Weekend Reading for Financial Planners (Dec 26-27)

Author: Michael Kitces

Team Kitces

Michael Kitces is Head of Planning Strategy at Buckingham Strategic Wealth, which provides an evidence-based approach to private wealth management for near- and current retirees, and Buckingham Strategic Partners, a turnkey wealth management services provider supporting thousands of independent financial advisors through the scaling phase of growth.

In addition, he is a co-founder of the XY Planning Network, AdvicePay, fpPathfinder, and New Planner Recruiting, the former Practitioner Editor of the Journal of Financial Planning, the host of the Financial Advisor Success podcast, and the publisher of the popular financial planning industry blog Nerd’s Eye View through his website Kitces.com, dedicated to advancing knowledge in financial planning. In 2010, Michael was recognized with one of the FPA’s “Heart of Financial Planning” awards for his dedication and work in advancing the profession.

Read all of Michael’s articles here.

Weekend reading for December 26th/27th:

SEC Floats Rule to Rein In Funds’ Use of Derivatives (Melanie Waddell, ThinkAdvisor) - Earlier this month, the SEC released a proposed rule that would limit the amount of derivatives being used in mutual funds and exchange-traded funds, along with requiring them to implement new risk management processes to handle the derivatives they do use. The new rules are being initiated both in response to concerns about the extent of derivatives-based leverage in certain funds (alternative strategy funds have grown by nearly 50% in the past 4 years), and also whether the breadth of derivatives use across all funds could present a systemic risk in the investment marketplace. The proposed rule would require funds to comply with one of two limitations: a) the notional amount of derivatives transactions (plus certain other financial commitment transactions) could not exceed 150% of the fund's net assets; or b) the notional amount of derivatives can go as high as 300% of the fund's net assets but only if the fund satisfies risk-based tests (measured based on value-at-risk) that determine it is subject to less market risk than if the fund did not use derivatives (e.g., for funds that extensively use derivatives as a hedging strategy to reduce volatility, not a means to leverage and amplify it). The new rule would also require funds to segregate out an amount of assets sufficient to unwind the derivatives transaction, including an additional risk-based set-aside for what the fund would need to exit the derivatives position under "stressed" market conditions. Notably, the SEC rule, if implemented, is expected to be a "death knell" for many 2x and especially 3x leveraged ETFs whose current use of derivatives exceeds the limitations of the new rule (though it remains to be seen whether the rule will be changed or refined during its 90-day public comment period before the SEC finalizes it, ostensibly next year).

4 Factors That May Cause a Flood of Broker-Dealer Sales (Jon Henschen, ThinkAdvisor) - As of now, there are an unusually large number of broker-dealers and associated reps "on the market" and looking for buyers, including 9,500 Cetera Financial Group reps are on the market, along with 470 from NEXT Financial Group, and 4,925 from AIG Advisor Group. And while these firms all have 'special circumstances' driving their sales (Cetera is being sold to pay down debt of its parent company RCS Capital, AIG is being driven to split apart by activist investor Carl Icahn, and NEXT Financial's owners are simply looking for a liquidity event), Henschen suggests that there may be a rising "floodtide" of broker-dealers looking to be sold in the coming year or few. The biggest driver is the looming Department of Labor (DoL) fiduciary rule, as the limitations on non-liquid products (e.g., REITs and BDCs) and expected pressure on various types of commission-based products may put a severe squeeze on broker-dealer revenues and profitability, even as rising compliance costs to follow the rule will further squeeze broker-dealer profit margins. In fact, the increasing burden of complying with FINRA rules already appears to be squeezing out smaller broker-dealers, which are struggling both with the volume of tracking and reporting requirements, and steep FINRA fines that loom for broker-dealers that fail to comply. On the other hand, insurance companies appears to be shedding their independent broker-dealer arms as being "non-core" to the business, and focusing more on their broker-dealer divisions that distribute proprietary products. And notably, factors external to the industry are driving broker-dealer sales as well - for instance, the recent strength of the U.S. dollar over the Euro has made European firms that own U.S.-based broker-dealers (e.g., French-owned AXA Advisors, British-owned Jackson National, German-owned Allianz, etc.) potentially more interested in selling them while the dollar remains strong. The caveat to all of this selling activity, though: with the troubled outlook for the broker-dealer model, it's not entirely clear who the buyers would be (beyond perhaps some private equity firms), nor the price point (which may settle back to the fairly mediocre 30%-40%-of-trailing-revenue pricing that was the norm in the 2000s).

Can You Plan for a Black Swan? (Michael Finke, Research Magazine) - The concept of the "black swan" is relatively straightforward: a black swan event is one that is supposed to be so rare as to be statistically "impossible" that it will actually ever occur, yet in practice occurs with "surprising" regularity. It applies to everything from devastating earthquakes that occur with unusual regularity, to extreme events in the markets (further popularized by Nassim Taleb's book "The Black Swan" which showed in some detail how traditional financial models were/are grossly underestimating the likelihood of 'extreme' events). Notably, though, the potential for an "unexpected" extreme event is not always bad; it also represents a profit opportunity, for those who recognize that when the risk of extreme events is underpriced, so too is the insurance (e.g., put options) that protects against it. Thus, for instance, the hedge fund Univesrsa Investments (not coincidentally advised by Taleb himself) actually doubled its money in 2008, having bought "underpriced" put options waiting for the inevitable market storm to come (and profiting tremendously when it finally did in the fall of 2008). Unfortunately, though, most people take little or no steps at all to protect themselves, under-estimating the risk by extrapolating the fact that the event hasn't occurred recently into assuming it will never happen at all (and then after the fact convincing ourselves that in retrospect the risk was obvious). So what does this mean for financial advisors? Finke raises the question of whether advisors themselves are too-heavily discounting the risk of disasters, overweighting the favorable experience of US markets from the past century and failing to appreciate the risks that remain (which can be seen when looking at market returns from other countries in the last 100 years, such as Russian, Japan, and Germany [whose markets were devastated during World Wars I and/or II). On the other hand, the reality is that many of the biggest long-term changes (in markets and society at large) aren't actually driven by isolated "black swan" extreme events, but by the compounding of incremental change (think going to sleep in pre-computer and racially segregated 1965, and waking up 50 years later to find today there are supercomputers and a black president). Which means the biggest risks to clients still may not be black swans, but simply underestimating the impact of gradual but continuous change in the long run, and failing to formulate a plan about how to handle them.

Retirement Income and Chaos Theory (Dirk Cotton, The Retirement Cafe) - The classic view of markets and retirement analysis is that they can be modeled probabilistically, and that while the outcomes of a particular retirement are unpredictable (we don't know if the next few years will give good or bad returns) they are at least statistically quantifiable (we can figure out the likelihood of the good or bad outcomes, and plan accordingly). In this article, Cotton raises the question of whether markets - and retirement planning in particular - is not actually "probabilistic" but instead "chaotic" as described by chaos theory. The distinction is significant; while probabilistic systems are unpredictable the risks can at least be quantified, while with chaotic systems the potential feedback loops that can occur mean the risks aren't even fully quantifiable in the first place. And Cotton highlights that there are many aspects of retirement planning that do seem to map well onto chaos theory, including: highly sensitive to starting conditions (popularly known as the "butterfly effect" where small changes lead to magnified outcomes over time, which is exactly what occurs in retirement given sequence of return risk); unpredictability of the starting conditions (when we can't fully agree whether markets are overvalued or undervalued in the first place, it's hard to clearly model what the starting conditions even are, in order to predict subsequent outcomes and their likelihoods of occurring); the ways that seemingly stable order can quickly tumble into disorder (as exhibited by markets, which were stable from 2003-2007 and then suddenly very unstable in 2008!); and significant turbulence and feedback loops (even two seemingly identical starting points can wind up with drastically different outcomes). While ultimately there is some debate about even how to exactly define what is a chaotic system - and therefore whether retirement represents such a scenario - the fundamental point is that we need to be cognizant that our retirement models may be understating the uncertainty of retirement outcomes, especially since most retirement models focus on the uncertainty of market volatility but not all the other ways that retirement can be impacted (e.g., unexpected health changes and medical expenses). Or viewed another way, we may be understating the risks involved in the interactions between spending behavior and the uncertainty of markets, which appear to be even more "chaotic" to model than just analyzing market volatility alone.

Munnell Report Rattles DC vs. DB Plan Debate on Investing, Fees (Danielle Andrus, ThinkAdvisor) - A recent research paper from Alicia Munnell and her colleagues at the Center for Retirement Research has found that, despite the popular narrative that defined contribution plans have been damaging for most retirees because they are not good at investing their own money, the problem may not be nearly as severe as commonly reported. In fact, Munnell finds that in the multi-decade period from 1990 to 2012, using Department of Labor Form 5500 reporting, defined benefit plans only outperformed defined contribution plans in the aggregate by a mere 0.7% of annualized return. In terms of asset allocation, the study found that defined benefit plans have actually tended to be more conservative than defined contribution plans, due in part to plans simply trying to match liabilities (particularly as more and more are frozen), which might have made defined benefit plans look even worse were it not for the fact that from 1990 to 2012, given the market turmoil over that time period, equities and corporate bonds happened to have almost identical long-term returns (of 8.6% and 8.7%, respectively). In fact, the researchers found that the primary reason defined contribution plans ended out with lower returns than defined benefit plans is simply because fees tend to be higher on defined contribution plans, in part because there are more large defined benefit plans that can get institutional pricing while defined contribution plans tend to be smaller and much more expensive (especially the smallest plans under $1M of assets, which is a whopping 93.8% of all DC plans) and also more likely to use mutual funds (which just adds another layer of intermediary costs to DC plans compared to direct-investments or institutional shares for DB plans). Notably, the research also found that IRAs seem to have lower returns on average than either DB or DC plans, driven in large part by the fact that investors seem to be more likely to hold expensive funds and also typically hold far more in cash.

To Delay Social Security Claiming, Offer Lump Sum Benefit (Jamie Green, ThinkAdvisor) - As retirees live longer and longer, and governments around the world struggle with the commitments made to workers from their governmental pension and Social Security systems, the push is on to encourage retirees to either delay retirement and work longer (or else risk being forced to cut benefits). Yet in the U.S., few are actually delaying retirement; 37% claim Social Security as soon as they're eligible at age 62, another 31% claim benefits at full retirement age, and ultimately a mere 2.6% of workers actually delay benefits all the way to age 70 (despite the research published about why it is so beneficial to delay in order to obtain higher payments in the future). However, recent research by Olivia Mitchell at the Wharton School (and some international research colleagues) found that if workers are offered the chance to receive an actuarially-fair lump sum payment (instead of an actuarially-fair increase in future benefits), they are much more likely to delay. The research examined scenarios where retirees could delay either just past the early retirement age at all, or all the way until full retirement age, and found that the availability of the lump sum as a trade-off convinced people to work longer (and defer their benefits) by 6-8 months (with no adverse financial impact to Social Security, given that the lump sum offers were designed to be actuarially fair, but better for the retirees because they spend longer working in addition to getting the lump sum benefit). In other words, when those who delay receive their delayed retirement credits as a lump sum at retirement, rather than higher payments for future retirement, they appear more likely to delay - an indirect expression of the fact that retirees seem to often prefer lump sum payments to higher future pensions (and similarly why so few seem to annuitize their retirement assets). And notably, the effect seemed to occur regardless of income/wealth levels - from the affluent to the debt-ridden, the opportunity to receive delayed retirement credits as a lump sum was more effective at inducing people to work longer and delay claiming.

Blogging The Mistakes Your Clients Make (Susan Weiner, Investment Writing) - For all those financial advisors struggling to figure out what to write about on their company blog, Weiner offers up a remarkably simple and straightforward approach: write an article that describes common mistakes your clients already make, and your solutions to them. The basic format to the article would be: 1) you [the reader] do these good things (e.g., you've been saving for retirement, or setting up a legacy for your kids, or teaching your kids to spend wisely, etc.); 2) as you do these good things, you may be making some common mistakes (e.g., you're not investing your retirement portfolio properly, or your legacy for your kids is exposed to creditors, or your allowance strategy for your kids is all wrong); and 3) here are the best ways to fix those mistakes (e.g., ensure you have a well diversified portfolio, or use a trust as the beneficiary of the assets for your heirs, or give the kids more flexibility with their allowance so they can make mistakes and learn lessons in a controlled environment). When you're done, wrap up the article with a "Call To Action" - an indicator about what the reader should do next - which might include a suggestion to sign up for your email list for more tips (e.g., "Click here to download our research on the optimal asset allocation strategy for retirees!"). The bottom line: this simple structure can help make it easier to "fill in the blanks" to write out a blog article, and you don't have to think too hard for inspiration of what to write about, when you can simply draw upon the problems you're already seeing in practice with clients (which of course you'll discuss anonymously to protect their privacy!).

Figlo Swings for the Fences Against Financial Planning Software Heavyweights (Craig Iskowitz, Wealth Management Today) - Last year, Advicent Solutions (the makers of NaviPlan financial planning software) acquired Figlo, a Dutch goals-based financial planning software platform sold primarily to advisors in Europe and Asia. As Iskowitz notes, the recent Financial Planning magazine software survey shows the NaviPlan and Profiles planning software platforms lagging behind the current leaders MoneyGuidePro and eMoney Advisor, and the Figlo acquisition appears to be Advicent's attempt to challenge them. The distinction is that Figlo is primarily known for its interactive and collaborative planning capabilities, as the software is built assuming that the advisor and client will be meeting with the Figlo dashboard in front of them (although Iskowitz notes that Figlo doesn't yet allow a direct remote screensharing option for clients who aren't physically in the office with the advisor). The central feature is a client "lifeline" that shows as green when the plan is healthy, and turns red if a problem is projected - which the advisor and client then solve (turn green again) by showing the impact of various strategies on the fly. And notably, while the lifeline models a goals-based approach, users can still drill down to an underlying cash flow view and see all the cash flow details (though Iskowitz notes that the detailed planning functionality is still not as robust as eMoney Advisor or MoneyGuidePro at this point, lacking features like a Social Security optimizer, variable annuity functionality, or long-term care insurance analysis). Figlo also offers a client portal for clients to see and interact with their plan and keep up on their overall financial situation - i.e., a "personal financial management" (PFM) dashboard similar to what eMoney Advisor offers for clients, with data updated every night through account aggregation (in partnership with Quovo). However, Figlo lacks the depth of integrations of eMoney Advisor's PFM dashboard, currently only working with Orion Advisor Services and Redtail (although more integrations are likely in the future). At this point, pricing is $1,800/year for the planning software alone and $600/year for the client portal, with pricing expected to increase in the future as Figlo adds in more capabilities (at this point, it sits between MoneyGuidePro and eMoney Advisor). Ultimately, Iskowitz notes that Figlo is a promising start (and shines in areas like data security), but still has a ways to go to be fully competitive with MoneyGuidePro or eMoney Advisor (but may still be appealing to those who like Figlo's particular way of presenting information).

Doctor's Orders (Jerilyn Klein Bier, Financial Advisor) - This article is a profile of Dr. Carolyn McClanahan, a physician-turned-financial-advisor who is pioneering the adoption of integrated health-care planning as a part of her financial planning process. The starting point is simply to recognize that planning for clients should differ between those who have healthy versus unhealthy lifestyles, given how it impacts their longevity and planning time horizon. For those who have health issues, McClanahan emphasizes how the financial planning process can help affirm and strategize about how the client will pay for their health issues without decimating the family finances. Ironically, McClanahan became an advisor in part because she couldn't find one for her own family needs, and as she self-educated about financial planning issues, realized she wanted to become a planner herself. 10 years later, her practice oversees a little more than $100M of assets for 78 client families, and McClanahan is also a frequent speaker at advisor conferences about the issues at the intersection of health and finance (with topics ranging from how clients can clean up their medical records to get better insurance rates, to planning strategies under the Affordable Care Act in the years after it was first signed into law). Notably, McClanahan has also built her practice as a fee-for-service consistent with her medical background. Clients pay an ongoing retainer fee (where assets are managed as a part of the retainer fee but not a separate AUM charge) that starts at $10,000/year and rises from there based on complexity, covering both investment management, income tax and estate planning, and her health care planning services. Clients with simpler needs are referred out to other advisors.

From Functioning to Flourishing: Applying Positive Psychology to Financial Planning (Sarah Asebedo & Martin Seay, Journal of Financial Planning) - The past 15 years have witnessed the rise of a segment of psychology called "positive psychology", where the former has focused primarily on the treatment of mental illness but the latter is more oriented towards developing our human strengths to optimize our well-being. And notably, this progress from "needs-focused treating problems" to "strengths-focused flourishing" is not unique to psychology; financial planning itself has gone through a similar progression in recent years, from just trying to solve problems (e.g., by selling various products) to exploring how money can be used as a tool to optimize well-being (e.g., with the rise of financial life planning). Asebedo and Seay dub this intersection of positive psychology and improving financial well-being as "positive financial planning", focused on the intersection between money and topics like purpose in life, meaning, achievement, supportive relationships, etc. Accordingly, there is an opportunity for further research in financial planning about how different/"better" uses of money can facilitate well-being across its five dimensions (positive emotion, engagement, relationships, meaning, and accomplishment, or "PERMA" for short). The framework can be relevant directly in the financial planning process as well, and the authors suggest that advisors could even help clients assess where they stand across the five elements of well-being using a PERMA assessment tool, and discuss with the clients in what areas they're looking to improve; for instance, clients who want to improve engagement might deploy their money towards engaging in new hobbies and activities, while those who want to improve relationships might invest into experiences with others, and those seeking meaning might engage in charitable giving or getting involved with religious or special interest groups, etc. Advisors might also adopt positive psychology techniques as well, such as the "what-went-well" exercise where clients regularly write down three things that went well (and why) in their lives, or taking the Values-In-Action (VIA) Signature Strengths survey to better understand their own strengths to focus on.

Radical Candor: The Surprising Secret to Being a Good Boss (First Round Review) - This article is a profile of the research of Kim Scott, an entrepreneur, former long-term director at Google, and now acclaimed coach and consultant for major companies about how to create successful work environments where people love their work and working together. And as Scott has found, the single most important thing a boss can do to create such an environment is to encourage guidance - both giving it, receiving it, and getting employees to give guidance to each other. Fundamentally, guidance is just praise or criticism - i.e., "feedback" - but Scott finds that the most effective guidance is a form of "radical candor" that is crucial to helping employees actually know what they need to do to improve. For instance, Scott shares one of her own experiences, where she gave an important presentation to the Google founders about the success of her business division, and while the meeting went well, her boss shared the "radically candid" feedback that Scott said "um" a lot in the meeting... to the point that it made her sound stupid. Of course, most of us fear sharing such direct feedback, but Scott emphasizes that it's precisely that kind of feedback that really gets an employee's attention, and makes them actually respond and do something about the issue, which is vital for personal improvement. Notably, radical candor is not just about giving direct criticism to employees, which can otherwise come across as harsh or even mean; it only works for leaders who first demonstrate they care about employees in the first place, as that's what transforms criticism from being destructive into constructive instead. Or viewed another way, first you have to show your team that you 'give a damn', and then be 'willing to piss people off' by giving them the sharp feedback they sometimes need to hear. Of course, giving praise is important as well, though Scott notes that leaders should be cautious to give criticism in private and only praise in public. The bottom line - if the focus of financial planning is ultimately more than just helping clients with their money, and about helping clients use money to improve their overall well-being, then it seems only a matter of time before the research on positive psychology and well-being becomes increasingly adopted in a new form of "positive financial planning".

Are We Moving Towards A Profession? Recent Developments Re: DOL Rule, CFS, IFS, SEC, And CFP Board (Ron Rhoades, Scholarly Financial Planner) - As 2015 comes to a close, Rhoades notes what a 'monumental' year 2015 was in the evolution of financial planning towards becoming a true profession. The biggest news was the progress made by the Department of Labor, and its "Conflict of Interest" rule that was proposed early in 2015, and survived multiple challenges throughout the year as anti-fiduciaries organized an intensive coordinated lobbying effort to get Congress to stop or delay the rule. Yet ultimately, despite what Rhoades suggests may have literally been "hundreds of millions of dollars" of lobbyists, campaign contributions, and advertising, all of these attempts to block the DoL fiduciary rule (culminating in an attempt to attach a "policy rider" to the omnibus spending legislation passed earlier this month) were ultimately not successful, thanks to strong support from a broad coalition of consumer groups (including the Financial Planning Coalition), U.S. Secretary of Labor Tom Perez, as well as President Obama himself and his Council of Economic Advisors (who made the DoL rule a "priority" during negotiations). Beyond the DoL rule, also notable this year is spreading awareness of the "Fiduciary Oath" promulgated by the Committee for the Fiduciary Standard, and the development of fiduciary "Best Practices" by the Institute for the Fiduciary Standard. The momentum for building a financial planning profession looks poised to continue in 2016 as well, as the final DoL rule is released, the SEC potentially takes up its own rule-making process to propose third-party exams for SEC-registered investment advisors, and potentially promulgate its own fiduciary rule for broker-dealers (not just limited to the scope of IRAs like the DoL rule) under Section 913 of the Dodd-Frank Act (with the DoL providing the SEC some political cover to potentially make its own rule at least as stringent as the DoL's). Also notable in the coming year is the CFP Board's own announcement that it is forming a 13-person Commission to review its own Professional Standards in 2016, potentially bridging the infamous gap that CFP certificants can hold out as financial planners to the public but avoid fiduciary duty by not actually delivering financial planning services and "just" selling a product instead, following on the heels of the CFP Board's win in the Camarda lawsuit affirming that the organization has a right to enforce its professional rules of conduct against its members. Will 2016 be the year that financial planning finally sheds its "product sales" roots?

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.