Weekend Reading for Financial Planners (December 23-24)

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 23rd – 24th:

President Trump Signs Tax Cuts & Jobs Act Of 2017 (Michael Kitces, Nerd's Eye View) - After a tumultuous process of drafting tax legislation, including a last-minute change to comply with Senate rules, today President Trump signed into law the Tax Cuts and Jobs Act of 2017 (TCJA), in what most are hailing as the most significant tax overhaul in decades. In practice, the primary focus of true tax reform - sweeping changes and simplification - was for corporations, which had their rates cut to just 21% (down from 35%), along with a repeal of the AMT, in an attempt to encourage especially global US-based businesses to bring their profits back home and reinvest into the US. For individuals, the new legislation was less "sweeping reform" (and the simplification that usually comes with it), and more of a series of tweaks and adjustments, which will produce new tax planning opportunities for years to come. An expansion of the Standard Deduction, combined with a cap on the deduction for state and local taxes, a reduction in the amount of mortgage debt for which interest can be deducted (down to $750,000 of debt principal, and home equity indebtedness no longer applies), plus the repeal of miscellaneous itemized deductions, means that less tax planning will likely happen in the realm of itemized deductions in the future (with as many as 90% of households projected to just claim the Standard Deduction going forward). However, the introduction of a new "pass-through business deduction" that allows S corporations, partnerships, LLCs, and even sole proprietorships to claim a 20% "qualified business deduction" will lead to an array of new tax planning strategies, especially since while the new QBI deduction is not allowed for "specified service businesses" (including doctors, lawyers, accountants, and consultants), it is permitted for those who have less than $157,500 of taxable income (or married couples under $315,000), which creates a lot of appeal for forming small businesses (and even reshaping existing employee relationships into independent contractor status instead). Of particular note for financial advisors will be the potential for the new QBI deduction to apply to them (as financial advisors are also a "specified service business", which means the deduction will phase out for advisors at higher income levels), the fact that the repeal of miscellaneous itemized deductions means that investment advisory fees are no longer deductible by clients, and the loss of Roth recharacterizations of prior Roth conversions (which limits a number of proactive Roth tax planning strategies). On the other hand, the rule that would have required all investors to report investment sales on a FIFO basis - which initially created a significant uproar amongst financial advisors who would lose the ability to do tax loss harvesting with many clients - was not included in the final legislation.

CFP Board Issues Revised 2nd Proposal For New Standards Of Professional Conduct (Michael Kitces, Nerd's Eye View) - Earlier this year, the CFP Board issued its proposal to update its Standards of Professional Conduct for the first time in nearly 10 years. The primary focus of the changes was to more clearly apply the fiduciary duty to CFP professionals at all times, and not "just" when they provided financial planning or material elements of financial planning (which opened the door to CFP certificants who marketed themselves as financial planners, but then didn't actually do any financial planning, thereby avoiding any fiduciary obligation to clients). Other key elements of the original proposal included key clarifications on the definition of "fee-only" and a crackdown on the "fee-based" label, an expansion of the 6-step financial planning process to 7 steps (separating out the development of recommendations from the presentation of recommendations), and new disclosure requirements to clients both at the time of engagement and upfront with prospects (akin to the RIA's Form ADV Part 2), along with a rebuttable presumption that any time a client engages a CFP professional it's presumed (for purposes of applying the Practice Standards) the CFP professional will be doing financial planning (unless proven otherwise). The amended 2nd proposal of the Standards of Conduct retains the prior requirement for "fiduciary at all times" (when providing any kind of financial advice, even just including product recommendations), which the CFP Board touted in an $80,000 full-page ad (or $1 per certificant!) in the Wall Street Journal, but in a concession to the broker-dealer community, eliminates the require for initial disclosures to prospects (which are standard for RIAs under Form ADV Part 2, but could have been deemed "advertising" for broker-dealers under FINRA Rule 2210) while retaining the disclosure requirements at the time of engagement, and (unfortunately for consumers) steps back from the rebuttable presumption that consumers can safely assume CFP professionals are providing financial planning. The CFP Board will be taking feedback on the revised rules in a 2nd Public Comment period that will open on January 2nd and run for 30 days (through February 2nd), with a goal of finalizing the new standards at the end of March, and taking effect on January 1st of 2019.

Even In Limbo, The DoL Rule Drives Brokerage Attrition To RIA Model (Christopher Robbins, Financial Advisor) - In a new TD Ameritrade "Break Away To Independence" survey of mid-career brokers who plan to go independent in the next 3 years, the majority of those planning to break away cited the final outcome of the DoL fiduciary rule as a driving factor in the decision to go independent (with 26% stating that they may become RIAs sooner because of the pending fiduciary regulation). The most common reason for not breaking away is a fear of the legal and compliance issues, and 25% of advisors also expressed a fear of losing revenue during the transition (particularly if they were subsumed with the difficulties of business management, scale, and branding, that are necessary as an independent RIA, although a mere 10% of planning-to-depart brokers expressed concern about abandoning the brand-name status of their existing brokerage firm). Notably, the survey was conducted before Morgan Stanley and then UBS stepped away from the Broker Protocol, which would only amplify the fear of legal/compliance challenges breaking away and the risk of losing revenue in the transition (suggesting that the wirehouses were well attuned to the fears of brokers when deciding to leave the Protocol to staunch the flow of departing brokers). Although ultimately, it's not clear that even leaving the Protocol will really stem the tide, as the survey also found that the majority of brokerage reps who want to leave aren't just doing it for the financial opportunities of the RIA channel, but more directly because they're dissatisfied with their broker-dealer itself, from the broker-dealer corporate culture, limitations on career advancement, changing compensation policies, and a lack of confidence in corporate leadership.

Fidelity Report Says RIAs Are Cutting Fees & Working Harder (Jeff Benjamin, Investment News) - The latest Fidelity RIA Benchmarking Study is out, and the big news is a rapid rise in the use of "fee-discounting" for clients, with a whopping 60% of RIAs reporting that they discount their fees below their published fee schedule for at least some clients (with a median gap between stated and actual fees of 21 basis points, although the overall revenue/AUM yield of advisory firms was down just 3 basis points), opening up an industry debate about whether fee-discounting is a good pricing strategy or not (and some confusion with other industry studies still showing advisory fees are holding steady at most firms). In addition, profit margins for advisory firms continue to compress, as advisors work harder to attract and retain clients, with the average profit margin holding at just 19%. At the same time, growth continues to slow (to just 5% in the past year), though fortunately advisor productivity remains near record highs (with an average of 71 clients/advisor and an average client household of $1.1M, with overall average revenue per advisor at $538,000). In addition, Fidelity finds that advisory firms are increasingly starting to unbundle their AUM and financial planning fees, adopting a lower AUM fee for investment-only work (and removing the number of related services they do for their AUM fee alone), and charging a separate financial planning fee for non-investment advice on top. Other notable areas include more advisors focusing on differentiating services across segmented client tiers, a growing interest in digital "robo" solutions, and a continued struggle to attract and retain female professionals (with just 37% of all advisory firm employees being female, and only 18% as advisors and 12% as owners).

SEC Cracking Down On Wrap Fee Abuses (Tracey Longo, Financial Advisor) - This month, the SEC issued a new Investor Bulletin specifically regarding RIAs using wrap fees, and the fact that some RIAs (particularly large corporate RIAs tied to broker-dealer platforms) are failing to disclose their collection of wrap fees (where a single basis point AUM fee is charged for all trading and other brokerage services) combined with or on top of investment advisory fees. In addition, some are also raising concerns that, if not priced properly, bundling wrap fees into an advisory agreement may actually be more expensive than simply letting the client pay a per-transaction cost for each trade (in essence, a form of reverse churning, which is especially concerning when the RIA is owned by the brokerage firm that earns the wrap fee). Another concern is the combination of wrap fees with third-party managers, who may have their own trading costs (in addition to the wrap fees) that are not fully disclosed (e.g., where the third-party manager executes its own trades at a different broker, stacking that broker's transaction costs on top of the not-fully-utilized wrap fee of the original brokerage firm). Notably, the SEC's wrap fee scrutiny is coming in part from concerns that bubbled up from its Retail Strategy Task Force, but also because the SEC itself is becoming increasingly sophisticated in using Big Data tools to analyze its own regulatory data and spot potential problem areas and suspicious activity.

How To Thrive When Profit Margins Decline (Glenn Kautt, Financial Planning) - Back in 1999, Mark Hurley of Undiscovered Managers issued a then-controversial report predicting that in the coming years, there would be a decline in profit margins and a wave of advisory industry consolidation as RIA competition increased, ultimately putting small RIAs out of business and concentrating the industry into a small subset of mega firms. Ultimately, the industry has not quite evolved as Hurley predicted - or at least, not as rapidly as anticipated - but many of the forces Hurley predicted are now starting to play out, with a rising volume of advisory firm mergers and acquisitions and steadily eroding profit margins (even as markets continue to make record highs). At the individual firm level, though, Kautt suggests - based on the work of Alfred Chandler's "The Visible Hand" - that at the individual company level, great managers can still overcome and navigate market forces successfully, with a combination of executing the right business strategy, with the right operational and organizational structure, to the right segment of the marketplace (that the firm can effectively serve). Or viewed another way, an advisory firm essentially sits on an "efficient frontier" of possible firms, all of which can be optimal, but a firm can only be at once place on the curve at a time; as a result, just like constructing a portfolio, the goal is to both choose where to be on the curve (e.g., aggressive growth or conservative, or in the case of advisory firms focused niche or big consolidator), and then make adjustments to the "portfolio" (the business) to try to have the optimal mix of strategy and operations at that point on the efficient frontier. For instance, in the case of Kautt's firm, they decided that since they're a larger firm that already has a lot of "gray hair", they would try to maximize on that positioning by not competing against large scaled firms (e.g., wirehouses), and instead doubling down on their experience-and-expertise position (by reinvesting into their advisors to become deeper experts, publish research, etc.). The key point, though, is simply to recognize that if you're trying to be "good" at too many things at once, there is no optimal solution - just as you can't simultaneously invest a 30/70 and a 60/40 portfolio for clients, and a blended combination of the two may be less efficient than either alone) - and that instead advisory firms can succeed by truly focusing at the one thing they can do most efficiently (and then owning it).

RIA Sellers Need Their Own Zillow (Jeff Benjamin, Investment News) - In today's landscape of advisory firm mergers and acquisitions, the number of buyers far numbers the sellers (by some estimates as much as 50:1). The good news of all this buying demand is that it can help to sustain favorable valuations of advisory firms. The bad news, however, is that most advisory firm owners will only ever get one chance to sell, while a number of buyers are experienced "serial" buyers who acquire one firm after another... which means even though the supply/demand mechanics favor the seller, most sellers don't really have any idea what their advisory firm is worth, and what they should ask for. Which in some cases leads advisory firm owners to have unrealistically high expectations of what their firms are worth. And in other situations, creates the risk that firms will underprice themselves and fail to realize their full value. Accordingly, this opacity in advisory firm pricing is leading some to suggest that it's time for a "Zillow-like" website that can help firms effectively value themselves and compare to others. Of course, the primary challenge is that Zillow itself is often criticized for misjudging the value of a home, and that's with publicly available data on other transactions in the area, whereas most advisory firm sales are private, which makes it especially hard to even get good comparables data (outside of existing marketplace websites like FP Transitions). At a minimum, though, an online valuation tool could use known pricing mechanisms for advisory firms - from revenue and growth rates to profitability and client demographics - to give a more robust estimate of the firm's value (as least better than the typical 2X revenue "rule of thumb"). Still, though, with so many moving factors in the valuation of a firm, including local geographic, internal talent, brand positioning and niche focus, and more, it's unclear whether it would even be possible to generate enough data volume to give robust estimates of value. Although notably, some firms like Truelytics are already trying.

How To Build, Cross, And Burn Bridges (Angie Herbers, ThinkAdvisor) - It's a common old saw in investing that good times can lead to complacency... and in the context of business, including advisory businesses, complacency in the good times can sow the seeds of destruction for when the bad times eventually come. And as Herbers notes, with the S&P 500 having nearly doubled in the past 5 years (and nearly quadrupled from the market bottom in 2009), there is a growing concern that complacency in advisory businesses could make the next bear market especially traumatic. And so, for advisory firms who want to get ahead and be prepared for the next inevitable bear market (whenever it occurs), recognizing what it may do to the profitability (or even survivability) of some advisory firms, Herbers suggests the following: 1) recognize that if your firm is getting more complex - especially once it grows beyond $1M of annual revenue - it may be time to hire dedicated "C-Suite" executives (e.g., a COO, or even a CEO) to formalize the management of the increasingly complex business (with people who have experience to navigate the downturns when they come); 2) remember it's still important to be spending time on the business, including the key steps of overseeing an increasingly complex business, including projecting business cash flows, managing profit margins and client turnover, compliance and new projects (and at a minimum, have the reporting tools to monitor the health of the business in these areas!); 3) recognize that with investment management increasingly becoming a commodity thanks to technology tools, advisory firms are increasingly compelled to up their game on providing real advice (which may necessitate learning how to effectively sell advice and not just investment management services or investment products, but also reinvesting into the firm's advisors to actually be able to deliver valuable advice in the first place!); 4) take steps to protect the brand of the firm, including against the risk of attrition of your own advisors (e.g., Herbers advocates rotating client service/operations staff amongst advisors and clients, so it's not too easy for a departing advisor to take a dedicated CSR that clients will be more likely to follow); 5) take a fresh look at your service model, to be certain that it's focused appropriately (and recognize that if you want to attract a new client demographic, like Millennials, you may need a new business model!); and 6) recognize that sometimes, to stay competitive, it's necessary to make changes, including to staff... which means, as hard as it is, now may be an especially good time to consider making changes to employees, or even partners, who aren't a good fit for the future of your business.

Serving Millennial Clients With A 3-Step Model (Russell Kroeger & Yusuf Abugideiri, Journal of Financial Planning) - The conventional view of financial planning is that it's all about helping clients to focus their resources; by the time a client engages an advisor, most already have their basic needs met, including a healthy income and at least some assets/savings, and want help to navigate their future. However, Kroeger and Abugideiri note that when it comes to doing financial planning for younger generations - i.e., Millennials - this is not an accurate assumption, as with everything from an unstable job market to a mountainload of student debt, many (or even most?) young people need help specifically with how to find that initial financial stability in the first place (and may be quite willing to pay for it!). Accordingly, the real key for working with younger clients is not about helping them to allocate their resources, per se, but to develop "financial planning policies" that can give them the necessary structure to move towards that financial stability and success in the first place. For instance, relevant financial planning policies for younger clients might include allocating 5% of monthly surplus to a Roth IRA, with any excess allocated towards travel and vacations, or directing 10% of monthly take-home pay towards building a 6-month cash reserve and then redirecting those cash flows as extra payments towards student loans, or coordinating and adjusting the deductibles on automobile and homeowner's insurance to coincide with the building of available emergency funds. A key point of this policy-based approach to financial planning is that it's more flexible to what is likely to be a rapidly-changing environment for young clients; policies that are based on percentages (e.g., a percentage of savings, or earnings, or free cash flow) can naturally adapt to a change in situation, without always requiring the advisor to be re-engaged at every step along the way. At the same time, designing such financial planning policies also creates a rich opportunity for productive conversations about potential life trade-offs (e.g., the long-term consequences of taking vacations after saving 5% of income, instead of trying to save 10% of income first).

Harold Ford Is Just The Tip Of The Iceberg (Diana Britton, Wealth Management) - With the recent Morgan Stanley firing of former Congressman Harold Ford Jr after an investigation into sexual harassment, along with Sallie Krawcheck's recent #MeToo story, there is a growing awareness that sexual harassment is just as present in the financial services industry as other industries that have had public revelations. In this article, independent financial advisor Stephanie Sammons - who was formerly in leadership at two wirehouses - shares her challenging experiences in the financial services industry. In fact, Sammons notes that as she was moved around to various branch offices to manage, there was typically "a predator in every office", and one that was usually protected by the wirehouse culture at the time, with behaviors ranging from lewd gestures and comments, or outright sexual harassment. Yet at the same time, for aspirationally-oriented women, the stakes of coming forward are very high, with the (unfortunately sometimes well founded) fear that speaking out could impair one's ability to climb the corporate ladder. And the problem is made worse by the fact that firms often pay settlements for such inappropriate behavior, but don't actually fire or hold the original individual accountable, which just allows or even encourages the inappropriate behavior to persist. Notably, though, Sammons points out that the dynamics are far different for her now in the independent channel, and that she feels far more supported outside of a large-firm environment where the culture was supporting sexually harassing behavior. In the meantime, Sammons advocates that for those going through such challenging situations, there is an increasing opportunity to speak up now; in fact, she suggests getting the other women together in the firm or local office to file a complaint jointly if a sexual harasser has been repeatedly engaging in inappropriate behavior to multiple female employees.

How Small Financial Advisory Firms Can Prevent Sexual Harassment (Carolyn McClanahan, Financial Planning) - Notwithstanding the slew of sexual harassment allegations and revelations rippling through most industries, it's somewhat surprising that there have been relatively few reports out of the wealth management and advisory world... despite the rather male-heavy finance culture. While this may be in part because the financial services industry had its own sexual harassment scandals back in the 1990s, McClanahan suggests that in part the problem may simply be even more underreported in the advisory industry because so many firms are small firms. After all, in a large financial services (or other) business, there's typically a human resources department to report such issues, while in a small business, the owner or person in power doing the harassing may actually be the only person to report it to as well. And given that in most businesses (large and small), culture is set from the top, in a small business where founder, owner, lead advisor, and manager are all one and the same, it's difficult to drive any kind of change (or again, even have someone to report to). So what's the alternative? McClanahan suggests that an effort to shame advisory firm owners as sexual harassment perpetrators won't likely be constructive (especially since it still won't necessarily change the business' underlying culture). Instead, the better course of action may be for firms to better focus on filling their boards and executive-level positions with more women (which helps to set a more constructive and balanced culture from the top), and to more clearly articulate open communication cultures (even assigning an employee as a "culture keeper" whose job at least in part is to advocate for a great working environment). In other words, the key is to recognize that the most pervasive sexual harassment problems in businesses aren't just about a single individual, per se, but a culture that accepts and even supports such behavior, which means long-term industry change is about making long-term changes in culture, and learning how to have the difficult conversations (McClanahan recommends Susan Scott's "Fierce Conversations").

How To Have Difficult Conversations About Diversity (Brian Thompson, XY Planning Network) - Having difficult conversations, especially about sticky issues like diversity of race, gender, or sexual orientation, is very challenging for most, as feelings from anxiety and shame to fear and vulnerability come forth. In fact, one of the biggest challenges in talking about diversity is literally the challenge in talking about and having conversations about diversity. Yet the conversations themselves are crucial, as avoiding discussions about racial (or other diversity) tensions can lead affected stakeholders to feeling unheard (which just perpetuates the cycle of misunderstanding and misinformation). Still, the difficulty of the conversation itself remains - usually not because of the content of the exchange, but the underlying context, feelings, and emotional investment that may surround it. Which means the starting point is to come from a place of empathy, trying first to understand the other person's perspective and putting yourself in their shoes, to better understand their context of why a conversation or issue is frustrating or problematic. The good news, though, is that even a relatively short non-confrontational conversation can help combat existing biases; one study found that a discussion as short as 10 minutes, where an individual was asked to put themselves into the shoes of a transgender person, was able to materially reduce anti-transgender attitudes. Key points to make the conversation work: 1) start from a place of humility and try to be genuinely curious to understand; 2) approach with an interest in problem solving (not just trying to be "right"); 3) focus on what you're hearing, not just what's being said; 4) try to put yourself in the other person's shoes; and 5) expect a positive result (which will help focus your attention on finding the opportunities for mutual gain). And notably, the benefit of this exercise is not merely one of promoting better understanding, but the fact that more and more studies are showing that more tolerant, inclusive, and diverse workplaces actually generate better bottom-line results, too!

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, in the spirit of all the recent 'buzz' about Bitcoin, with its rapid rise (and followed by a rapid decline over the past 24 hours), you may enjoy this light-hearted comedic take on the recent Bitcoin frenzy...