Weekend Reading for Financial Planners (December 30-31)

Author: Michael Kitces

Team Kitces

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

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

Read all of Michael’s articles here.

Weekend reading for December 30th – 31st:

Many Comments Critical Of Fiduciary Rule Are Fake (James Grimaldi & Paul Overberg, Wall Street Journal) - With the recent news that millions of fake comments were filed with the FCC leading up to its vote to repeal Net Neutrality, reporters at the Wall Street Journal started delving into the public comments filed for the recent delay to the Department of Labor's fiduciary rule... and found that a whopping 40% of their sample of 50 fiduciary critics hadn't actually filed those comments. Instead, as with the FCC and other recent incidents of Federal agencies gathering public comments, the DoL fiduciary objection comments were written by an unknown third party, who fraudulently submitted the comments using the real names of other people. Ultimately, the fact that a large segment of comments against the fiduciary rule and supporting the delay were fake doesn't necessarily mean the delay will be rescinded; under the Administrative Procedure Act, agencies are not bound to follow public comments, and the overwhelming majority of comments were already against delaying the fiduciary rule, yet the delay moved forward nonetheless. However, if it turns out that the fiduciary rule delay had even less support than previously believed, it does lay more groundwork for either courts, or a future administration, to reverse efforts to delay the fiduciary rule or bolster it further in the future.

New York's Financial Watchdog Proposed 'Best Interest' Rules (Katherine Chiglinsky, Bloomberg) - With the ongoing delay to the Department of Labor's fiduciary rule, states have increasingly been discussing whether to create their own state-level consumer protections. First it was Nevada that established its own state-level fiduciary duty for financial advisors, and this week the New York Department of Financial Services issued a statement that it is issuing a proposed regulation for its own "Best Interest" standard specifically for those licensed to sell life insurance and annuity products in New York. Notably, the new rule would only impact insurance and annuity sales in New York – which the industry is using as the basis for complaining that New York's rule would create an uneven playing field and present a significant challenge for firms that operate in multiple states and would be subject to different standards across state lines. Yet on the other hand, with ongoing industry efforts to block Federal fiduciary regulations from the Department of Labor, the trend towards states implementing their own fiduciary rules may be the only and inevitable path forward for a fiduciary duty for financial advisors (especially for insurance and annuity sales, which are already regulated at the state level by State Insurance departments). In fact, the New York Department of Financial Services explicitly cited the delay of the DoL fiduciary rule as part of the reasoning for issuing their own state-level fiduciary regulation. The New York proposal is subject to a 60-day public comment period before being officially issued.

IRS Advisory: Prepaid Real Property Taxes Deductible In 2017 Only If Assessed In 2017 (IRS) - With the Tax Cuts and Jobs Act imposing a $10,000 cap on the cumulative amount of state and local sales, income, and property tax deductions started in 2018, an end-of-year frenzy has emerged for taxpayers to try to prepay their 2018 property taxes in 2017 in order to claim the deduction this year before the cap kicks in, after a provision in the legislation explicitly denied taxpayers the ability to prepay state income taxes but was silent with respect to property taxes. However, the tax code generally doesn't allow payments to be deducted for expenses that haven't actually been incurred, and consequently issued a "clarification" this week that prepaying 2018 property taxes in 2017 will only be deductible if the property tax had actually been assessed (i.e., the property tax amount has been determined, and the taxpayer has actually become liable for it). In general, this means that prepaying property taxes that were assessed for the 2017-2018 year (e.g., counties that bill property taxes from July 2017 to June 2018) should be deductible if the 2018 portion is paid by the end of the year, and prepaid property taxes due in early 2018 may be deductible as well (if the county had already sent out the assessments in late 2017). But simply trying to prepay an "anticipated but unknown" property tax amount in 2018, or one that hadn't been formally assessed, won't be deductible. Although with so many people trying to prepay property taxes, and individual counties handling the payments in a variety of ways, it's not entirely clear whether or how the IRS will be able to determine who "improperly" prepaid 2018 property taxes, short of having them overturned for the unlucky few who are audited next year.

Digital Marketplaces Aim To Ease RIA Access To Alternative Investments (Ryan Neal, Investment News) - With markets making record highs in what is arguably a "long-in-the-tooth" bull market, advisor surveys show a growing interest in using alternative investments to hedge the potential for a future bear market. Except the challenge is that access and due diligence of alternative investments is still a challenge for most advisors in independent channels. To help fill the void, technology platforms like iCapital and CAIS have developed digital marketplaces with a curated list of highly rated alternative products (CAIS uses Mercer for its due diligence, while iCapital works with the CAIA Association). Available alternative investments include private equity and private credit deals, venture capital, real estate, and hedge funds, and the platforms even assist with pre-populating some of the requisite paperwork, along with providing data feed integrations to existing RIA custodians and other platforms. From the perspective of alternative asset managers themselves, platforms like iCapital and CAIS are appealing because the independent advisor marketplace is so fragmented, it's difficult for them to gather assets, especially given that most RIAs will only allocate a moderate portion of client assets to alternatives anyway... while the digital marketplaces provide a central point of aggregation (which in turn means CAIS and iCapital offer lower investment minimums than what clients and advisors would typically face by going direct). Notably, the platforms do vary with respect to their own revenue models, though; iCapital's platform is free to browse and research, but charges a management fee once an investment is made, while CAIS is free to advisors and generates its revenue directly from asset managers (who ostensibly pay CAIS for distribution out of the funds' expense ratios), while newcomer iFunds charges a 50bps fee that is waived once certain asset minimums are met.

Build Your Own Index (Diana Britton, Wealth Management) - Separately managed accounts and customized model portfolios have been increasingly popular amongst high net worth investors in recent years, but the practical cost challenges of holding a high volume of individual securities makes it challenging for the "average" investor, who tends to still purchase mutual funds or ETFs. But the ongoing rise of increasingly sophisticated rebalancing and model management tools, paired with ever-decreasing wrap fees, and technology that makes it feasible to hold fractional shares, is making it possible to bring separately managed account structures to investors who are further downstream. But the technology isn't being used to "just" create more customized model portfolios; instead, it's also being used to replace mutual funds and ETFs altogether, where the software is used to directly own the underlying components of the index. The appeal of such "direct indexing" strategies is that, by owning the underlying securities directly, it's possible to engage in more proactive tax loss harvesting, and potentially even reduce costs to the extent the fee-based wrap account or other trading fees are lower than the expense ratio of the mutual fund or ETF (not to mention reducing the sometimes duplicative overlap of similar stocks held across multiple ETFs or mutual funds). Another appeal of the approach is that by owning the index at a more granular level, it's also possible to adjust or "tilt" the index, whether based on popular investment factors (e.g., overweighting small-cap and value) or ESG mandates. Notably, some third-party managers have already offered a form of direct indexing in a separately managed account structure – such as Active Index Advisors – but now technology companies like Orion and SMArtX Advisory Solutions are working on bringing direct indexing capabilities directly to advisors to manage and implement themselves.

5 Retail Model Marketplaces Struggle For Advisor Assets (Craig Iskowitz, Wealth Management Today) - 2017 was the year that Model Marketplaces burst onto the scene, as a means to allow financial advisors to directly access third-party-created investment models while retaining control over (and responsibility for) the actual trading implementation. The good news of model marketplaces is that they're essentially an opportunity for financial advisors to replace TAMPs at a lower cost, and for some are preferable simply as a means to better retain control of the investment portfolio and the client relationship. The bad news, though, is that so far, there seems to be more buzz than actual client and advisor assets flowing onto the platforms. Nonetheless, Iskowitz highlights a half dozen of the key players, including some that are offered directly from custodians, and others that are made available by standalone technology companies. The tech-company-based model marketplaces include Riskalyze's AutoPilot Partner store, Orion's Eclipse Communities, and HedgeCoVest's SMArtX. In the case of Riskalyze and SMArtX, institutional investment managers provide a series of model portfolios for advisors to choose from, while in the case of Orion Communities the platform initially will allow financial advisors to share their own models with each other on a peer-to-peer basis (though third-party managers are expected to follow soon). When it comes to the custodian-based model marketplaces, including Folio Institutional's Model Manager Exchange, Trust Company of America's Money Manager X-Change, and TD Ameritrade's Model Market Center (via iRebal), the tools are deeply integrated directly into the underlying custodial platforms – which is important, because it means that their model marketplaces are generally restricted to just their own custodian platform (as opposed to the tech-based companies, which require the use of their software, but are custodian mostly custodian agnostic). At the same time, though, when the core goal is to create a standardized model portfolio, all of the model marketplace solutions appear to be quickly becoming commoditized, as a similar subset of asset managers that are looking at this technology as a distribution channel are consistently appearing in the lineup of virtually every model marketplace available (e.g., Blackrock and Morningstar Managed portfolios).

The Return You Need (Dirk Cotton, Retirement Cafe) - When comparing portfolios to lifetime annuities (or Social Security, or some other form of guaranteed payments), it's common to calculate the "hurdle rate" of returns that the portfolio would need to earn in order to replicate the guaranteed stream of income. The caveat, however, is that even if returns average out in the long run, once ongoing withdrawals occur, the sequence of returns matters, too. And the problem is even more significant if the goal is to save for a specific financial event (e.g., paying for a wedding, or buying a retirement home), as there's really no way to know whether the portfolio will be worth the desired value on the exact date that the goal (and financial commitment) comes due. In essence, the problem is that the nature of the asset is not well matched to the nature of the liability, even if the asset is capable on average and over time of producing the needed return. The situation becomes especially complicated in situations where retirees want to invest now in order to purchase a guaranteed income stream in the future – for instance, taking Social Security payments to invest with a plan to buy an annuity later (rather than simply taking the guaranteed delayed retirement credits built into Social Security), or waiting to buy an annuity in the future instead of buying a longevity annuity now. Because the strategy only "works" if the markets deliver the desired rate of return over a very specific time period (and more generally, it's somewhat paradoxical to say "I want to invest in risky stocks now in order to buy more safe income later!"). Which means, at a minimum, if the goal is to delay the purchase of an annuity for 15 years, it would probably only be wise to invest in stocks for the first 5 years or so, and then begin to dial down the risk and shift into bonds as the time horizon shortens – which, not coincidentally, may so reduce the long-term returns over 15 years that the strategy is no longer appealing in the first place.

Managing Sequence Risk For Retirees (Wade Pfau, Financial Advisor) - One of the fundamental challenges of a portfolio-based retirement is the need to sustain a relatively stable standard of living from a potentially volatile base of assets... which exposes the retiree to "sequence risk", or the danger that even if the portfolio averages out to the anticipated long-term return, that ongoing withdrawals could deplete the portfolio during a streak of bad returns before the good years finally show up. Which means retirees need a strategy to manage that sequence risk. Pfau suggests four different options: 1) simply spend conservatively (i.e., follow a safe withdrawal rate approach, where spending is set low enough as a starting point that even if a bad sequence does occur, the portfolio will likely survive); 2) maintain spending flexibility, with a plan to trim spending in the event of a market downturn, in order to keep more of the portfolio intact for a subsequent recovery; 3) reduce portfolio volatility, either by outright owning a more conservative portfolio (which can produce higher withdrawal rates even if returns are lower, by reducing sequence of return risk) or at least with a plan to reduce volatility during high-valuation environments and/or at the beginning of retirement when it matters most; or 4) use "buffer assets" (e.g., cash reserves, or other bucket strategies) to have a spending source to tap during market downturns (although notably, holding a multi-year cash allocation throughout retirement can ultimately drag down returns so much that withdrawal rates are still lower with the strategy, which is why recent research has begun to investigate other "buffer asset" sources such as a reverse mortgage line of credit).

Fixing A Broken Retirement Withdrawal Plan (Bill Bengen, Financial Advisor) - The appeal of retirement income strategies like the safe withdrawal rate, is that the initial spending level is set low enough that even if there is a market pullback, the retiree shouldn't need to cut their spending. However, in practice, some clients start their spending higher, either because they want to and are willing to take the risk of future spending cuts, or because they "need" to in order to maintain their current lifestyle, and are willing to take the gamble of sequence of return risk. Which raises the question – if an adverse market event does happen, and it becomes necessary to make an adjustment, what is the best way to proceed in getting the withdrawal plan back on track? The first key to making adjustments is to recognize that it's actually not just about the sequence of returns, but also about the sequence of inflation, as Bengen shows that an early decade of higher inflation can actually be even more destructive than a first-decade bear market (thus why a late-1960s retiree who experienced the 1970s inflationary decade actually fares worse than a 1929 retiree in the face of the Great Depression). In fact, because both inflation and the portfolio can vary, Bengen suggests that monitoring a "current withdrawal rate" is the best means of spotting red flag scenarios – specifically by comparing whether the current withdrawal rate is trending lower than it did in prior historical scenarios that necessitated the 4% rule to begin with. Of course, the biggest challenge is simply that even when a bear market occurs, we don't know how quickly it will recover, and whether it's actually necessary to cut spending, or simply allow time for the market to bounce back; nonetheless, given that the longer the retiree waits to make adjustments, the more extreme they have to be, active monitoring to make mid-course adjustments is arguably the more appealing path.

Robots Will Transform Fast Food (Alana Semuels, The Atlantic) - In Japan, where the economy is booming but the population is shrinking, unemployment sits at just 2.8%... and it's spurring an investment into robots, even in traditionally human retail industries like hotels and fast food, given an outright shortage of workers to hire. Of course, the opportunities for hiring robots aren't unique to Japan, though, and raises concerns in other countries – including here in the US – where the economy isn't quite as strong, and employment in restaurants and hotels has been one of the few sectors with strong employment growth in recent years (and since 2013, have accounted for more jobs than the manufacturing sector). Yet restaurants that have been early to adopt technology report that it's not necessarily resulting in lost jobs; for instance, at Panera historically customers purchased their food from cashiers and picked it up at the counter, but self-service order and payment kiosks mean that now employees bring the food from the kitchen to the tables in an effort to improve the guest experience. Although some restaurants have found that over time, customers just don't value the human interaction as much as previously believed, and that just one or two "greeters" may be sufficient (while an army of robots fulfills the food orders). Yet the introduction of technology is creating new jobs in the process as well; in one pizzeria that adopted robots to make pizzas, there's now a "culinary program administrator" that oversees the software that manages the nutritional decisions that go into making the food. Of course, a real-world challenge is that current workers in the food service and hospitality industries may not necessarily have the skills and training to manage the robots and their software. Yet the increased efficiency of food-making robots is leading many stores to do more business overall, and the sheer growth of higher customer demand alone may help to more than make up for any potential job losses; for instance, since Starbucks launched its efficient payments app its employment levels are up 8%, just as when ATMs were launched by banks in the 1990s and expanded in the 2000s the number of bank teller jobs actually grew as well (because improving the efficiency and lowering the costs of banking ultimately increased demand for banking and expanded the number of bank branches).

The Crisis, The Fallout, The Change (Michelle Park Lazette, Cleveland Fed) - As we pass the 10-year anniversary of the Great Recession of 2008, researchers at the Cleveland Fed have done an in-depth analysis on what really happened during the financial crisis, and in the aftermath, in an attempt to better understand the risk that it might happen again (and how to handle it next time). From the Fed's perspective, their primary focus was and is on the banking system itself, scrutinizing the safety and liquidity and funding needs of banks as the number of bank failures spiked over 150 by 2010 (with the majority of bank failures in Georgia, Florida, Illinois, California, and Minnesota). Fortunately, at this point bank failures are back down to just a half dozen per year that fail (nationwide), but median family net worths still haven't recovered to pre-crisis highs, and the Fed is now much more cognizant of the systemic risks in the banking system. Of course, the underlying challenge was the belief that "housing prices only go up", or at least that if they ever went down, it would only happen in a small region due to local factors; the sheer national scale of the real estate decline was what ultimately put pressure on the banking system nationwide (even as failures were concentrated in the most high-flying real estate markets). At the same time, though, the Fed notes that there were still large swaths of banks that escaped relatively unscathed, that were still profitable every quarter, and never had to cut their dividend through the financial crisis. The most lasting impact seems to be in the realm of commercial real estate loans in particular, which still haven't fully recovered from their speculative boom volume of the 2000s (and home equity loans are still down 37% from their 2007 highs as well). And from the Fed's perspective, their oversight of banks now involves a much wider range of stress tests to evaluate the consequences of potential severe economic downturns, which for many have led to an increase in the level of (risk-based) capital reserves that banks are now required to hold. At the same time, though, the Fed is cognizant that the growth of the "shadow banking" system, from hedge funds and investment banks, to alternative payment platforms like PayPal, Venmo, and Bitcoin, mean that more money than ever moves outside the Fed's purview, which means even as the Fed tries to prepare to better deal with the next crisis, it acknowledges there is still uncertainty in how the next inevitable recession will unfold.

What Happened To The American Boomtown? (Emily Badger, New York Times) - In 1850, Chicago was a small frontier town with barely 30,000 people, but within two decades it was over 300,000, which then jumped to more than 900,000 in another 20 years, and reached a whopping 2 million residents by 1910 as it became the "hog butcher for the world"... making Chicago at the turn of the 20th century the fastest growing city America had ever seen, attracting anyone in search of opportunity. Yet this phenomenon of American "boomtowns" – where local economic booms created tremendous bursts in city growth and local opportunity – that dominated the late 1800s and much of the 20th century, is now slowing. Over the past 30 years, interstate mobility is down, and migration is actually stalling in the very places that have the most opportunity. And to the extent that any cities are booming with growth these days, it's more commonly driven by cheap housing, than the job opportunities of higher wages. Which raises the question: why aren't the cities with the greatest prosperity and highest productivity, like Boston, New York, and the Bay Area, operating as the magnets they once did to attract people from regions suffering from high unemployment and meager wages? The problem, it appears, is the cost of housing, and the fact that many wealthy regions have limited local housing construction, and more generally that land use restrictions – particularly in coastal metropolitan cities – mean "boomtowns" can't boom with housing growth the way they once did. The "good" news of these policies is that, for local homeowners, property prices are booming, but the geographic regions themselves aren't, as even the opportunity for higher wages is partially or fully offset by the higher costs of housing. In fact, one recent NBER study estimates that the country has lost several points of GDP growth in recent years driven by the inability of workers to move to areas of opportunity due to local housing costs. For many metropolitan regions, the only reason they're growing at all is actually immigration; based on domestic-only moves, New York has lost almost 1 million people since 2010, and San Jose, Washington DC, and Boston are down as well. The challenge, however, is that while improving housing policy is a national opportunity for growth, local housing policies are set by local cities and suburbs, where often existing homeowners – who may be enjoying the appreciated house prices that come from those restrictive policies – continue to resist making substantive changes.

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.