Weekend Reading for Financial Planners (Dec 22-23)

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 22nd/23rd:

401k Fee Disclosure: What 6 Months Tells Us - This interesting article from Chris Carosa at Fiduciary News looks back at how the Department of Labor's new Rule 408(b)(2) on Fee Disclosure has impacted the marketplace after nearly six months since its July 1 effective date. Early on, it appeared that some providers were lowering fees prior to the rule taking effect, perhaps realizing their fees wouldn't be viewed as competitive and/or simply not wanting to disclose how high the fees had been, although the article suggests that bundled providers may have simply shifted the fees to another less apparent part of the bundle. Overall, the gist suggests that the massive plan participant uprisings that had been predicted about qualified plan fees are not coming to fruition, as many participants may just be overwhelmed by the amount of disclosure notices these days, although clearly the perception that 401(k) plans are "free" is on the decline. Perhaps the greatest challenge is that the fee disclosures are not as clear as they were anticipated to be, and the DOL's failure to create a standard template that all service providers would be required to follow - which could have allowed for easy comparison from one plan to another - has made it hard for the voluminous disclosures to have an impact. In the end, the article notes that ultimately fee disclosures and the potential for the marketplace to develop its own benchmarks may have some effect, but thus far it's becoming clear that just "warning [through disclosures] is not always the same protecting."

Age-Based Options Take Over 529 Industry - This Morningstar Advisor article looks at the rising popularity of age-based "glidepath" investment choices for 529 plans, noting that in September even the behemoth CollegeAmerica 529 plan launched its first age-based options - despite the fact that the CollegeAmerica plan is sold exclusively by financial advisors, who ostensibly are already available to help clients make custom asset allocation decisions and adapt them over time. Nonetheless, the rise in age-based options - both in the CollegeAmerica and elsewhere - appear to be driven in large part by the fact that managing multiple plans for multiple children (across multiple families, in the case of an advisor) quickly gets complex and difficult, and the automation of age-based investments is appealing. Overall, about 32% of advisor-sold 529 plans are in age-based investments, while about 40% of direct 529 plans use them. However, the advisor statistics may be distorted by the lack of an age-based choice in the largest advisor-sold plan; the percentage jumps from 32% to 55% when CollegeAmerica is excluded. Notably, though, the data suggests it's not just about advisors adopting a "set-it and forget-it" approach; as Morningstar notes, "the data also suggests that the conveniences of age-based options can help advisors become more, not less, involved in customizing clients’ college savings."

Capturing Returns - This Financial Advisor magazine article does a nice job explaining the "capture ratio" - an investment metric that separates upside returns from downside returns, looks at what percentage of each a portfolio captures, and then compares the two. Although the capture ratio is not often published, Morningstar does report upside and downside capture ratios separately, making it easy to calculate the balance between the two. The goal, not surprisingly, is to find funds that capture more upside than downside, but the article makes the point that this metric does a better job in evaluating prospective investments than just diversification alone - especially for funds that consistently maintain favorable capture ratios over time. Of course, the caveat to all of this is that evaluating with capture ratios ultimately only looks at relative performance; if the underlying benchmark is delivering mediocre returns, even investments with favorable capture ratios may be limited in total return.

Central Bank Insurance - In his weekly missive, John Mauldin takes a hard look at gold, as an investment, and as insurance against central banks and the risk of currency debasement. Mauldin notes that although he would not call himself a gold bug, he personally has been slowly accumulating in his own portfolio as well. Notwithstanding this, Mauldin points out research suggesting that gold has not necessarily had as strong a relationship to inflation as is often implied (suggesting it may not be as good of a hedge as we think it is, or at least it may hedge over a time horizon longer than most clients intend to be invested), and that in fact its price in real dollars has actually be rather flat for centuries (and even millenia) up until a wild volatility ride began when gold started to be market traded in the 1970s. Ultimately, the conclusion seems to be that gold is definitely not an investment (in that it doesn't have a long-term expected real return) except when used speculatively, but that it can still function as a reasonable (but not perfect) store of value, especially as insurance against potential central bank policy mistakes and the risk that uncontrolled deficit spending begins to debase the currency. 

Why A New Inflation Gauge Will Hurt Seniors - This article from Mark Miller at Reuters provides a good explanation of "chained CPI" - the proposed change to Social Security benefits from the White House to help shore up the sustainability of the system. Current, Social Security benefits are indexed to CPI-W (the Consumer Price Index for Urban Wage Earners), but many economists argue it is inaccurate (specifically, overstated) because it fails to fully account for consumer substitution behaviors (where consumers avoid price increases in one good or service by substituting another less expensive one). However, there is some debate about whether chained CPI is really representative of the inflation that impacts spending for seniors, especially given their disproportionate spending on healthcare costs that are inflating at a faster rate (including Medicare Part B premiums that can't be substituted). Overall, the impact is modest year to year - in 2013, chained CPI would have produced a 1.4% COLA, instead of 1.7% from CPI-W - but over time, the effect is magnified. Of course, the entire principle of chained CPI is that it's a more accurate measure of inflation, not a problem, but the article notes that several advocacy groups are pressing that at a minimum, the issue needs to be studied more in the context of seniors in particular. On the other hand, it's notable that the chained CPI would also be applied to the thresholds on ordinary income tax brackets, potentially causing them to rise more slowly as well (which means if people grow income at a faster rate, they will wind up in higher tax brackets more quickly over time).

Finding Success In Retirement Income Planning - This article from the Journal of Financial Planning reviews the FPA's 2012 study on how financial advisors are implementing retirement income strategies. The study contrasts the 25% "most successful" advisors (whose clients did not have to make significant spending changes in the past year) versus the 25% "least successful" (where at least 1/3rd of their clients had to make spending changes). The study notes that systematic withdrawal strategies appeared to be associated with the most successful advisors, while essential-versus-discretionary approaches were far more common with the least successful advisors (an approach that has been previously criticized on this blog). Unfortunately, though, it's not entirely clear how to interpret these results - after all, essential-versus-discretionary approaches are often designed to have more flexibility around discretionary spending, and if that's the client's expectation and decision, it's not necessarily clear that spending adjustments indicate a "less successful" advisor. Nonetheless, there are clearly some material differences in advisor strategies and the results they are producing. At the end, the article points out that advisors are now typically recommending a 4% safe withdrawal rate, consistent with the research, although notably this is only after six years of declines from a withdrawal rate as high as 5.3% prior to the financial crisis!

The Next Generation Of Income Guarantee Riders: Part 3 - This article is the last in a series by retirement researcher Wade Pfau regarding the Aria RetireOne "Stand-Alone Living Benefit" (SALB), which provides an annuity-like lifetime income guarantee wrapped around a non-annuity investment account (previous articles in this series were covered in Weekend Reading here and here). After discussing his assumptions, Pfau dives into the core of the analysis beginning on page 2, finding notably that the RetireOne guarantee actually tends to provide even less (inflation-adjusted) income than the annuity with a Guaranteed Living Withdrawal Benefit (GLWB) rider, especially given today's forward market assumptions with low yields on the 10-year Treasury (which are part of the RetireOne income formula). In addition, income over life declines for both vehicles, due to the inability of the guarantees to keep pace with inflation in adverse scenarios. Conversely, Pfau does find that the RetireOne offering does a better job preserving wealth, but that in part is due to the simple fact that the guarantee pays (and therefore the projections assume) lower withdrawals in the first place. Compared to a portfolio of unguaranteed mutual funds, neither guarantee holds up terribly well; although the RetireOne has lower failure rates than the GLWB rider, its income streams are also more easily replicated without any guarantees. Pfau notes at the end that the outcomes are more favorable for the income guarantees with more favorable return assumptions, but of course if returns are favorable the guarantees may not be needed in the first place.

Divorce and Life Insurance Proceeds: Be Aware of the Law - This article from the Journal of Financial Planning provides a good overview of the rules, along with some of the case law, that applies to life insurance proceeds after a divorce - especially in the scenario where a former spouse is (still) named as the beneficiary, as opposed to children, other family members, or even a new spouse. Unfortunately, just getting divorced is now well established as not revoking beneficiary designations, and instead it's usually required that there's a direct expression of intent to revoke (i.e., something stipulated in the separation agreement as a part of the divorce decree at a minimum, if not outright changing the beneficiary designation itself). On the other hand, there are some state laws will automatically revoke a beneficiary in the event of a divorce, yet clients should be cautious to rely on state law as Federal law may preempt in certain scenarios (especially where the beneficiary designation ties to something governed by ERISA). Notably, most of these rules and issues would also apply to IRA beneficiary designations as well. Of course, ideally planners will guide clients to always proactively update beneficiary designations after a divorce, but the article is a good reminder of the quagmire that can result if this step is overlooked (or if clients simply try to rely on the fact that they got divorced to control the outcome). 

Sentimental Fools: Pity the Poor Mutual Fund Investor - This article from Research Magazine discusses the tendency of investors to be the "dumb money" that makes poorly timed investment decisions in and out of mutual funds. While this isn't exactly new ground, the article - written by Professor Michael Finke of Texas Tech - does a better job than most of citing and explaining some of the actual research that has been done showing whether and how investors hurt themselves. In general, Finke labels the phenomenon as "sentiment-driven investing" where the investor is guided by emotions, rather than rational calculations. The research itself is somewhat daunting; fund investors appear to lose about 1.5% annually according to one study, while another suggested that the most aggressive investments tend to have the biggest gaps (as high as 3%/year). Notably, the impact of selling at the wrong time appears to be greater than the impact of just buying the wrong funds and chasing returns, and investors appear to excessively focus on recent past performance (despite its weak predictive value) because it's an easy metric to identify and compare given limited time and attention span. While in theory a primary value of advisors, then, is to "de-bias" clients away from these decisions, the research notes that advisors too are subject to these forces and that debiasing may be harder than we realize (although advisors compensated on a transactional basis appear to do even less debiasing).

Why Too Much Data Disables Your Decision Making - This article from Psychology Today looks at a recent study from Princeton and Stanford psychologists entitled "On the Pursuit and Misuse of Useless Information" which showed how superfluous information can actually make it harder for us to make good decisions. The study looked at a scenario where participants were invited to evaluate a mortgage application for a recent college graduate with $5,000 outstanding credit card debt, but one group was initially told the debt might be $5,000 or $25,000 and only later found out it was $5,000. Ultimately, both candidates had the same final details, but the superfluous information that the debt might be $25,000 (even though it ultimately wasn't) led to only 21% rejecting the application, compared to 71% who didn't receive the extra information. In other words, for the second group, the $5,000 debt just didn't seem as bad compared to the $25,000 debt and the fact there was a financial problem at all was ignored, even though the $25,000 debt was never actually a fact, just superfluous and incorrect information that was stated to be irrelevant. The fundamental point - while we often crave more and more data, in reality it can easily lead us astray.

Building Trust, Or Are You? - This article by consultant Bill Bachrach in Financial Advisor magazine looks at the different approaches advisors take and the roles they can play in trying to build trust with clients. For instance, some advisors are educators, trying to aid clients through the philosophy "it's my job to educate people, give them information and options, and let them decide." However, Bachrach notes that it's often hard to determine when it's time to move from information to action (especially given the prior article about too much data!), and that sometimes over-education can become a blocking point. Other advisors adopt a therapist-style approach, although Bachrach cautious that many advisors aren't really trained as therapists, which may be especially problematic as this approach may drawn in the clientele who need the most therapy! Yet another style is the "salesperson" approach, with the philosophy that ultimately we're all still salespeople in some manner or another; Bachrach simply outright counsels not to approach clients as a salesperson (probably not news to readers of this blog!). The fourth approach - and the one Bachrach recommends - is to be a true advisor, which means your value is not just to educate or provide therapy, but to inspire people to action so they get results. And Bachrach notes that this itself inspires trust as well. Ultimately, I realize that "be a real advisor" is nothing new, but Bachrach makes some interesting points that sometimes we need to do less educating, less therapy, and less selling, and focus on inspiring clients to action.

The Myth of the Generalist - This article from LinkedIn makes the interesting point that in reality, there may not be such a thing as a true generalist expert - and even if you could find such a walking encyclopedia, would he/she really be a good fit for your business (or a good person to service clients?). Instead, the article notes famous management consultant Peter Drucker's definition: "The only meaningful definition of a 'generalist' is a specialist who can relate his own small area to the universe of knowledge" or in other words, a generalist is someone who can translate specialization in their field to be relevant and connected to other domains. In a way, the concept reminds me of the best practice for a financial planner "generalist" - someone who can translate the technical complexities of financial planning and apply them to the varied domains of complex individual human beings.

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!