Weekend Reading for Financial Planners (Jun 25-26)

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 June 25th/26th:

Why Brexit Is Grim News For The World Economy [Or Not?] (The Economist) - As it became clear overnight that the UK had voted to leave the European Union, the pound pluged by over 10% against the dollar to a 30-year low, and markets around the world plunged (in parts of Asia, by nearly 10%, and so far more than 3% in the U.S. as well) as U.S. Treasuries rallied. Of course, the reality is that Britain accounts for less than 4% of the world's economic output, which means even an adverse recession there doesn't really have a significant economic impact on the global economy. And the Bank of England has stated that it was 'prepared' for this, and will cut interest rates (to the extent possible given its 0.5% level) is necessary (or possibly even revive its own quantitative-easing program?). In addition, the majority who voted to leave the EU have characterized a potential UK recession as a "scare tactic" of the Remain advocates, and thus may not curb their spending very quickly anyway. Nonetheless, as the outcome of the Brexit vote unfolds, investment begins to scale back, and the falling pound makes foreign goods more expensive (essentially "importing inflation" to British citizens), spending may slump there, and a recession still seems likely, which in turn could spill over into a recession for much of Europe. However, the real driver of the market volatility so far has arguably not been the immediate economic impact, but the uncertainty that it has introduced. The referendum and outcome in the UK may lead to a referendum in other European countries that have been unhappy with their plight in the European Union, which means a new form of 'European Union breakup contagion' fear may be taking hold. In addition, Britain will now have to (re-)negotiate a regional trade deal with the European Union, which may be challenging as EU leaders try to extract trading concessions from Britain in exchange for the chaos and political uncertainty they have unleashed (not to mention the overall rise in protectionism that have been sweeping through the G20 countries in recent years). And of course, the longer that all of this takes to unfold - which could be years - the more uncertainty there is remaining, which is often more of an impediment to markets than the events and their economic outcomes themselves.

Brexit Isn't About Economics, It's About Xenophobia (Zack Beauchamp, Vox) - The big discussion today has been the economic ramifications of the UK's decision to leave the European Union, but a detailed look at the voting numbers and rhetoric leading up to the decision wasn't about economic policy but immigration policy. At issue is the massive surge of immigration that the UK has experienced since joining the European Union; while prior to 1993, net migration to the UK was less than 100,000 people per year, the foreign-born population of the UK more-than-double over the subsequent 20 years, from 3.8 million to 8.3 million. And the shift accelerated over the past 10 years, as the EU expanded to include a number of mostly-post-Communist countries in central and eastern Europe, who began migrating to the UK for job opportunities, leading the percentage of migrants entering the UK from Europe to spike from 25% to 50% in barely a decade (which was further accelerated after the financial crisis as hard-hit countries like Spain, Italy, and Portugal also saw increasing migration to the UK given the rise of unemployment in their own countries). Given this dynamic, being a part of the EU became linked with immigration in the minds of many Brits, and the referendum on the EU turned into a referendum on immigration, with the primary focal point of the "UK Independence Party" (UKIP) becoming 'a vote to leave the EU is a vote to regain control of UK immigration policy' (as membership in the EU requires rather open cross-EU borders). Which meant in the end, the UK vote was not really framed as whether it's better economically to be part of the EU or not, but instead turned into a decision of whether it would be worth regarding control of immigration despite the economic consequences... to which the "Leave [the EU]" vote had a surprise win by a small margin.

What's Behind The Record Sanctions Against Merrill Lynch? (Andrew Welsch, Financial Planning) - This week, the SEC made the bombshell announcement that it was assessing Merrill Lynch for a whopping $415 million fine for misusing the cash in their customer accounts and putting customer securities at risk, and that Merrill agreed to admit wrongdoing as a part of the 'settlement' in the case. At issue was a significant violation of the Customer Protection Rule, which stipulates that brokerage firms must hold customer cash in a segregated reserve account; instead, the SEC found that Merrill engaged in "complex options trades that lacked economic substance and artificially reduced the required deposit of customer cash in the reserve account" which in turn freed up billions of dollars every week from 2009 to 2012 that Merrill Lynch used to finance its own trading activities. Ultimately, it doesn't appear that any customer cash was actually lost, but the SEC noted that if Merrill had ever gone into financial distress, customers would have been exposed to significant risk and uncertainty of getting back their own cash and securities. In addition, the SEC also chastised Merrill Lynch for having employment agreements and policies that further limiting the ability of employees to provide necessary information to the SEC, and as a part of the settlement required Merrill to implement a new mandatory annual whistleblower-training program for all employees. In the meantime, the SEC also announced that it would be rolling out now "self-reporting" rules that allow broker-dealers to proactively report potential violations of the Customer Protection Rule in exchange for "cooperation credit and favorable settlement terms", suggesting that Merrill Lynch may just be the first of several broker-dealers the SEC is targeting regarding this practice.

Indexed Annuity Distributors Weigh Launching B-Ds Due To DoL Fiduciary Rule (Greg Iacurci, Investment News) - Almost 60% of Fixed Indexed Annuities are sold through "Field Marketing Organizations" (FMOs), also known as Independent Marketing Organizations (IMOs), which help to provide sales and distribution support to independent annuity agents who sell the products. However, the DoL fiduciary rule has introduced a significant wrinkle - under the new rule, agents who sell indexed annuities into an IRA must engage in a Best Interests Contract with the client. Except technically, the Best Interests Contract (BIC) is signed between the client and the Financial Institution, not the client and the agent. And given how the DoL fiduciary rules were drafted, an IMO isn't treated as a "Financial Institution" for the purpose of these rules (and while there is an alternative under the DoL fiduciary rule to request to be considered a financial institution, the DoL hasn't yet even provided guidance on how that process would work). Of course, the financial institutions that issue the annuities themselves and work with FMOs and IMOs could be the signing institution, but have expressed concern about taking on the fiduciary duty liability exposure of independent agents that they don't oversee in the first place. As a result, one of the largest IMOs - Annexus - is now looking to launch its own broker-dealer, which will allow its annuity agents to become registered representatives of the broker-dealer, be overseen by the broker-dealer, and provide the client with a Financial Institution who can be a counterparty to the signed BIC (while still serving as an intermediary so the original annuity company doesn't have to sign a BIC and accept liability for independent agents it oversees). On the other hand, if more IMOs follow suit - which is increasingly expected - the whole nature of being an "independent" annuity agent may soon be at an end, as independent annuity agents who in the past might have worked with multiple IMOs will at best end out being subscribed through one IMO's related "independent" broker-dealer. And given the costs of establishing and operating a broker-dealer, smaller IMOs may end out banding together to pool their resources anyway, sharing distribution networks through a commonly owned broker-dealer.

Wall Street Splits With Smaller Firms Over Fiduciary Rule Lawsuit (Robert Schmidt, Financial Planning) - Earlier this month several lawsuits were filed against the Department of Labor regarding their fiduciary rule, most visibly by SIFMA and FSI (which lobby on behalf of "Wall Street" firms and broker-dealers in general). However, while the lawsuit has been filed, it's now emerging that several major Wall Street firms actually opposed the lawsuit, including Morgan Stanley, Bank of America Merrill Lynch, J.P. Morgan Chase, and Wells Fargo (which at one point threatened to quit SIFMA altogether). The concern from the major firms is that continued opposition to the fiduciary rule is substantially and adversely impacting public perception of large financial services firms, and that they don't want to face yet another reputational hit trying to overturn a rule billed as pro-consumer, and instead would prefer to simply focus efforts on complying with the new rule. The issue was so contentious that the SIFMA board, which normally makes consensus decisions, had to resort to a (voice) vote at the board level about whether to file the suit, although it appears that support came disproportionately from small-to-mid-sized broker-dealers (and some larger players like Raymond James and Ameriprise) and not the largest ones (including most of the wirehouses) which have already been shifting clients towards fee-based advisory accounts for years and may be better positioned to handle the fiduciary rule. (Michael's Note: One wonders whether this rift is also why LPL, which similarly has been more supportive and less vocal in fighting the rule, broke away from FSI and developed its own separate lobbying presence instead.) 

Jackson National's New Variable Annuity Hints At Annuities' Future Post-DoL Fiduciary Rule (Greg Iacurci, Investment News) - Jackson National Life is the #1 producer of individual variable annuity sales (almost twice its next closest competitor), and what the company does is often viewed as a guide to where the annuity industry as a whole is heading. Accordingly, many took note when it was announced that Jackson National is launching a new "Perspective Advisory" annuity this fall, which will be a new fee-based annuity contract in which the advisor charges a level "wrap" fee on AUM, while the underlying M&E expense of the contract itself is just 30 basis points and will have a relatively short surrender-charge period of just 3 years. More notably, though, is that the new product offering will include a range of optional living and death benefit riders, a significant shift from today's current fee-based annuities available to RIAs that have tended to eschew guarantees and just focus on being an "investment-only" low-cost tax deferral vehicle. Of course, the caveat is that historically, such fee-based annuities have had limited traction amongst RIAs, which is the primary reason why relatively few have been offered; however, with the DoL fiduciary rule expected to drive a significant increase in the number of fee-based advisors across broker-dealer and RIA channels, the new Jackson National Life annuity suggests that significant shifts are underway in how annuity carriers expect to design and distribute annuity products in the future.

What Is Your Sustainable Growth Rate (Mark Tibergien, Investment Advisor) - While most advisors (and business owners in general) focus on the opportunity for growth, Tibergien notes that one of the most common business pitfalls is when growth outpaces the company's ability to support it. This is common in the manufacturing industry (where adding inventory in advance of sales that don't manifest quickly enough can sink the business), and leads to a heavy focus on key financial indicators like the company's available liquid cash flow and its debt loan (debt/equity ratio). And while advisory firms don't typically have heavy debt loads and don't have to invest heavily into business assets like inventory and manufacturing factories, Tibergien suggests that the need for metrics remains the same. After all, the reality is that many advisory firms actually invest even more heavily into people - our biggest business assets - and taking on too many staff members without sufficient cash flow can still create problems. On the other hand, a limitation in the staff capacity of an advisory firm is also the single greatest inhibitor that limits most advisory firms from growing in the first place. To find the balance, Tibergien suggests focusing on five key performance indicators for the staffing of the business: clients per advisor, clients per total staff, revenue per client, revenue per staff, and operating profit per staff. For instance, the latest InvestmentNews Advisor Compensation And Staffing Study found that top ensemble firms had 83 clients per professional staff and 43 clients per total staff (compared to just 53 and 29, respectively, for the average ensemble firm); if the average client pays the firm $10,000/year, the 30 client difference in advisors per professional staff represents a difference of $300,000 of revenue per advisor (times all the advisors in the firm adds up to a huge difference in the financial health of the firm). Once the firm tracks its key metrics, then as with any benchmarking study, it's feasible to compare, and decide where or whether changes must be made, whether it's eliminating sub-optimal clients, redefining client services, adding (or subtracting) staff, or even changing pricing.

Business Is Personal For Owner-Advisors (Laurie Belew, Investment Advisor) - In the world of accounting and management consulting, the career path to partnership is well defined, with clear expectations about how to earn promotions and move up the ladder to partnership. In financial planning, on the other hand, the career track to partnership is still being defined, made messier by the fact that these are still small businesses (as even the largest of independent RIAs are miniscule compared to the size of the big 4 accounting firms). This has led to significant frustration from many younger advisors entering the profession, who are struggling to figure out the financial advisor career track and what steps they need to take to earn a seat at the partnership table. On the other hand, Belew notes that many young advisors may be failing to recognize what's at stake in becoming an owner: owning an advisory firm can be lucrative, but also has substantial financial risk, from taking a potentially severe pay cut in a bear market as the firm's profit margins absorb the hit, to the fact that the successor will need to pay for those shares - often with third-party financing - and the bank expects payments even if the firm isn't distributing profits that year! And ownership brings additional responsibilities to the table - additional work that has to be work, above and beyond 'just' your duties as a financial advisor. Of course, becoming an owner does have a lot of benefits as well, but Belew emphasizes that it's crucial to recognize the financial and personal commitment it entails, to the business and your (new) partners.

How To Begin Creating A [Differentiated] Value Proposition (Tony Vidler) - Creating an advisor value proposition that truly differentiates is both crucial and incredibly difficult for most advisors. And the more that financial planning is adopted amongst advisors, the harder it is to differentiate on the financial planning services alone. Vidler provides a good framework to set forth a differentiated value proposition. The starting point is to recognize six big 'categories' in which the advisor can try to compete: Service (frequency, reliability, personalization), Information (education and engagement), Knowledge (specialization and qualifications), Delivery (quality, style/methodology), Convenience (location, availability, mobility), or Experiences (events, rewards). For instance, an advisor might choose to differentiate by focusing specifically on the style of how they Deliver advice up front, and then the event Experiences they provide for clients on an ongoing basis. Notably, though, crafting a clear value proposition still requires defining who the advisory firm wants to target in the first place; for instance, charging a flat $10,000/year retainer might be a positive pricing differentiator for high-net-worth clients, but just represent sheer unaffordability (and therefore a terrible differentiator) for mass affluent clients; similarly, if the differentiator will be to deliver advice in person, be certain that you're working with a clientele who appreciates and values the in-person advice (e.g., foreign service expatriates may not be the best target clientele for you!). On the other hand, a crucial point is that firms only need to clearly differentiate in a category or two; your advice delivery can be the same as others, but more specialized and at a different price point, or your pricing could be the same as the competition but you excel at superior client service and experiences at that price point. But for those who are having trouble figuring out where to begin in the process of differentiation, Vidler's 6-category framework provides a good means to begin thinking through the options.

Soon We Won't Program Computers, We'll Train Them Like Dogs (Edward Monaghan, Wired) - The growth of computers and the digital age over the past 50 years has been transformative, not just for how we use computers directly, but the ways that it has transformed our perspective on how the world works. For instance, in the mid-1900s, we tended to think of the brain as a black box system that could be trained behaviorally but not understood; with the rise of computers and the underlying programming code that supports them, we have increasingly applied those concepts to define how the brain works as well (where we store information in memory, struggle with the limitations of our [mental] bandwidth, and try to 'reprogram' our brains to break habits). Yet the emergence of artificial intelligence, and computer approaches like "machine learning", the framework of computers is changing; in the past, we might teach a computer how to identify a cat picture by coding how to recognize whiskers, ears, fur, and eyes, but now with machine learning neural networks you "just" have to show the computer pictures of a few thousand cats, correct it when it misclassifies the cat, and eventually the computer figures it out for itself. Except the approach is being used in increasingly wide application; machine learning is used by Facebook to pick stories for its News Feed, by Google Photos to identify faces, by Skype Translator to do real-time language translation, and by self-driving cars to avoid accidents. While this approach can ultimately be more efficient to 'train' a computer to do something - as it doesn't require creating complex code - the challenge is that even as we increasingly decode the brain from a black box into something more understandable, machine learning is making computer programs more like a black box where we don't understand the underlying mechanics of how the computer's 'brain' makes the final decision. And ultimately, the implications of this are profound. At a minimum, it fundamentally changes what it means to be an engineer and a computer programmer (which for the past few decades, has been a 'sure path' to a solid job, but may be less so if we don't "code" computers in the future and instead merely "train" them). But more substantively, it begins to open the door to a world where the engineers can't even understand and decode the computers they "programmed" - the virtue is that the machines can learn faster than we do (this is a 'more efficient' programming process to tackle complex issues, which is why companies like Facebook and Google have adopted it), and it means more people may be able to program/code/train their computers (without needing a Ph.D. in computer science!), but the bad news is that it might be very hard to force the computers to 'unlearn' problematic habits they develop, when it's no longer just a matter of deleting a line of buggy code.

From Scarcity To Abundance: Mastering The Mindset Of Wealth (J.D. Roth, Money Boss) - In recent years, there's been a growing awareness of the difference between the "scarcity" and "abundance" mindsets. Those with a scarcity mindset tend to believe that everything is limited (time, money, etc.), which tends to lead to worries about the future, what might go wrong, and can lead to fears of missing out, making bad decisions, or not having enough. The abundance mindset, on the other hand, suggests there's plenty of wealth/prestige/happiness to go around, and tends to lead to optimism about the future (which it turn makes it easier to balance between today and tomorrow, because you're more confident that both will turn out well). Roth suggests that the scarcity mindset can in turn lead to impulsive spending; if you fear for the future, it's hard to justify most forms of delayed gratification (as there's a 'risk' that the gratification of the future won't come, and you gave up something for nothing). Or alternatively, those with a scarcity mindset might actually save, but in a potentially 'dysfunctional' way, spending so little and saving so much that even when there is enough to protect themselves from the future, they can't break the habit and start spending to enjoy all those accumulated savings (for fear that there will 'never' be enough). So if a scarcity mindset leads to self-defeating behavior (given that fear is at the heart of scarcity, and fear leads to all sorts of emotional/problematic behaviors), how does one actually change the mindset? Roth suggests one path, based on a recent article from Psychological Science, that those who struggle with a scarcity mentality try to be more giving to others. The approach sounds contradictory - those who fear for scarcity are likely the ones most fearful to give to others in the first place - but what the research finds is that when we give to others in need, it helps us gain perspective on how much we have, and our own lives feel fuller.

Not Just The 1%: The Upper Middle Class Is Larger And Richer Than Ever (Josh Zumbrun, Wall Street Journal) - There's been extensive discussion in recent years of growing income inequality, and how the top 1% have rebounded more effectively since the financial crisis than the rest of the (US) population. But a growing number of studies suggest there's an entire swath of "upper middle class" that are also booming, which are those households below the top 1% but generating well-above-average incomes. One recent study by Stephen Rose of the Urban Institute characterized the group as those earning at least double the U.S. median income or about 5 times the Federal poverty level, which corresponds to households earning between $100,000 and $350,000 for a family of three. This upper-middle-income group, which are generally not inheritors of significant wealth or executives at large companies, but simply middle-managers or professionals with advanced degrees (e.g., lawyers and doctors), has grown from just 12% of the population in 1979 to nearly 30% today (after adjusting for inflation differences in incomes between the past and today). In fact, what the research is increasingly finding is that the middle of the middle class is shrinking, and that the upper middle class and lower middle class are separating and segmenting more substantively. And some are suggesting that it's the difference between middle class and upper middle class that's actually driving much of the income inequality narrative, as it's the growing volume of upper middle class households most likely to be sustaining the rise in $3,000/month apartments and $32,000/year college tuitions. (Michael's Note: On the other hand, it's notable that the growth in the upper middle class over the past 30 years may also be what's helped to drive the substantial growth in financial planning as well, as those households are the exact "mass affluent" and millionaire households that are the bread-and-butter clients of so many advisory firms today!)

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!

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!