Weekend Reading for Financial Planners (Jan 2-3)

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 2nd/3rd:

Deleted: FINRA Erases Many Broker Disciplinary Records (Ann Marsh, Financial Planning) – Securities lawyers have long complained that the FINRA arbitration system for consumer complaints encourages investors to take settlements and keep quiet. Up until last year, those settlements also often included an agreement that the broker’s record would be expunged of wrongdoing, preventing the BrokerCheck system from serving its purpose of warning other consumers about potential problem brokers. Yet even with FINRA’s recent action to ban the practice, concerns remain about the integrity of BrokerCheck and its record of disciplinary actions against brokers, and whether settlements are still happening (in part because the arbitration process leading to those settlements is still a private matter). And ironically, when brokers still try to have their records expunged, it ends out being the consumer who was harmed that must operate as the “last line of defense” to prevent their former broker from hiding prior misdeeds – for those consumers who have the time, resources, and inclination to fight the matter even after their arbitration ruling has already been delivered. And it turns out that most consumers don’t do so, which means even though FINRA insists that expungement should be “an extraordinary remedy” in practice a whopping 88% of brokers who sought to have their records expunged following settlements with aggrieved clients were able to do so. FINRA defends itself by claiming that the expungements were only situations in which there wouldn’t have been “any investor protection or regulatory value” to keeping the disciplinary action public, yet FINRA itself cannot produce any data regarding the expungements to validate the claim. Furthermore, consumer securities lawyers report routinely being “railroaded” and prevented from giving testimony to prevent expungements in cases with substantive concerns, and even struggle to challenge expungement arbitration results in court. Fortunately, a recent FINRA panel has provided a series of 51 recommendations to improve the FINRA arbitration process, which will be considered in the coming months. However, critics still question whether FINRA is really taking its consumer-protection regulatory role seriously, given its conflict operating as a self-regulatory organization run by the very firms it is supposed to oversee.

SEC Report Revisits Sting Of Unsolved August 24 Market Slide (Jeff Benjamin, Investment News) – The SEC has analyzed the market irregularities of August 24^th, when a number of ETFs experienced “unusual price volatility”, but the recently released 88-page report only explains what happened and not why (or what to do to prevent future recurrences). The impact was wide-spread, with a whopping 19% of all ETFs declining by 20% or more than morning, and going through 1,278 trading halts, even as the underlying securities held by the ETFs didn’t start trading at the NYSE open (ironically due to safeguards in place to prevent catastrophic market sell-offs). Though notably, even ETFs where the underlying securities were trading – such as the PowerShares QQQ tracking the Nasdaq 100 – experienced extreme volatility that morning (and all the Nasdaq-listed stocks opened on schedule). In fact, the range of ETFs that were impacted, and how little many had in common with each other, has added to the confusion over “why” the volatility happened in the first place.  Nonetheless, the study is expected to be the basis for future debate about whether it’s time for structural changes in how stocks and ETFs are traded, and in practice the ETF “flash crashes” appear to be making many advisors wary of using stop-loss orders with ETFs at all.

Are You Impressing Or Intimidating Clients? (Bob Veres, Financial Planning) – In an effort to establish their credibility and professionalism, the typical advisory firm has professional-looking offices and dress, and communicates its credentials and expertise, before delving into the information and data that a prospective client provides. Yet Veres points out that in practice, sometimes these efforts to establish credibility with potential clients don’t just impress them but intimidate them, potentially making the prospect ashamed to “undress” in front of a financial stranger and share their financial state of disorder. Notably, this doesn’t mean the ultimate results of the financial planning process are bad, but that the up-front process may be so difficult, awkward, or intimidating for prospects that it makes them not want to even engage in the first place! The alternative is for advisors to focus more directly on the real value they provide, and learn to communicate it better, though Veres notes that many advisors struggle with this as well, still too rooted in communicating the investment products they sell rather than their own financial planning value-add. Veres also suggests focusing on ways to make the up-front process a better experience, such as using mind maps to help the clients get oriented and organized, or engaging in a collaborative financial planning session up front to explore the possibilities. The bottom line – try to figure out how to make the upfront process less like a painful root canal for a client, and more of a positive experience from day 1 (not just after the plan recommendations are delivered).

How DoL Fiduciary Will Change The Industry, And Careers (Melanie Waddell, Investment Advisor) – With the Department of Labor’s fiduciary rule looking increasingly likely to be published in final form early in 2016, the industry is beginning to prepare for the future in a fiduciary world. In the near term, the focus will likely simply be on helping advisors, both on the broker-dealer and RIA side, to get up to speed on exactly what the new rules entail, particularly for those who advise on retirement accounts (both employer retirement plans and IRAs) and may be affected. Unfortunately, it’s difficult to fully prepare now, not knowing how the previously proposed rule might be changed when released in its final form. Still, the expectation is that when the rule is released, commission-based brokers will increasingly feel compelled to shift towards a fee-based model, either remaining with their broker-dealers or switching to an RIA altogether. And with the pressure for ongoing service in a fee-based model, advisors are increasingly expected to adopt a more holistic financial planning approach to justify their ongoing value-add. Still, it’s not entirely clear whether the DoL rule spells doom for the B/D model altogether, or simply will force it to change; some commentators suggest that it would take just a few “reasonable” changes to the Best Interests Contract Exemption (BICE) proposal to make it palatable regulation for traditional broker-dealers, particularly once the initial transition hurdle of adapting new systems and procedures is completed.

Stop Blaming Millennials For Bad Management (Mark Tibergien, Investment Advisor) – Over the past 7 years, more than 40,000 financial professionals have left the industry, and with more CFPs over the age of 70 than under 30, commentators have worried for years about the looming talent shortage of Millennial advisors. Yet the prospect of a talent shortage is a bit of a mystery, given that financial planning is both financially rewarding, professionally fulfilling, and has positive impact on the lives of others. Tibergien suggests that ultimately, the problem may actually be that advisors are so much more interested in “just” serving clients that they are (willingly) neglecting the advisor recruiting and development process in their firms. Or viewed another way, the problem is not that “younger employees don’t want to work hard, develop business, have unrealistic expectations of promotion, etc.,” but that advisory firms are simply failing to train and develop their new advisors to overcome these misconceptions that are natural for any inexperienced employee. Ironically, this implies that advisory firms are struggling with inexperienced employees because of their own inexperience as managers, from writing clear job descriptions, to providing effective employee reviews, and learning how to provide proper feedback to help employees improve. Accordingly, the talent shortage may be less an issue of the industry’s inability to attract young employees, but the possibility that they’re simply leaving quickly because of the negative experience of working for inexperienced managers.

How Live Oak Bank Is Solving RIAs’ Succession Problem (Savita Iyer-Ahrestani, Investment Advisor) – While much has been written about succession planning from the perspective of advisory firm owners looking to sell their practices, or prospective buyers looking to acquire one, a notable “gap” in the industry landscape for many years was the lack of options to finance the transactions. While seller financing is an option, it’s not a risk all sellers want to take, and banks have traditionally balked at lending for advisory firm acquisitions due to the lack of hard asset collateral. In the past two years, however, North Carolina-based Live Oak Bank has developed a process to properly underwrite advisory firm acquisition loans (including hiring loan specialists who actually understand the industry) based on the anticipated cash flows of the deal, and in under 3 years has already made a whopping $250M of loans (as a part of its $1.1B loan portfolio into a wide range of small business niches) to finance advisor succession plans. Live Oak is even willing to finance 100% of transactions, although in practice most tend to be in the range of 25%-75% of the acquisition price, most commonly as a “30-70-5” structure where the buyer makes a 30% downpayment in cash and finances the remaining 70% over 5 years. Loan terms are generally favorable, often enjoying low interest rates thanks both to the overall interest rate environment and also the arranged backing of the United States Small Business Administration (SBA). Of course, ultimately executing a succession plan is about more than just the financing arrangement, but industry commentators suggest that the presence of Live Oak Bank to facilitate the transactions is accelerating the pace of succession deals being executed now that specialized financing options are available.

Why Investors Shouldn’t Ignore The Power Of The Sun (Ginger Szala, ThinkAdvisor) – For most financial advisors, the focus of the recent Congressional spending legislation was on various planning-related “Tax Extenders” provisions like qualified charitable distributions from IRAs being made permanent, the law also extended for 5 years the investment tax credit for solar (and wind) power. The estimated impacted is an effective doubling of the potential for the solar power business in the US, building on the back of what already has been a global boom in solar panel installation (with investments in developing countries up 36% in the past year to $131.3B as well!). Notably, though, the primary beneficiaries of the new rules are expected to be “utility-scale” providers (e.g., regulated electric utilities building out solar farms), not necessarily “retail” solar stocks. Although companies like SolarCity (the largest rooftop installer of solar panels) did jump 34% on the legislative news, Morningstar warns that may solar generation companies are only generating cash flow from the government tax credit subsidies themselves, which isn’t necessarily a “sound” investment. Nonetheless, the extension of the tax credit is expected to drive a significant investment into the solar industry; expect to hear a lot more about its related investment opportunities (and impact on other competing energy-related investments) in the coming years.

Quantifying The Value Of Downside Protection (Jerry Miccolis & Gladys Chow & Rohith Eggidi, Journal of Financial Planning) – The classic challenge of portfolio design is that in order to earn the desired (or sometimes “necessary”) long-term returns to achieve long-term goals, investors must invest heavily into “risk assets” such as equities. Except, of course, risk assets have frequent declines (thus being “risky”), averaging a drawdown of at least 10% every 2.7 years over the past century. The traditional response to this challenge is to moderate how much is invested into risk assets, with the remaining allocation to more “stable” asset classes like fixed income… except in today’s environment, low fixed income yields make these allocations a significant drag on long-term returns as well (and other solutions like “liquid alternatives” have had their own struggles). The authors suggest that given this dilemma, the better option is to employ strategies that address the risk of equities directly, such as tactically rotating in and out of equities (based on macroeconomics or volatility targeting), using quantitative momentum strategies, or deploying derivatives to help hedge tail risk. However, the value of these methods is much debated, in part because their value isn’t necessarily to enhance returns (just to mitigate risk), in a manner that doesn’t fit well with traditional quantitative portfolio metrics (which fail to capture the compounding impact of volatility drag, or sequence of return risk for those taking withdrawals). The authors suggest that downside risk measures should be evaluated based on the degree of downside protection (at what loss threshold does it kick in), the protection it provides (what percentage of damage is mitigated once the downside threshold is breached), and the cost (to ensure the cost drag during upside doesn’t outweigh the downside protection benefits in the long run). On this basis – which incorporates the fact that a certain percentage decline requires an even-larger growth percentage to recover – the authors find that risk management strategies have far more room to deliver value than is commonly recognized.

Could A Health Savings Account Be Better Than An Employer-Matched 401(k)? (Greg Geisler, Journal of Financial Planning) – A Health-Savings Account (HSA) is a form of tax-free account intended primarily to be used to cover the out-of-pocket medical costs for someone who has a high-deductible health insurance plan (HDHP). Contribution are tax-deductible (and also exempt from FICA taxes if made through an employer arrangement), and distributions are tax-free if used for qualified medical expenses (otherwise facing both ordinary income tax and also a 20% penalty tax). For those over age 65 and enrolled in Medicare, no further HSA contributions are allowed, but distributions can still be taken, either tax-free for medical expenses, or subject to ordinary income taxes (but not the penalty tax) for other spending needs. However, Geisler notes that since most retirees have a substantial component of medical expenses they’re likely to need to pay anyway, in practice most retirees will be able to use an HSA tax-free in retirement. In fact, the opportunity to contribute pre-tax up front, and get tax-free distributions in retirement is so appealing that contributing to an HSA can even beat contributing to a 401(k) plan with an employer match. The higher the tax rate at the time of contribution (and the tax deduction to the HSA), the more of a match that can be overcome with the HSA; those subject to a 20% tax rate can beat a 25% match, while those with a 33% tax bracket (Federal plus state plus FICA) can beat a 50% match (and of course a no-match 401(k) loses at any tax rate). Notably, these conclusions only hold as long as the future retiree will really use the HSA funds tax-free for medical expenses in the future, but given that likelihood, Geisler suggests that the “standard” approach for retirement savings should really be maxxing out an HSA first (as long as the tax deduction at contribution is enough to beat the employer match), then getting the match for 401(k) plans, and then pursuing other goals (e.g., paying down high-interest debt, additional retirement contributions, or funding college savings plans).

A View From The Top: Merrill’s John Thiel Speaks Out (Ed McCarthy, Research Magazine) –  While the world of financial advisors faces regulatory turmoil in 2016, the head of Merrill Lynch Wealth Management, John Thiel, remains optimistic that the wirehouse is poised to compete effectively in the future fiduciary landscape. Despite the firm’s size, Thiel suggests that Merrill Lynch is ready to adapt to the looming regulatory changes, along with the rising ‘threat’ of technology (i.e., robo-advisors), and evolving the nature of wealth management services itself. In fact, Thiel suggests that the future environment, and the size and scale that may be required to comply with future regulations, will bode especially well for the employee-advisor model. Which means to say the least, while some RIAs seem to anticipate that potential fiduciary regulations will drive broker-dealers away, firms like Merrill Lynch appear to be positioning for a fiduciary future – perhaps not surprising given its nearly $2 trillion in AUM and 14,500 advisors generating over $15B of revenue.

Less Is More: Clearing Out The Business Clutter (Daniel Finley, Journal of Financial Planning) – As we transition into 2016, it’s a good opportunity to “de-clutter” and start the year anew. And as Finley notes, advisors can often have a lot of clutter, including both physical clutter (all that stuff sitting on and around your desk!), emotional clutter (carrying the ‘baggage’ of prior business challenges and failures that keep you from getting a good start in the new year), product clutter (do your client investments look like a laundry list of all the products you’ve “tried out” over the years but never simplified?), and outright client clutter (from those “small” clients who occupy the time of yourself and your staff but aren’t beneficial to the business, to those clients you just don’t enjoy working with who are an emotional drain). So if you haven’t, take a few minutes to look around and think about the clutter that may be impacting your practice… and whether it’s time to de-clutter a bit for the new year!

The Hidden Reasons People Spend Too Much (Charlie Wells, Wall Street Journal) – The conventional view to how most consumers should get their spending under control is that it’s just an exercise of budgeting and monitoring … and the fact that so often people fail when they try is simply a failure of willpower. Yet a growing base of research is finding that the psychological impulses and blind spots that drive our spending behavior are far more nuanced than we commonly realize. For instance, we tend to be overconfident in our future income but terrible at imagining our future expenses, leading to unrealistic future budgets as we accurately project income rising and just ‘roughly’ (and usually incorrectly) estimate that expenses will rise in line. This can be especially problematic in situations like moving to take a job with higher income, and underestimating how much different/higher the cost of living might be in the new location. Ironically, it appears that the solution may still be the “old” exercise of budgeting, but that an effective budget of future expenses must deliberately get very detailed, to ensure that unanticipated but material expenses aren’t missed. Another gap being discovered by researchers is that when people save, they may become so attached to their savings success, that it leads to subsequent irrational behavior – for instance, someone who accumulates an emergency fund, but then when an emergency occurs they want to keep the “savings” they’re so proud of, and end out using high-interest debt anyway! A third study found that when we struggle with willpower, we tend to reward ourselves for good behavior that demonstrated our willpower – which in turn can cause financial trouble when the cost of the reward ends out outweighing the behavior we were self-rewarding in the first place! And notably, another recent study found that one of the biggest drivers of our saving and spending behavior is simply our mood; those who are sad tend to spend more, while those who are happier tend to save, which ironically means that not only can money buy happiness, but that happiness contributes to money!

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.