that the lack of diversity was a problem; in particular, only 36% of white advisors agreed that diversity was an issue. Notwithstanding these dynamics, change appears to be coming slowly, as the concentration of white advisors is even higher amongst older advisors and less so amongst those younger, implying that the industry is doing at least a slightly better job getting more diverse, which will be reflected in the numbers as older (and 88% white) advisors retire in the coming decade. On the other hand, diversity is actually worst at independent advisory firms (the channel with the most current growth), and far better in wirehouses, large broker-dealers, banks, and insurance and trust companies. Though organizations like the FPA are trying to shift the dynamic in independent advisory firms as well with their recent diversity initiatives.

What Is Disruptive Innovation? (Clayton Christensen & Michael Raynor & Rory McDonald, Harvard Business Review) - The theory of "disruptive innovation" was first published in the Harvard Business Review in 1995, and over the past 20 years has grown tremendously in popularity... so much, in fact, that its creators argue that it is today both widely misunderstood and misapplied to loosely describe any industry that is shaken up and previously successful incumbents stumble. The distinction matters, though, because the specific strategies for true "disruptive innovation" are different than other types of industry disruption or mere competition. The authors frame true disruption as a situation where existing incumbents focus on their most demanding (and usually most profitable customers), leaving open gaps that new entrants can serve (usually at a lower price), and then as the new entrants move upmarket and add services that can compete for the incumbents' mainstream customers, disruption occurs. Notably, by this context, the highly touted "disruptive" Uber is certainly transforming the taxi business, but is not actually disrupting it. The distinction is that Uber didn't actually start by breaking into a low-end market to get a foothold, or find a new market that didn't previously exist; instead, Uber is simply deploying technology in a superior manner to outright outcompete the taxi industry head-to-head (and in fact, is only looking to expand into historically overlooked segments now that it is already building a mainstream position first!). Another notable distinction of true disruption is that its initial solution is usually not appealing to the mainstream, and is considered too simple or of too-low quality; it's only after material improvements are made, built on the back of the initial market success, that disruptors actually begin to disrupt. So why, again, does this matter? It matters in part because for established companies, new competitors that nibble at the periphery shouldn't actually be viewed as a threat in the first place, until/unless they're on a true improvement/disruption trajectory. On the other hand, because of the nature of true disruption, established firms often misjudge and underestimate disruptive potential, failing to recognize that companies not initially competing are on a trajectory to do so and may do so with substantively different business models that make it impossible for the incumbents to compete without making significant (and potentially untenable) changes themselves.

How Demographics Rule the Global Economy (Greg Ip, Wall Street Journal) - With sluggish economic growth for the past 7 years since the financial crisis, economists have blamed everything from fiscal austerity to the Euro meltdown to quantitative easing, but there is a growing recognition that simple demographics alone may play more of a role than first realized. In fact, the aging of the Baby Boomer population, next year the world's advanced economies will, for the first time since 1950, see an outright decline in their combined working-age population, and by the year 2050 it will shrink by 5% (even as the share of countries' populations over age 65 will skyrocket). In other words, over just a few decades, the world is shifting from a concern about whether we will have too many people, to a fear that we might have too few, a combination of both lengthening lifespans (increasing the number of over-age-65 citizens) and a broad trend of declining fertility rates. The net result of population decline is that companies run out of workers, customers, or both, and economic growth suffers. The demographic shift also helps explain why the unemployment rate has dropped by half since 2009, even as economic growth has been sluggish - because the economy simply doesn't need as many new jobs to employ the smaller net flow of new entrants to the workforce. The burst of people currently in the final stages leading up to retirement - when saving is heaviest - is also a demographically-based explanation for the "savings glut" that is driving down both interest rates and inflation (and limiting the ability of central bankers to impact the economy with their traditional tools). These demographic shifts in turn are raising all sorts of new societal questions, from realistic expectations for pensions, to what the appropriate retirement age is (given that today's 65-year-olds are as healthy as 58-year-olds were in the 1970s, implying more productive working years), and the importance of immigration laws (where older richer countries can boost their population growth with immigration, but only if political opposition can be overcome). Still, at a broad level, the fact that the population is growing more slowly suggests that economic growth will increasingly rely on productivity improvements for long-term improvements in real GDP - although in fact, many companies are turning to technology for automation and productivity improvements already, if only due to the lack of workers!

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!

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!