Weekend Reading for Financial Planners (Jan 14-15)

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 14th/15th:

SEC Announces 2017 Exam Priorities (Greg Iacurci, Investment News) – Every year, the SEC’s Office of Compliance Inspections and Examinations (OCIE) publishes a list of its main priorities for the upcoming year’s exams. Most of this year’s 2017 RIA exam priorities are similar to years past, highlighting issues like reviewing the use of multiple share classes and wrap fee programs (especially when used in an RIA context, given the potential conflicts of interest), the use of ETFs, expanding the “Never-Before Examined” initiative to send examiners to RIAs that have never been visited before, RIAs with multiple branch locations, and targeting “recidivist representatives and their employers” (i.e., problem advisors with bad conduct, and the firms that hire them). Notably, though, this year OCIE has added a big new item to the exam priority list: “Electronic Investment Advice”. In other words, the SEC is raising its scrutiny on so-called “robo-advisors”, along with “firms that utilize automation as a component of their services while also offering clients access to financial professionals” (e.g., Vanguard Personal Advisor Services, or the new Schwab Intelligent Advisory), with a focus on the company’s marketing, investment recommendations, data protection, and disclosures of conflicts of interest, as well as their compliance practices regarding how the companies oversee their own automation algorithms that generate recommendations. Notably, though, these exam priorities are based on outgoing SEC commissions Mary Jo White, and not incoming commissioner Jay Clayton, who may direct the SEC’s energies in other directions over time (although, it seems likely most of these priorities will remain, as they transcend the typical partisan divide).

Lower-Cost T Shares Coming To A Fund Near You (John Rekenthaler, Morningstar) – With the DoL fiduciary rule coming to fruition in just a few months, the mutual fund industry is finally consolidating around a solution to the thorny issue of consistent mutual fund compensation for broker-dealer platforms: the creation of a new “T share” class of mutual funds. Going forward, the new T share classes will be available for virtually any/every mutual fund that currently offers an A-share class. The difference between the two is that T shares will have the same sales charges across all types of funds and categories (unlike A shares, which often have higher loads on stock funds than bond fund), to ensure there are no compensation differences across different investments (which the DoL could interpret as an incentive to invest clients more aggressively). In addition, T shares will be uniform across fund companies as well – they will all offer a 2.5% upfront commission (with breakpoints for larger purchases), and a 0.25% 12b-1 fee, with no other dealer reallowances or similar incentives that are found amongst many fund companies’ A shares. Notably, though, the significance of T shares is not merely their uniformity to avoid running afoul of DoL fiduciary rules; it’s also that they’re just outright a lower commission incentive structure, with an upfront charge that’s about half the typical A-share, and a lower 12b-1 trail as well, raising the question of whether T shares will even see significant adoption, or whether their uniform rollout will just hasten the shift to advisory accounts anyway, as it takes “only” 4 years for a fee-based advisory account to generate more revenue for the advisor anyway (but without the conflict of interest to churn). In addition, once T shares are available on a widespread basis, it’s not clear that A shares will really stick around at all, as while they may remain in existence to be used in taxable brokerage accounts, will investors really still tolerate their cost when identical-but-less-expensive T shares are available as well?

DoL Fiduciary Rule Hastening Death Of L-Share Variable Annuities (Greg Iacurci, Investment News) – L-share variable annuities typically have shorter surrender periods than “traditional” B-share annuities, but higher ongoing expense ratios, and have become especially controversial in recent years as regulators cracked down on the use of L-share annuities with retirement income guarantees (as there’s little reason to pick a short-surrender more-expensive annuity for a long-term multi-decade annuity guarantee). As a result, L-share annuities were roughly 27% of all contracts sold by the end of 2009, but are now just 3.4%. And with additional scrutiny on share classes as a result of the DoL fiduciary rule, it’s now expected that L-share variable annuities will likely disappear altogether, with several broker-dealers like Commonwealth and Voya already stepping away, along with insurers Prudential and Jackson National that have been discontinuing the L-share version of several annuity products. On the other hand, the pressure of DoL fiduciary is also spurring a rapid growth in filings for new I-share variable annuities, an “advisory” share class that will have no commission, which representing more than 50% of all new variable annuity filings in 2016. And the rise of new I-share annuities appear to be coming with a more robust range of guaranteed income riders – a notable contrast from most fee-based annuities of the past, which have primarily been “investment-only” variable annuities simply meant to serve as a tax-deferral wrapper.

Help Staff, And Your Firm, Grow And Thrive (Glenn Kautt, Financial Planning) – While financial planning is all about helping clients to succeed in achieving their goals, running a good financial advisory firm is all about helping employees to succeed in achieving their (personal/career) goals, too. Of course, the development plan for the advisor needs to match the needs of the advisory business, but Kautt notes that these usually will align (or at least, can become aligned). But the starting point, as with financial planning for clients, is simply to help employees articulate what their personal and career development goals actually are, from the needs of the firm (job-specific competencies, client experience/service, and business development) to the needs of the employee (personal and professional development), and the ones that at least partially overlap in personal and professional (e.g., networking and community involvement). Of course, ultimately the needs of the firm, and the goals of the employee, will still vary from one advisory firm to the next, but the point remains that as with financial planning, it’s valuable to help people (clients or employees) articulate what their goals are, and then develop their personalized roadmap to get there.

Do Incentives Motivate People? (Mark Tibergien, Investment Advisor) – One of the fundamental challenges of very successful business people is that, in the end, they often report that even with their success, they often do not find happiness. And at the same time, some of the people who are happiest and most engaged at work are employed by nonprofits and charitable organizations, putting people in challenging or outright dangerous environment, with modest compensation at best. The key point – motivation to work and happiness don’t appear to have much of a relationship to compensation and the financial success of work. Instead, Tibergien cites Clayton Christensen’s “How Will You Measure Your Life?”,  which suggests that if you really want to engage motivated employees, the key is not to figure out the “right” way to incentivize them, but simply to find motivated people, match them to the right jobs, and then eliminate their distractions and give them the opportunity to excel. The key point is to recognize that motivation itself is driven by a combination of “hygiene” factors (e.g., status, job security, work conditions, and compensation), along with true motivation factors (challenging work, recognition, responsibility, and personal growth). The key distinction – unsatisfactory hygiene factor can cause people to become dissatisfied (including paying them too little), but the true motivating factors go beyond compensation and financial incentives (which is why even the best business developers often don’t do it for the money, but the intrinsic motivations of a desire to win and succeed or a fear of losing).

Brain Drain: How RIAs Can Hang Onto Employees (Kelli Cruz, Financial Planning) – The larger independent advisory firms become, the more important it is to create a formal structure around how employees can advance their careers at the firm… or risk losing top talent to another firm that provides a more engaging opportunity with clearer long-term potential for success. In essence, employees need a career path – a defined track that shows how they can advance over time, with the potential to have greater levels of responsibility (and compensation), based on the progression of the employee’s own capabilities, skills, and experience. Cruz notes that the need to create employee career paths typically crystallizes around $170M of AUM and 7 staff members, as the organizational chart of the company gets deep enough to merit an actual “track” for progression. Key issues and expectations to cover in each stage of the career track include: years of experience; time in role/position; training targets; credentials/education; leadership and management skills; compensation structure (base salary and incentives). Notably, as firms grow, it’s important to not only have a track for financial advisors (e.g., support advisor, service adviser, lead advisor, partner), but also a track for operations/administrative employee as well (e.g., admin assistant, client service admin, operations manager, COO, partner).

Why You Probably Can’t Collect Social Security When You Turn 62 (Karen Damato, MONEY) – The standard rule for Social Security is that benefits can be claimed as early as age 62 (with a reduction for starting early), but the reality is that only about 7% of people can actually get a check for the month they celebrate their 62^nd birthday; for everyone else, the earliest actual starting point is age 62 and one month. The reason is that in order to claim a Social Security benefit for the month you turn 62, you must actually have been 62 for the entire month – which means if you weren’t born at the very beginning of the month, you won’t be 62 for that whole month. However, it’s also notable that Social Security actually assumes that you reach your 62^nd birthday at 11:59PM of the evening before your birthday. Which means if you were born on February 1^st of 1955, you’re deemed to turn 62 at 11:59PM on January 31^st of 2017, and you still won’t be able to start benefits the month you turn 62, because now the month you turned 62 is January (and you were only 62 for the last day of that month!); instead, the only person who can get benefits for the month they turn 62 is someone who was born precisely on the 2^nd day of the month, such that they’re deemed to reach age 62 at 11:59PM on the 1^st of the month, and will therefore “be age 62” for “every” day that month. On the plus side, if your benefit actually cannot begin until age 62 and 1 month, the benefit will be reduced by less than the maximum 25% reduction to account for the fact it was started one month later than age 62. Either way, though, Social Security doesn’t actually pay the first check until the month after they are due, so even someone who was born on February 2^nd – such that February will be their first month of benefits, at age 62 – still won’t get the first February check until March.

Helping Clients Weigh The NUA Distribution Decision (Robert Westley, Journal of Financial Planning) – The “Net Unrealized Appreciation” (NUA) rule allow an employee to make an in-kind distribution of employer stock held inside of an employer retirement plan directly to a taxable investment account, where the stock can be liquidated at preferential long-term capital gains rates (rather than the ordinary income rates of the retirement account itself). Notably, the cost basis of the employer stock (from inside the plan) will still be taxed at ordinary income rates when distributed (and with a potential early withdrawal penalty, if an exception doesn’t apply); it’s only the “net unrealized appreciation” (that had occurred inside the plan) that is eligible for long-term capital gains rates when liquidated (without any 3.8% Medicare surtax). However, the fact that all the appreciation inside the plan can be converted from ordinary income tax rates into long-term capital gains rates doesn’t make the NUA decision automatic, because the caveat is that if the individual wants to liquidate the stock and change investments, the capital gains tax on the gain (and the ordinary income on the basis) will be due immediately, whereas held inside the retirement account it may have grown for many more years or even decades on a tax-deferred basis. Thus, to be most advantageous, the NUA strategy should ideally have: 1) a big gap in tax rates between long-term capital gains and ordinary income (getting 20% capital gains to avoid the 39.6% tax bracket is a 19.6% difference, far better than getting 15% capital gains instead of 25% ordinary income rates for only a 10% tax rate differential); 2) the amount of cost basis vs actual gain (as the cost basis is taxable as ordinary income either way, so the NUA strategy just pays taxes earlier than would have otherwise been necessary); 3) time horizon (as the longer the funds could have stayed in the retirement account growing tax-deferred, the better it is to leave them there and skip NUA); 4) the need for diversification (as taxes on the NUA strategy can be deferred by continuing to hold the stock, but that risks concentration); 5) the need for asset protection (as asset protection treatment is more favorable in retirement accounts); 6) any desires for charitable giving (as the NUA strategy might be paired with a CRT or a Donor-Advised Fund); and 7) estate planning goals (as the NUA stock does not receive a step-up in basis, but may make it easier to equalize high-net-worth estates to fund a bypass trust).

Help Clients Avoid Disaster When Naming Financial Surrogates (Martin Shenkman, Financial Planning) – It is a staple of financial and estate planning to recommend that clients have a strategy in place for who should manage their affairs in the event that they are no longer capable of making their own financial decisions. However, as more and more platforms come up with solutions, it’s possible that a client may have multiple different “financial surrogates” for various tasks, such as one child who’s the agent under a durable power of attorney, but another child who’s the lapse designee on a long-term care insurance policy, a sibling who is the representative payee for Social Security, and another family member or friend who watches out for other financial matters. In addition, the reality is that many financial institutions require their own power of attorney documents, which if created over many years (as the client moves from using one financial institution to another), could name differing friends or family members who each have responsibility for some portion of the money. The end result – it’s often unclear who handles what, and the situation can be even more complex when there’s a conflict between multiple surrogates who may each have a role in being responsible for a particular financial issue. Accordingly, Shenkman suggests that a key opportunity for financial advisors is simply to help take a full inventory of exactly who all the different financial surrogates are, both to help the client simply be organized and aware of who really is responsible for what, and also to spot scenarios where there may be potential conflicts, or where the list of names could be simplified.

6 Things Advisers Can Learn From Clients’ Tax Returns (Allan Roth, Financial Planning) – When a new client comes on board and needs to make changes to the portfolio, a key first step is to review the tax return, which can provide substantial insight into investment issues and opportunities. Roth notes several key insights that can be gleaned from reviewing a tax return, including: 1) clients may claim they have a high tolerance for risk and handled the 2008-2009 market decline just fine, but if you review the tax return, do you see big carry-forward tax losses that suggest the client may have actually panicked?; 2) is there a high level of trading activity, which is not only an outright drag on tax costs, but suggests that the client may be more prone to chasing performance?; 3) are there big capital gains showing up even if the client hasn’t had much actual turnover, suggesting there may be highly inefficient mutual funds with big embedded gains that need to be replaced?; 4) can you use the capital gains on the tax return, combined with the unrealized gains shown on the client’s investment statements, to glean whether they’ve had lackluster performance during the bull market?; 5) are clients actually itemizing their deductions or claiming the standard deduction, and if it’s the latter, does it make sense to actually pay down the mortgage since the client isn’t getting the benefit of the tax deduction anyway?; and 6) what is the client’s current marginal tax rate (not just the tax bracket, but the true tax rate at the margin, after considering the impact of all factors), and does it suggest there’s an opportunity to harvest capital gains at 0% or do a partial Roth conversion at low tax brackets? And of course, the client’s prior year tax return can also be a helpful baseline to develop a current year tax projection, to understand the tax ramifications of the advisor’s proposed investment changes themselves (and whether it’s better to “rip the band-aid off” and make changes all at once, or to do so more gradually over time!).

The Mistakes We Make When Giving To Charity (Shlomo Benartzi & Christopher Olivola, Wall Street Journal) – Over the past decade, there has been a growing awareness of the impact of behavioral finance on the sometimes-irrational investment decisions that we make, but in this article Benartzi and Olivola point out that our decision-making ‘quirks’ can distort our charitable giving strategies, as well. The first challenge is simply that so many believe they’ll be happier to receive gifts than make them, despite a growing base of research that finds it’s giving equivalent gifts to others that actually makes us happier. Similarly, many people assume that it’s more valuable to donate their time than to take the “easy way out” and just donate money, even though the truth is that for many charities, a financial donation actually does more good than “just” a single person’s volunteer time. Other behavioral biases that distort our charitable efforts include: 1) the “martyrdom effect” (where we favor and show more admiration for forms of giving that involve significant sacrifice or effort, such as running marathons or the ice-bucket challenge or joining Doctors Without Borders, even if outright financial giving might be more effective from a utilitarian perspective); and 2) the “other-nothing neglect” (where we might weigh whether to give money or keep it based on our own needs, but fail to recognize how impactful the money might have been for the charitable recipient who gets nothing).

The Size Of Our Heart (Mitch Anthony, Financial Advisor) – The reality when it comes to charitable giving is that different people do it for different reasons; some give a little and some give a lot, and some who give a lot may actually still only be giving very little of their actual net worth (and it just seems like a lot to others who have different levels of wealth). In fact, given the social dynamics of charitable giving, in many cases the decision to give is more about the need for social recognition than actual desire to give towards a charitable need. On the other hand, for many, the decision to give is truly charitable, to the point that it constrains their own financial needs and situation; in fact, for some, the decision to give “more” than one can afford is the truest measure of the genuineness of the gift. Though as Anthony notes, from a financial planning perspective, the ability to give and not impair one’s needs is directly related to what that person considers to be “enough” to live on in the first place… which means that those who can decide what is “enough” and give the rest may not necessarily constrain their financial need, per se, but are nonetheless able to give more by effectively recognizing the difference between their own needs and wants. In fact, organizations like BolderGiving.org and GenerousGiving.org are emerging specifically to support the idea that many of us can afford to live on far less… and in the process, become able to give far more. For clients who may be charitably inclined but struggle to find the means to give what they want, this can be a powerful financial planning conversation.

Giving Pro Bono Financial Advice Can Provide Hope In These Divided Times (Jon Dauphine, Investment News) – It’s long been recognized that financial planners only serve a limited subsection of the population, and that large swaths of the public cannot get access to or outright afford a financial advisor. Nonetheless, the need for financial advice is there, leaving pro bono financial planning as the sole means to bridge the gap. Fortunately, the reality is that many financial advisors are proactive in “giving back” and providing pro bono financial planning; in a survey last year, the Foundation for Financial Planning found than more than half of financial advisors provide at least 1-2 hours of pro bono service every month, and 10% provide more than 10 hours per month (ranging from group sessions to one-on-one advice). For those who want to get more active with pro bono financial planning, Dauphine suggests advisors contact their local Financial Planning Association chapter (as many FPA chapters have active pro bono programs locally), recognize that pro bono financial planning services still counts towards the experience requirement, and consider engaging in pro bono financial planning as a firm. In addition, it’s notable that the Foundation for Financial Planning itself funds grants specifically to support pro bono financial planning – having made more than $6M in grants to local organizations over the past 20 years – so be aware that it’s a potential source of funding to start a local pro bono financial planning effort as well. Of course, advisors who don’t have the time to personally engage in pro bono financial planning can also support the Foundation for Financial Planning with donations as well!

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.