Weekend Reading for Financial Planners (July 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 July 11th/12th:

Judge Ends Camarda Case Against CFP Board -- Time To Finally Fix The Fee-Only Compensation Definition? (Michael Kitces, Nerd's Eye View) - This week, the ongoing case of Jeff and Kim Camarda versus the CFP Board case to an abrupt conclusion, as U.S. District Judge Richard Leon granted the CFP Board's long-standing motion for summary judgment and threw the case out, bringing an end to the 2-year ordeal that is estimated to have racked up more than $600,000 in legal fees for the organization. However, as the case has been shrouded in confidentiality throughout, Judge Leon's opinion itself has also been sealed for 14 days, and during that time the CFP Board (and the Camardas) can make their case about whether/why any portions of the ruling should remain secret. Hopefully, the ruling will become public, as for CFP certificants, it's important to know whether the judge ruled in favor of the CFP Board to uphold its disciplinary process, or more concerningly whether the judge's opinion was that as a private organization the CFP Board is not accountable in a court of law in the first place (a concerning precedent if another CFP certificant has a bona fide dispute with the CFP Board in the future). In the meantime, the resolution to the case - unless the Camardas appeal, which is still a possibility - may also finally clear the way for the CFP Board to begin a new process of updating its problematic "fee-only" compensation definition... which the organization will hopefully do by engaging CFP stakeholders in a public comment process, unlike the CFP Board's recent unilateral decision to reduce the CFP experience requirement.

Focus Financial Is Preparing SEC Paperwork For Its IPO -- But Is It Jumping The Gun? (Brooke Southall, RIABiz) - A number of 'unnamed sources' are affirming that Focus Financial is preparing to file an S-1 document with the SEC, a key filing that is normally done when a firm is on the path to an Initial Public Offering (IPO). With estimated earnings (on an EBITDA basis) of $120M and a prospective multiple of 14-16 times earnings, this means Focus could IPO with an enterprise value of $1.5B or higher; even if its earnings and multiple end out a bit lower, the firm still appears positioned for a favorable increase over its last valuation of $540M just two years ago when Centerbridge bought a 40% stake for $216M. However, some critics suggest that Focus' path to IPO still seems a bit premature with a stated revenue run rate of 'just' $325M, and that it's unclear whether Focus is seeking to IPO from a position of strength or necessity (e.g., whether it is Centerbridge pushing the IPO path for its own liquidity event, or if the IPO is intended to avoid a potential cram-down provision in the Centerbridge agreement). Still, a successful IPO from Focus would arguably be a significant validation for its roll-up model of bringing together "smaller" independent advisory firms, and could spur an additional uptick in M&A activity for advisory firms while also providing a liquidity event for Focus shareholders (though if history of similar deals in the past is any guide, advisor shareholders may not enjoy the same beneficial 'pop' as Focus' private equity investors).

Evaluating Investments versus Insurance in Retirement (Wade Pfau, Advisor Perspectives) - In the world of retirement income strategies, there continues to be a divide between 'investment-based' and 'insurance-based' solutions. Those favoring investment strategies anticipate that equities will eventually provide favorable returns for retirees over bonds, and that the upside potential is significant enough that the best course of action is simply to manage spending to handle the intervening sequence of return risk (or with a safe withdrawal rate approach, just make spending low enough to ride out any unfavorable sequences). By contrast, the insurance-based approach views investments alone as either too tenuous to rely upon, or that riding out market volatility may still be too emotional to be viable for retirees. But notably, Pfau suggests that retirement income planning doesn't have to be an 'either/or' proposition in this context, and that in fact the idea of retirement "product allocation" is gaining favor - a line of research that studies how retiree dollars should be allocated amongst various investment and insurance-based retirement solutions. In this context, the purpose is to determine the balance between the investment and insurance solutions, recognizing that different solutions have a different impact on the "four L's" of retirement goals: Lifestyle, Liquidity, Longevity, and Legacy. For instance, investment-based solutions can fund increasing lifestyle goals with growth and remain liquid, btu are especially weak on addressing the longevity issue in the event that the retiree starts spending assuming a shorter time horizon and then turns out not to get enough growth to fund a longer lifetime (though conversely, the high likelihood that a safe withdrawal rate approach will leave significant assets over at the end of retirement also helps the investment-based approach support the legacy goal in most cases, too). By contrast, insurance-based - especially lifetime annuity - solutions are especially good at solving the longevity challenge efficiently by pooling retiree spending, and may even be paired with life insurance to fund a legacy goal, but if retirement assets are insufficient to fund a lifestyle goal in the first place an insurance-based approach with no upside will force a cut in lifestyle from the start, and many insurance/annuity solutions lack liquidity as well. Accordingly, as retirees seek their own balance amongst the four L's, the optimal retirement strategy may end out being a blend of investments and insurance, such as using an investment portfolio of stocks to fuel growth but paired with a lifetime annuity that covers the fixed-income portion of the portfolio more efficiently than bonds alone.

The Retirement Risk That the Models Miss (Gil Weinreich, Research Magazine) - The Retirement Income Industry Association recently awarded its Thought Leadership Award to Dirk Cotton, an advisor and retirement researcher (and publisher of the Retirement Cafe blog) who published an article in the Spring 2015 issue of the Retirement Management Journal on the concept of "sequence of consumption" risk and the idea that retirement risk and probability of failure needs to be more explicitly separated into both a sequence-of-returns "path dependency" issue and a longevity issue. For instance, if a retiree's plan fails because he/she lives to age 105, the reality may be that the plan failed despite having a favorable sequence of returns (the failure was due to longevity), while a plan that runs out of money at age 80 may have been because of an unfavorable sequence of returns. The distinction is especially important if you consider the possibility that retiree spending is not level as the classic "4% rule" assumes, but instead may decline in the later years, or conversely that a major event in the client's life could further deviate that spending path (whether due to an adverse health event, or perhaps unexpected wealth found in a favorable bull market). In other words, not only is the portfolio volatile in various not-always-predictable ways, but spending has a level of uncertainty to it as well, and the sequence and timing of spending changes/shocks can favorably or adversely impact retirement success, too. Ultimately, then, Cotton suggests that not only does this mean that ongoing updates to a retirement plan are especially important, but that clients should be prepared for more dynamic spending strategies in retirement in the first place.

Fraudsters Are Targeting Your Elderly Clients -- Fight Back (Kenneth Corbin, Financial Planning) - As the ranks of seniors continues to grow, so too has the frequency of financial abuse of the elderly, from unscrupulous financial salespeople to outright fraudsters and schemers, to family members and friends and caretakers. NASAA reports that 34% of enforcement actions taken since 2008 have involved elderly victims, and given that elder abuse is likely under-reported (especially in "complex" family situations, and sometimes simply because they're embarrassed to admit they've been 'had') one study estimates the cost may be more than $36B per year. To combat the issue, a few states are enacting a "pause law" which allows financial professionals to delay a request to disperse funds by up to 5-10 business days if they suspect the client might be a victim of abuse (and would also be required to notify adult protective services and local law enforcement to investigate), and NASAA is considering adopting a model rule to expand the approach across the country. State legislatures - again supported by a model NASAA rule - have also been limiting and cracking down on specious designations some advisors have sought out to gain (inappropriate) credibility with seniors, and tougher penalties for financial abuses are gaining momentum as well. Some states have even been adding rules that would require designated persons - which can include financial advisors - to report suspected elder abuse in some situations. Regardless of the requirement, though, advisors who work with elderly clients on an ongoing basis may be best positioned to spot financial abuses, such as when the client makes a request that veers sharply from their typical pattern and the plan set with the advisor. Unfortunately, though, this also puts advisors in the awkward position of potentially needing to challenge client requests for money. Privacy protections for clients can also be a challenge, often limiting an advisor's ability to notify other family members if there's a problem as well, though a rising number of advisors are having conversations with clients early on to get permission about who should be notified if a potential abuse situation is identified in the future.

The Hugely Profitable, Wholly Legal Way to Game the Stock Market (Yuji Nakamura, Bloomberg) - As the amount of assets going into indexing continues to grow - with assets in passive equity products now over $3.7 trillion in assets - so too is the amount of money that is front-running the addition of stocks to widely-held public indices (and the index funds that buy them). For instance, American Airlines was added to the S&P 500 after markets closed on March 20, but since the addition of the airline to the index was announced four days earlier, its stock price had already jumped 11% over that time span, forcing the index funds to buy in at an 'artificially' elevated price point that effectively reduces the funds' returns. On an ongoing basis, one recent study from Winton Capital estimated that front-running of index additions and subtractions is costing index funds 0.2% in annualized returns, and a study in 2008 by Antti Petajisto pegged the cost at 0.28%. While ultimately those costs are still somewhat 'modest', they're a significant additional burden relative to the expense ratios of index funds in the first place (e.g., 0.28% is a lot given that the Vanguard 500 Index Fund has an expense ratio of just 0.11% in the first place!). Some index fund providers (including Vanguard and DFA) are now trying to mitigate the impact by gradually building positions over time in stocks that are scheduled to be added, though that introduces the risk of "tracking error" as the index fund will hold a slightly different composition of stocks than the actual index during the transition period. And notably, by investing in a total stock market index - e.g., Vanguard's $411B Total Stock market Index Fund - the front-running risk is mostly mitigated, as when "every" stock is already owned, there isn't anything left to be added, subtracted, or front-run.

Build Capacity by Engaging Your Staff (Jay Hummel, Wealth Management) - The rise of better and better advisor technology has become a double-edged sword in some advisory firms, allowing the business to run more efficiently and expand capacity with fewer staff... but potentially so much that staff members may even begin to fear whether they're going to lose their jobs! Hummel suggests that advisory firm owners tackle this issue head-on, by recognizing that indeed some staff positions may no longer be necessary in the future thanks to technology, but that such scenarios are an opportunity for the firm to reinvest into staff and help them to grow and develop in a direction that supports the future of the firm. For instance, a staff member in a no-longer-needed-thanks-to-technology position can become the driver of a new service for clients or an entirely new line of business. Of course, for many firms, the challenge is simply figuring out if they have a capacity issue in the first place; problem areas to watch out for include a rise in late-night and weekend email activity, a slip in service standards for clients (is communication lagging?), and a lack of internal meetings to work on the business (or where business meetings keep getting cancelled for client meetings). For firms that are at capacity, look to staff for ideas about how to improve upon any bottlenecks in the firm (and make sure you're solving problems for the majority of your clients, not the few who have complex exceptions), and look carefully at what should be insourced versus outsourced in the first place.

Hold The Innovation! First, Build A Solid Foundation (Angie Herbers, Investment Advisor) - Despite the conventional view, innovation is not merely the result of catching brilliant lightning in a bottle; even Thomas Edison, who invented both the light bulb and 1,083 other inventions for which he was granted patents, had hired a team of scientists, mathematicians, and engineers and built a company around them to turn their ideas into reality. The key point in the advisory firm context is that most firm owners "do" innovation backwards - they come up with ideas first, and then try to implement the ideas on a foundation that can't support them. To be successful, advisory firms must instead focus more on building a foundation upon which the firm can grow, and only then try to come up with and implement innovative ideas (and ideally, turn the entire firm and its staff into a steady pipeline of new ideas). So how should firm owners build this solid foundation? Herbers suggests that the first step is to empower employees in the first place - hiring support to leverage yourself will only go so far, so if you really want a bigger and better foundation for innovation, employees need to be more directly involved in the process. Second, recognize that a sound foundation has a broad base, including all the key areas of supporting the business: management, client service, human capital, operations, finance, and sales/marketing. Deficiencies in any one of these areas can create weaknesses in the firm overall, and limit its ability to grow and implement new ideas (and even once those areas are in good order, recognize that it takes proactive effort to sustain them that way). Once all of this is in good order, then it's possible for the advisory firm to really begin to innovate... but the key point remains that the innovation still won't go anywhere if that foundation isn't (sustainably) built in the first place.

The New Sheriffs (Jerry Gleeson, Rep Magazine) - As a part of the Dodd-Frank regulatory reform, the minimum threshold of assets under management for SEC registration was shifted from $25M to $100M (with certain exceptions for advisors registered in 15+ states or those who were over $100M but temporarily fall below that line). The change thrust over 2,000 RIAs into what some call the "Wild West" of state securities regulators in 2012, with fears that the regulatory transition would leave many RIAs mired in a bog of conflicting state regulations. Yet three years later, it seems that most fears were overblown, and while some attorneys are still critical of the capabilities of state examiners, for the most part the shift to state registration for those areas seems to have been a non-event. Still, some advisors note that the state-based regime does require more paperwork, especially as a firm grows into multiple states and needs to go through a registration process with each state, and each state's regulators may have slightly different views about what's expected to be reported in ADV forms or stated in client agreements (which in turn racks up some additional legal costs for a compliance attorney to assist, in addition to registration fees for each state). On the other hand, some advisors report that the examination process from state securities regulators is more effective, and that the state examiners have a more constructive attitude than SEC examiners. In the meantime, the shift and reduction in the number of RIAs the SEC must oversee seems to have at least slightly improved the pace of investment adviser exams (which are up slightly), though it's not entirely clear whether states have been able to add enough staff to accommodate the increased number of RIA exams they must now conduct.

Assembling Your Personal Board Of Advisors (Yan Shen & Richard Cotton & Kathy Kram, MIT Sloan Management Review) - While a great deal of research has shown the value of mentoring and coaching, the authors make the case that today's career landscape is so much more complex that just having a mentor is no longer good enough, and that top performers will need to create a whole "personal board of advisors" each fulfilling various roles. The six types of personal advisors in this framework include: Personal Guides (someone with whom there was a supportive relationship in the past, but current interaction is limited, even while continuing to exist as a role model or source of inspiration); Personal Advisors (an emotional outlet or sounding board, typically outside of the existing scope of work); Full-Service Mentors (the "true" mentor relationship, with a deep ongoing closeness and interaction); Career Advisors (tend to be shorter in duration, with higher levels of interaction that is focused primarily towards long-term career paths); Career Guides (also shorter in duration, usually triggered by specific events or key career/professional decisions that must be made); and Role Models (may have no direct relationship at all, but still viewed as a person/role to aspire to). Ultimately, the key point is that having 'advisors' to fit each of these categories may be necessary for challenges that crop up from time to time, and having missing categories - or trying to fit one mentoring relationship into a category in which it doesn't belong - can lead to a shortage of guidance and insight at times when it may be needed most.

Who Invited Teresa Ghilarducci To The Table? (Nancy Cook, National Journal) - In recent months, economist Teresa Ghilarducci has become one of just a handful of informal economic advisers to Hilary Clinton's second presidential campaign. Some may recall Ghilarducci's name from a highly controversial NY Times Op Ed she wrote back in late 2008, suggesting that self-directed 401(k) plans were too risky and that the Federal government should create its own version of a plan with a mandatory (unless already a participant in a pension plan) 5%-of-income contribution and investments managed (more conservatively) by the Social Security Administration. The plans would be more restricted and less liquid than 401(k) plans, and would be funded in part by eliminating the current tax deduction for 401(k) plans, in lieu of an up-to-$600 refundable tax credit that could be used towards the 5% contribution. When conservative political commentators including Rush Limbaugh heard about the proposal, Ghilarducci was called the "most dangerous woman in America" for trying to put the government "in total charge of [Americans] retirement" and even received death threats. At the time, the reality is that Ghilarducci's proposal didn't garner much interest, from Republicans nor even Democrats, but with a rising number of states beginning to implement their own state-level automatic-enrollment retirement plans, there's been a new-found interest in Ghilarducci's work, and she is viewed as a 'fresh face' in political circles, as she's never worked in Washington. Ultimately, it remains to be seen whether the Clinton campaign will more formally adopt any of Ghilarducci's ideas - nor has she even officially become part of the Clinton team - yet nonetheless, her involvement suggests that retirement policy, and potential reforms, may increasingly become a more political issue in the coming years.

Redefining Failure: What's Your Worst Case Scenario When Launching Your Own Firm? (Alan Moore, XY Planning Network) - The rise in the number of "employee advisors" at larger advisory firms has also created a rising number of advisors considering whether to go out and start a new firm of their own... except even serving as a great advisor in a firm, not everyone knows if they'll be any good as the owner of their own advisory firm, and the "fear of failure" can be a blocking point for many. Yet as Moore points out, given the shortage of talent for younger advisors (with more CFP certificants in their 70s than in their 30s!), few who go out on their own will have much trouble finding another advisory firm to work for again in the future - and given that it's not very expensive to actually start an advisory firm, at worst a "crash and burn" scenario really just means the lost salary that wasn't earned during the time period. The next alternative is that you start your firm and it grows, but not as fast as you'd like... but in that scenario, there's often a possibility of selling your small advisory firm practice to a larger firm, which may be interested in both your (likely-to-be-younger) clients and yourself as a younger advisor to work in their firm. Ultimately, then, the reality is that for most younger advisors today, the "worst" scenarios of "failure" for going out on your own is just earning less salary/income for a while and then landing back in another employee advisor job in the future, either by walking away from your new firm if it doesn't work out, or selling your new firm back into a larger existing one. And of course, there's always the possibility that you'll succeed, too.

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!

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 latest Bits & Bytes weekly video update on the latest tech news and developments, or read "FPPad Bits And Bytes" on his blog!