Weekend Reading for Financial Planners (Jan 11-12)

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 January 11th/12th:

CFP Board Will Switch To Electronic Exams Later This Year - This week, the CFP Board announced that it is going to transition from its 'traditional' pencil-and-paper exam format to a computer-based testing system instead, to be rolled out with the November 2014 exam; accordingly, the March and July testing dates this year will be the last of the paper-based tests. With computer-based testing (at over 250 proctored exam centers overseen by Prometric), the CFP Board hopes to streamline the exam reporting process; candidates will be able to access preliminary, "unofficial" results immediately upon completion, and the official results will be available in 1-2 weeks, rather than the typical 5 weeks of the current process. In addition, the CFP Board's "FAQ" notes that candidates will be able to register for take the exam any time in a 5-day testing window rather than having everyone take the exam simultaneously at the same time across the country. While the CFP Board notes that the exam content will stay the same and only the delivery is changing, the CFP Board also noted that the new exam format will allow it to "streamline" the current day-and-a-half 10 hours of testing time into a one-day event requiring only 6 hours of testing, which means the number of exam questions will be reduced from 285 to 170 (though the reduction is not intended to change the difficulty of the questions, just their quantity).

Roth IRA Tax Break Lures 10% of Millionaires - Last Friday, the IRS released 2010 data on Roth conversions, the first year that the income limit on Roth conversions was removed (along with an incentive program that allowed two-year averaging for those who completed a 2010 conversion). Analysis of the data reveals that the pace of Roth conversions exploded that year, spiking from $6.8B of conversions in 2009 to $64.8B in 2010 (and marking the first time that conversions exceeded total contributions). Notably, the IRS found that conversions were especially common among IRA holders with annual incomes exceeding $1M - more than 10% of them converted to a Roth that year, and while they made up a total of only 4% of all Roth conversions they moved 22% of the total money (or a whopping $14.4B, which comes out to an average Roth conversion of $414k). The results significantly exceeded the estimates from the Joint Committee on Taxation about how much revenue the rule would raise, which was originally projected at $6.4B over a span of 10 years, yet the IRS will have taken in multiples of this amount from just the $64.8B of conversions in 2010 alone; of course, the reality is that as more assets are built in tax-free accounts, the revenue created from the legislation has merely accelerated it from the future instead. One expert suggests that the wealthy were especially attracted to the Roth conversion strategy as an estate planning device to leave tax-free assets to future generations and "pay the taxes for those beneficiaries", though ironically the reality is that for individuals with $1M+ in income, it may actually have been cheaper in the long run to not convert to Roth and just let the beneficiaries pay at their own tax rates instead!

Technology for Planners: Trends, Spending, and the Rise of Robo Advisers - From the Journal of Financial Planning, this article is a roundtable discussion of technology issues for advisors, featuring advisor tech gurus Joel Bruckenstein and Bill Winterberg, practice management consultant Jennifer Goldman, and financial services consultant JP Nicols. The biggest trends the roundtable group sees on the horizon include the roll out of Personal Financial Manager (PFM) software (think "Mint" for advisors) that makes the advisor-client relationship more efficient, big data tools that allows advisors to actually analyze their clientele and produce actionable insights, and the ongoing transition towards mobile (including actionable tools like mobile check deposit) - and the fact that there will be a growing gaps between the "haves" (advisors that take on and integrate this technology) from those who do not. Other trends include an ongoing migration towards the cloud - more and more vendors are there now, and the questions are shifting from "should I do it" to "how do I do it" instead. Cloud-based technologies are also making it easier for software to integrate (reducing the need for all-in-one solutions as advisors can patch together integrated best-in-class solutions instead), and reducing the software-/technology-maintenance burden on advisors. While there's no clear benchmark on how much to spend on technology, all the experts emphasized that training and figuring out how to use software is at least as important (and expensive) as just buying the (right) software itself. The article wraps up by looking at the rise of the so-called "robo advisors" - with mixed views of whether they're enemies or actually friends, and an inspiration or a threat - and a glimpse of some of the new tools that may be coming in 2014, from PFMs to workflow software to more scalable automated financial planning software.

Is WealthTrace the Right Financial Planning Software for You? - From the blog of advisor consultant Craig Iskowitz, this article is a review of the relatively new financial planning software platform WealthTrace, which was launched just 3 years ago by CEO Doug Carey, a CFA, former portfolio manager, and financial software developer. WealthTrace is available in two versions - one directly for individual consumers, and the other for advisors, with over 300 paid users on the consumer platform and 50 advisors paying for the software. What's unique about WealthTrace? Carey says the software has a heavily focus on making it possible for the user to immediately see the results of changes to the plan, with those results front-and-center on the screen and easy to access; advisors don't have to run their analytics and then see the results in a report, as they're shown immediately on-screen, allowing the software to be used more interactively with clients. The software is intended to position somewhere between MoneyGuidePro (which has more functionality, such as a Social Security optimizer, but Carey says is cumbersome to use) and MoneyTree (which is easier to use with a good interface, but Carey claims WealthTrace has stronger analytics). WealthTrace does have Monte Carlo capabilities (though not continuously updated automatically like inStream), and includes a robust What-If Scenario Manager that can model multiple potential changes side-by-side, as well as the cumulative effect of implementing all those changes together. WealthTrace also supports modeling of life insurance and long-term care insurance needs, though a disability insurance module is not currently included. While the software is focused on ease of use, Iskowitz does note in his review that it lacks the 'polish' of MoneyGuidePro and a web 2.0 kind of experience - for instance, while many parts of the plan can be updated live and interactively, WealthTrace generally relies on a large number of text entry boxes, rather than the sliders-and-gauges interface of MoneyGuidePro. WealthTrace claims that it is targeted primarily to small RIAs with 1-5 advisors, and is beginning to explore working with broker-dealers; the software currently has integrations to Schwab PortfolioCenter, TDAmeritrade (presumably through Veo), Redtail CRM, and Morningstar, with more integrations coming in 2014 (along with an asset allocation optimizer, and a mobile app). The article cites the advisor annual fee for the software is $895, with discounts for multiple licenses, though it currently lists for $949 on the WealthTrace website.

InStream Solutions Moves To Subscription Model, Adds Wade Pfau Tool - Financial planning software provider inStream announced a change to its business model, transitioning from a free to a subscription-based service at an annual price of $2,400 for a single user (and volume discounts available); those who sign up before June 30 will receive a 50% discount on annual subscriptions, and existing users can sign up for just $1,000. In addition, inStream is rolling out a suite of new services, including the industry's first "Safe Savings Rate" planning function designed by retirement researcher Wade Pfau, integrated mind mapping tools, automated daily proactive financial planning alerts, and custom planning reports. In the coming months, inStream also plans to roll out a complete document management solution, account aggregation, and integrated investment analytics. As inStream founder and CCEO Alex Murguia puts it, the goal is inStream is not simply to be another financial planning software tool, but an integrated wealth management platform that planners can use to run their businesses.

'Deep' Portfolio Risk: How to Protect Clients - This article by Allan Roth in Financial Planning magazine discusses the recently released book "Deep Risk: How History Informs Portfolio Design" by noted financial theorist William Bernstein. The basic concept of "Deep Risk" is that it represents a substantive permanent loss of capital, defined as a real (inflation-adjusted) negative return over a 30-year period. Notably, this means even events like the Great Depression, by this definition, would merely be "shallow" risks (though obviously still dangerous, especially to clients taking withdrawals in retirement); in Bernstein's view, "deep risks" include things like severe inflation, severe deflation, (government) confiscation, and outright devastation (e.g., due to war). So how can deep risks be addressed? Bernstein notes that stocks can be effective against the inflation deep risk; while they can be volatile in the short run, equities are actually more exposed to shallow risk than deep risk. In the case of deflation, bonds - especially government bonds - tend to be the best deep risk defense (though notably, while they're effective against deflation, they can be severely damaged by inflation). The other two risks - confiscation, and devastation - are more geopolitical than purely financial. Risks of government confiscation can be managed by foreign-held assets (though it can expose such assets to the risks of foreign government confiscation); notably, Bernstein characterizes severe taxes as a form of confiscation. Devastation can also be managed with foreign-assets, though again it's important to pick a jurisdiction not likely to be impacted at the same time. Ultimately, Bernstein suggests that portfolio design becomes a balance of managing against shallow vs deep risks, and determining which risks can most feasibly be "insured" at a reasonable cost.

You Are Here - From the blog of "Reformed Broker" Josh Brown, this article provides a good overview of where the investment world sits as we start off 2014. In general, Brown suggests that there are fewer investment opportunities than there were a year ago - a simple fact bourne out by the reality that prices of almost everything are much higher than they were a year ago - but given that investor flows tend to follow recent performance more than value or opportunity, there is still plenty of room for markets to continue to rise given that even on a 5-year trailing basis equities are now showing whopping double-digit returns. This had led market valuations to be "rich across the board, though not egregiously rich yet", though Brown notes that the preferred valuation measure is still widely debated; bears use Cyclically-Adjusted P/E (CAPE) ratios to justify their stance, while bulls use forward P/E ratios or the Fed model to justify theirs, and Brown suggests that while the weight of the evidence does suggest that we're at least somewhere towards the higher side of historical valuations the reality remains that markets can and usually do overshoot to the upside ("When have you ever seen a bull market stop at fair value?") and that even corrections are unpredictable and can take a long time to materialize (for those waiting to buy one). So what's the outlook from here? Brown suggests four scenarios: 1) a 1994-style flattish, low-volatility market as reducing stimulus and slightly better-than-expected growth fight each other to a draw; 2) a highly dynamic, binary year where the first half continues the (bullish) trends of 20133, followed by a nasty inflection point (China debt bubble? Crack in rising rates?) that reverses in the second half; 3) cyclical bull market crescendo (the bull market just ramps up further as growth gets underway, CapEx kicks in, and labor market gets tighter); or 4) something totally unexpected (the proverbial black swan) catches everyone off guard. The bottom line - notwithstanding the fact that it's not exactly the cheapest time to buy stocks, the animal spirits are back, and it is very rare to seem them appear and then stop on a dime once they've arrived.

Could A Puerto Rico Default Hammer The $3.7T U.S. Muni Bond Market In 2014? - This Forbes article by Larry McDonald highlights the current challenges of Puerto Rico, a small U.S. territory to which the municipal bond market has a surprising amount of exposure. 75% of all U.S. muni bond funds hold Puerto Rican bonds, and Puerto Rico's total public debt is a whopping $53B, which amounts to $15,000 per person (by contrast, Texas' state government debt is only $40B, or about $1,577 per resident), and the Puerto Rican debt is even higher (about $70B) when inter-government debt is counted, and higher still ($160B) when under-funded pension (funding ratio only 11.2%!!) and healthcare obligations are included. Overall, Puerto Rico is the 3rd largest municipal bond issuer (behind California and New York), and its unique territorial status allows it to be tax-free on a Federal, state, and local taxes basis, dramatically raising its appeal for after-tax-yield-starved municipal bond investors across the U.S. who have "enabled" Puerto Rico to issue such a mountain of debt. In addition, McDonald notes that there is a severe lack of transparency about Puerto Ricos' true financial health, the mountain of debt is clear, and Puerto Rico continues to suffer as it has been in recession 95% of the time in the last 7 years and still has an unemployment rate of 14.7% (despite a tremendous amount of government transfer payments supporting the economy, including a whopping 27% of citizens on food stamps). In addition, while it's unclear when the country may finally hit the wall, a severe water inflation crisis (up 300% in the past 6 years), leading to a 25% delinquency rate on water bills, could become the cash flow choking point that triggers a default. In addition, tensions are mounting; in June of 2013, a $300M payment of US Medicaid funds was delayed, as the Puerto Rican government arbitrarily changed their nationally sponsored insurance carrier without getting approval from the US Health and Human Services Department and now the US Treasury is investigating. As it stands now, most U.S. investors have already stopped buying Puerto Rican bonds - the government is now heavily relying on regional bank financing at 9% rates for 5-10 year bonds which is unsustainable (9% interest on $70B of debt is over $6B/year in interest payments for a country with a $10B annual budget!), and making it up with taxes is limited as Puerto Rican population has been in decline for 13 years as the young leave for the opportunities of the U.S. mainland. Even with new bond buying stopped, though, the existing bond issuance and a potential default could have dramatic ripple (or shockwave!?) effects and trigger a repricing of risk in the entire municipal bond market (and/or require a bond forbearance, or an outright bailout that taxpayers may or may not be willing to support).

The Ticking Time Bomb Of Forced Drawdowns On Variable Annuities - Elderly clients holding a variable annuity for the purposes of maintaining a death benefit are discovering a new problem: many contracts have "maximum" ages for deferral, beyond which there is a required "commencement date" when contracts must be annuitized and converted into a stream of income. The requisite age varies from mid-80s to as late as 95 or 100, and varies by contract. The problem, however, is that the act of annuitizing the contract eliminates the account balance and the associated death benefit; as a result, clients who "fail" to die before the required annuitization date may find that their death benefit is effectively forfeited. The scenario is exacerbated in situations where clients had dollar-for-dollar annuity death benefits, and had "stripped out" most of the cash value and death benefit, leaving behind a large death benefit but a tiny account balance that must now be annuitized (or in some cases, even Required Minimum Distributions can deplete the contract, as the value for RMD purposes - which includes the actuarial value of the death benefit - may exceed the actual cash value). While in the past, insurers were sometimes willing to extend annuitization dates voluntarily, they appear to be far less likely to do so now - no surprise given the looming death benefit they may have to pay - and annuity owners have few other options, given that the annuitization date is contractual. (Michael's Note: The irony of this situation is that in the past, the media has lambasted annuities that have maximum annuitization ages of 100, 110, or 120 for 'only offering income long after most people will have passed away'; as this story illustrates, though, the reality is that a late maximum annuitization age can actually be preferable, as while clients may choose to annuitize earlier, being forced to convert to income sooner rather than later can actually be less favorable!)

How Advisers Can Overcome The Success Paradox - From United Capital CEO Joe Duran, this article looks at what Duran dubs the "success paradox" for advisors, where the things that made a firm successful in the early years become the limit that keeps it from being more successful in the later years - a phenomenon he has observed where firms begin to plateau after 20 years and now derive most of their growth from stock market performance and occasional referrals and therefore growth at a much slower pace than they used to. So how do mature firms break free of this growth stagnation? Duran suggests three key steps: 1) recognize that the bottleneck is always at the top, as it's the leadership of the firm that determines how decisions will be made and how adventurous or risk-seeking the organization will be (key factors for growth, evolution, and change); 2) remember that leadership is about focusing on the "what" and not the "how", so managers and leaders should focus on determining what needs to be accomplished, and then avoid getting mired in the details of how it's going to get done by delegating authority and empowering others in the organization to act (and if you still feel the need to control everything, figure out if it's because you think your team isn't good enough, or because you aren't trusting enough, and then address those issues); and 3) realize that change (risk) is a requirement for growth, so be careful about becoming too complacent and be willing to establish a workplace that encourages people to challenge the status quo.

Ten Predictions for Advisors in 2014 - In this article for Advisor Perspectives, industry commentator Bob Veres sets forth his predictions for the top 10 issues that advisors will witness or face in 2014. The key items on the list are: investment turbulence (even if there's not an outright bear market, there may well be some rough weather ahead, from the Fed taper to never-fixed European woes to rising bond rates and the hidden leveraged bets that may be unwound); regulatory disruption on the fiduciary front (with fiduciary rules coming from the SEC, the DOL, or both, but little clarity about whether the new standards will really be uniform or whether two playing fields will continue to exist for advisors versus brokers); continued efforts by FINRA to regulate RIAs (with no conclusion in 2014, but FINRA will continue to lobby its case); advisors becoming increasingly "front-office-only" as they jettison all of their back office in a world of virtual outsourcing (and perhaps a complementary coterie of back-office-only support firms); public challenges to the value proposition of retail advisors as online "robo-advisors" claim that they can bring comparable value at a fraction of the price (not that they'll win much market share yet, but they will raise the value question for traditional advisors with the public); increased M&A activity with advisory firms (and the more M&A activity that happens, the more experienced firms there are that do M&A and the more there will be in the future); advisor software will become significantly more useful as the software itself provides alert functions that help make advisors more proactive (telling you when to rebalance, or when planning goals are falling short); firms focusing on making the planning process more interactive and enjoyable; and the CFP Board imbroglio over its "fee-only" definition will continue to build as more questions are raised and as the Camarda lawsuit moves forward. Veres wraps up the list by reserving a spot for something that will turn out to be a big dramatic surprise that no one could have predicted but may affect us all.

Betterment’s Quest for Behavior Gap Zero - From the blog of "robo-advisor" Betterment, this article provides an interesting look at Betterment's own internal data about how they're faring in helping their investor clients manage the so-called "behavior gap" of bad market-timing underperformance. While research has varied in estimating the performance gap, from -4.3%/year from DALBAR (which may have a flawed methodology) to other studies by behavioral finance researchers finding behavior gaps around -1% to -2% per year, Betterment frames its goal as trying to track, and manage, and actively try to reduce, that gap between what is provided in model portfolios and what clients actually achieve in their accounts. So how has Betterment (and its investors) fared? Based on tens of thousands of clients investing between 2010 and 2013, Betterment first calculated the investor return (the internal rate of return with all cash flows), then determined the dollar-weighted average stock allocation for each customer over the life of the account, and finally calculated the time-weighted rate of return associated with that stock allocation. The end result found that Betterment investors had a behavior gap of only about 0.31% per year, far less than the typical research study showing about 1.5%/year of underperformance. Betterment attributes this to several aspects of their platform design, including extensive diversification (and reporting it only by showing parts of the portfolio as a constituent of the whole and never the return of each individual component), driving down transaction fees to nothing (Betterment charges no trading fees by acting as a broker on the trades itself and aggregating them together for implementation), having a strong focus on the future (you never see the day's performance of your portfolio), and automating everything. Of course, the reality is that Betterment's gap may be lower because of the self-selection bias of more passive investors who choose the platform, and the data set does not include a bear market; nonetheless, as Betterment points out, it is one of the few - or only? - consumer investment platform that has systematically analyzed, calculated, and publicly shared its behavior gap data.

In the meantime, if you're interested in more news and information regarding advisor technology I'd highly recommend checking out Bill Winterberg's "FPPad" blog on technology for advisors. You can see below his new Bits & Bytes weekly video update on the latest tech news and developments, or read "FPPad Bits And Bytes" on his blog!

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!