Weekend Reading for Financial Planners (Jun 3-4)

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 3rd/4th:

SEC Solicits Comment On Conduct Standards For Advisers And Brokers (Mark Schoeff, Investment News) - This week, SEC Chairman Jay Clayton issued a new request for public comment on the standards of conduct that should apply for brokers and RIAs providing investment advice, in what appears to be a first step from the SEC to begin its own fiduciary rulemaking process. Yet while many have called on the SEC to consider a fiduciary rule - dating back to a study mandated by Section 913 of the Dodd-Frank legislation, and a 2013 request for comment on a fiduciary cost-benefit analysis - the timing is concerning for fiduciary advocates, as Chairman Clayton specifically acknowledges the DoL fiduciary rule in its request, and Labor Secretary Acosta himself called on the SEC to act in his recent Op-Ed in the Wall Street Journal that affirmed the DoL Fiduciary rule's June 9th applicability date. The concern is that the SEC may be more impacted by industry lobbying pressures, and therefore may be more likely to issue a "watered down" fiduciary rule that would be built more around "fiduciary" disclosures than actually trying to mitigate fiduciary conflicts of interest. On the other hand, the reality is that the DoL's fiduciary rule applies only to retirement investors and retirement accounts, leaving a substantial gap for brokerage accounts, and an awkward regulatory imbalance for the majority of financial advisors who work with clients that have both retirement and non-retirement accounts (now subject to different regulatory standards). On the other hand, a fully uniform fiduciary rule for all brokers and investment advisers under the SEC raises troubling questions of who would oversee such a standard (FINRA?), and whether it's better to allow brokers and true financial advisors to co-exist (where salespeople are salespeople and advisors are advisors) rather than being subject to a single uniform standard. Of course, a public comment period is still a long way from an actual fiduciary rule, which prior SEC Chairwoman Mary Jo White also publicly supported but never managed to generate an actual proposal. Nonetheless, the wheels appear to be set in motion for the SEC to take up a fiduciary rule, even as the Department of Labor's version is just now finally about to roll out.

UBS Rushes Out Comp Changes Ahead Of DoL Implementation Deadline (AdvisorHub) - With the DoL fiduciary rule set to take effect next Friday (on June 9th), major wirehouse UBS - which had previously stated that it was skeptical the DoL fiduciary rule would stick, and was going to wait to announce its plans until it was clear that the rule was going to happen - finally announced its new compensation plan for brokers. Going forward, the company will continue to allow commission-based retirement accounts, but will suspend its grid-based payouts, and instead pay a flat fee based on the overall retirement assets being managed in both fee- and commission-based accounts. (The payout rate will be pegged to the broker's 2016 production, but may be adjusted up/down as assets rise/fall.) Notably, this means that brokers will not be paid based on their actual revenue going forward - thereby eliminating any incentive for using investments that would pay higher commissions, or for doing repeat transactions - and instead will simply be paid based on total assets. However, the change will only apply for retirement accounts; on non-retirement assets, UBS will continue with its existing grid-based payouts. In addition, UBS also announced that certain products will now be restricted in retirement accounts as well - in particular, initial public offerings that UBS may be underwriting, and structured products that are proprietary to UBS - akin to similar changes announced last week from Wells Fargo (which also stated it would eliminate a number of proprietary structured products, and revert from A and C shares to T and clean shares instead). Ultimately, UBS has announced that its change is "temporary" until the end of the year, indicating that it still intends to further revisit its payout structures in 2018 (when either the full force of the DoL fiduciary rule comes into effect, or it becomes clear the rule is being altered or with enforcement further delayed).

Merrill Lynch's Second Act For RIA Reinvention Is Revealed (Lisa Shidler, RIABiz) - In recent months, with the DoL fiduciary rule looming, Merrill Lynch has announced that it is ending commission-based retirement accounts, ceasing its (expensive) efforts to poach brokers from competing wirehouses (which historically included large bonuses for production and growth that could violate DoL fiduciary rules), and more recently also stated that it is ending lucrative bonuses that have typically been used to incentivize and retain top-selling brokers, effective June 1st (given that such bonuses can also result in untenable conflicts of interest under the DoL fiduciary rule). And with the dollars that are being freed up from this payouts, the wirehouse is instead shifting resources into building out a training program for new/young advisors (with a whopping 3,800 individuals currently enrolled), and a new recruiting program aimed towards advisors with 3-8 years of experience that will pay them a steady base salary for up to 3 years. In the near term, these shifts are expected to cause substantial attrition, as high-production brokers will inevitably be recruited away to competing wirehouses and regional broker-dealers (and some may even go out on their own and become RIAs through transition platforms like Dynasty and HighTower). But in the long term, the shift raises the question of the kind of success and profitability that Merrill Lynch might drive by focusing more on salary-based advisors who are primarily incentivized to service and retain existing clients, rather than selling new products to new (and existing) clients, effectively turning Merrill Lynch from a traditional wirehouse sales culture into one that looks more like a bank (not surprising given its parent company Bank of America), or even a giant national RIA. Yet given what is still tremendous economies of scale at Merrill Lynch, questions abound as to what Merrill might be able to accomplish with a more RIA-like structure... including whether in the future it might begin to engineer "reverse-breakaways" that compete with RIA custodians and tuck independent RIAs back into the broader Merrill Lynch/Bank of America platform?

Morgan Stanley’s 16,000 Human Brokers Get Algorithmic Makeover (Hugh Son, Bloomberg) - Morgan Stanley has announced that it is launching a "cyborg" initiative aiming to augment its 16,000 financial advisors with technology tools that help make their advisors more proactive. The project is known internally as "next best action", and will use Morgan Stanley's internal technology and data analytics to make suggestions to its advisors about steps they might take to engage with clients and deepen the relationship (e.g., reminder advisors when a client birthday is coming, or take over routine tasks), or make an appropriate recommendation (e.g., suggest an investment change/trade). The underlying key of the approach is to recognize that financial advisors can only mentally keep track of so many key issues for all their clients at any given time; "big data" technology, by contrast, can monitor and track the entire client base (across the entire firm), and use that data to spot both trends and opportunities to engage with clients. A pilot version of the program will roll out with 500 advisors in July, with broader deployment to the entire client base by the end of the year. Notably, though, the goal of the initiative is not to automate-away and replace the financial advisor entirely; instead, Morgan Stanley emphasizes that the whole point of the program is to place the advisor more centrally as part of the value proposition, using technology to help guide and prompt the advisor about when there may be opportunities to proactively engage with and connect with clients.

Destination Unknown: The 2017 Broker-Dealer Presidents Poll (Investment Advisor) - With the DoL fiduciary rule's applicability date looming in just under a week, the independent broker-dealer model is at a major crossroads. The broker-dealer community itself remains confident that it will be viable and relevant in a fiduciary future, but a survey of 45 leading broker-dealer presidents indicates that the scale needed to comply will likely lead to further broker-dealer consolidation (and in point of fact, the number of broker-dealers is already on a steady decline, down almost 10% from 5 years ago, even as the number of brokers is up about 0.5% over the same time period). In addition, a whopping 71% of broker-dealers report that uncertainty around the DoL fiduciary rule is still their top challenge over the next 18 months, and a similar number report that the intermediate term (3-5 year) challenges are also dominated by dealing with the DoL fiduciary rule and increasing compliance costs. Strikingly, though, only 11.1% of independent broker-dealers cite the need to keep up with technology as a major challenge over the next 3-5 years, suggesting that the "distraction" of the DoL fiduciary rule could still cause many to be blind-sided by the rapid pace of advisor technology changes. In the meantime, the primary issues of broker-dealer reps themselves are reported to be finding new clients, deciding on their optimal business model, and determining their own succession plans.

The Plight Of The Small Broker-Dealer (Dan Jamieson, Financial Advisor) - Small broker-dealers are suffering under the tremendous weight of overlapping regulators each examining their activities; in one small broker-dealer, it was recently examined by the Department of Labor, and then FINRA, and two weeks later by the SEC's investment adviser examiners, and then a few months later by the SEC's broker-dealer exam unit... in addition to two separate FINRA sweep inquiries the firm also responded to last year, all of which found that the firm was fully compliant. Broker-dealers also face a requirement that financial statements filed with the SEC must be performed by an accounting firm certified by the PCAOB - a requirement under the Dodd-Frank Act in the aftermath of the Bernie Madoff scandal - which is a challenging expense for small broker-dealers that rarely even custody assets in the first place. And the challenges are only being accelerated by the shift towards advisory accounts under the DoL fiduciary rule, which arguably is a benefit for most advisors and consumers, but has been a significant challenge for smaller broker-dealers that have a disproportionate number of transaction-oriented brokerage salespeople and don't necessarily work with the kinds of clients who want to be in managed accounts. And even for those who do shift, the regulatory overlap means that even as the DoL encourages accounts to be switched from commission-based to fee-based, the SEC is scrutinizing what registered reps are doing to earn those ongoing advisory fees and whether they're being appropriately managed. As a result of these trends, many smaller broker-dealers are folding into larger ones, often simply becoming an OSJ for their prior reps while being able to consolidate their firm-level compliance obligations into a larger broker-dealer. And ironically, broker-dealers that have shifted fully fee-based are also increasingly walking away from their broker-dealer, instead shifting to simply become full-fledged RIAs instead, where the broker-dealer operates more akin to an RIA custodian. Yet despite all of these challenges, many smaller broker-dealers remain upbeat, noting that the weight of compliance burdens in larger broker-dealers can be so frustrating for registered reps that many still prefer the smaller broker-dealer environment, which has the potential to offer a more niche or boutique level of support for a smaller base of registered reps.

Indie BDs Are Dwindling... Should FINRA Be Concerned? (Melanie Waddell, Investment Advisor) - The number of independent broker-dealers is declining steadily every month, while the number of independent RIAs are on the rise, and even regulators are beginning to recognize that a portion of the shift is a desire of firms to minimize their exposure to FINRA's cumbersome regulatory burdens on broker-dealers, especially as financial advisors at broker-dealers increasingly shift towards a fee-based RIA model anyway. The compliance costs are especially challenging for the whopping 1,000 IBDs (nearly 25% of the total) that have fewer than 10 reps, and don't even have the capacity to bring on a full-time compliance officer. And the challenge isn't only one for broker-dealers, but for FINRA itself, which faces a shrinking of its purview as the number of broker-dealers - and the amount of broker-dealer assets - dwindle lower with the shift to RIAs and fee-based accounts, which in turn is only being accelerated (including and especially amongst the largest broker-dealers which comprise the majority of FINRA's registered reps) with the looming DoL's fiduciary rule. Which means ultimately, FINRA needs to figure out how to either gain purview to examine fee-based advisory accounts, or face the risk that the SEC replaces FINRA altogether with a new regulatory body for (all) financial advisors. Yet FINRA's new CEO, Robert Cook, appears to realize the challenges that lie ahead, as he engages in the recent "FINRA360" initiative, that is probing all aspects of what FINRA does, and trying to figure out how the organization can remain relevant in the future.

RMD Arbitrage: Strategies For Legally Delaying And Reducing RMDs (Caleb Vaughan, Journal of Financial Planning) - While any traditional IRA owner faces the onset of Required Minimum Distributions (RMDs) once reaching age 70 1/2, most married couples (67%) have an age gap of at least one year, which means their RMDs will not actually begin in the same year (and for 23% of couples, the age difference and RMD-onset-difference is at least 6 years!). In turn, this creates the potential for a couple to minimize their RMD exposure, by planning their ongoing withdrawals and distributions around whose account will face RMDs, and when. The opportunity is especially material in situations where the spousal beneficiary is more than 10 years younger, as the older spouse's IRA will be able to use the more favorable joint life expectancy table to calculate a lower RMD amount (than what would be prescribed by the standard Uniform Life table that applies with any other beneficiary). So what can couples actually do to minimize RMD exposure? First and foremost, Vaughan notes that couples should maximize savings to a younger spouse's retirement accounts first (after obtaining any employer matching contributions), rather than just saving similarly/equally to both accounts, even if the younger spouse isn't earning the majority of the income. Conversely, to the extent that the couple is contributing to (or converting into) a Roth IRA, the older spouse should contribute (or convert his/her IRAs) first, as Roth accounts are not subject to lifetime RMDs at all, thereby again minimizing the size of RMDs for the older spouse. Other potential strategies include: if the couple can't afford to contribute to an IRA but has at least some earned income, consider withdrawing from an IRA (if one spouse is over age 59 1/2), to contribute new dollars to the (younger) spouse; when taking IRA distributions in retirement, use the older spouse's pre-tax (and sooner-to-RMD) retirement accounts first; and consider taking advantage of the still-working ability to delay RMDs for those who are a less-than-5% owner-employee beyond age 70 1/2 (and even consider rolling outside IRA assets into the plan to further delay RMDs on those dollars). On the other hand, be cognizant that these RMD-management strategies can distort the relative size of spouse's accounts, which may be of concern if there's a risk of future divorce, or if the couples' IRAs have different future beneficiaries after death.

When You Should Establish An IRA As A Trust (Ed Slott, Financial Planning) - Under the Internal Revenue Code, an IRA can be established as either a custodial account, or a trust. In practice, the overwhelming majority of IRAs are custodial accounts, but Slott points out that there are times when a trusteed IRA may actually be more appealing. The fundamental difference is that with a trusteed IRA, the sponsoring financial organization (which functions as a trustee) can add further potentially useful terms directly to the IRA-as-trust, particularly as a means to restrict control of the IRA assets after the death of the original owner... but without needing to go through the relatively complicated rules of leaving a (custodial) IRA to a trust as beneficiary (because the IRA itself is the trust). For instance, the trusteed IRA might stipulate that a beneficiary can only take annual post-death RMDs, but not have access to liquidate the rest of the account (or alternatively, limit access to principal for only specific purposes, like the beneficiary's health, education, maintenance, or support). And for those who want to maximize a stretch for multiple beneficiaries, the trusteed IRA also eases the process of creating multiple beneficiary IRAs for each beneficiary (as if the IRA is simply left to a single trust with multiple beneficiaries, all beneficiaries are stuck using the life expectancy of the oldest beneficiary), and also allows the original IRA owner to specify successor beneficiaries as well (in case the inherited IRA lasts longer than its original beneficiary) to further ensure the money stays in the family. And with a trusteed IRA, it may also be easier to protect an inherited IRA (at least compared to just leaving a custodial IRA outright to the beneficiary) since the Clark v. Rameker Supreme Court ruling (though annual RMDs would still be subject to creditors). In addition, it can be easier to administer a trusteed IRA in the event that the original IRA owner becomes incapacitated, as the trust will typically have terms allowing the trustee to act in their stead (e.g., to ensure that RMDs are still being taken properly) without the need for a Power of Attorney. However, it's important to note that a trusteed IRA can only have an institution as the trustee (not a family member), and because the account will be bound to that particular financial institution's trust structure, it may be nearly impossible to move the account in the future (unlike the typical custodial IRA, which can more easily be transferred to another provider in the future).

Portfolio Rebalancing Research: Momentum And Tolerance Bands (Andrew Miller, Alpha Architect) - Despite its popularity as a staple of prudent investment management for financial advisors, relatively little research has been done on how to optimally rebalance a portfolio, beyond recognizing that pure time/calendar-based rebalancing doesn't do much to increase returns (though it can help to manage exposure to equity drift), and that a "tolerance-band" based approach may be better than rebalancing based on time horizons alone. The challenge, in part, is that even though rebalancing is often viewed as a "passive" strategy, the fact that the advisor must make a decision about when to time the rebalancing activity effectively means it is a form of active market timing. Rather than reject this market-timing view of rebalancing, though, Miller instead digs into the data to identify if there really are reasonable rules-based timing strategies to execute rebalancing. Building on Ibbotson monthly data (which dates back to 1927), Miller finds that a 20% tolerance band (with allocations re-evaluated monthly) does slightly improve both absolute and risk-adjusted returns over simple monthly rebalancing, although a momentum-based strategy (where the rebalancing thresholds adjust based on whether market returns have positive or negative momentum over cash) produces slightly better results (albeit with significantly more trades), and a more tactical strategy (that simply applies a flat overweighting to stocks with positive momentum, or underweighting with negative momentum) performs even better. However, a regression analysis finds that in the end, the enhanced returns aren't actually from positive market timing, per se, but appear to be a result of permitting a higher average equity allocation (as tolerance bands allow a 50/50 portfolio to sit anywhere between 50% and 60% in equities before being rebalanced, which results in higher average equity exposure since stocks rise more often than they fall), a slight value tilt, and the ability to participate in positive market momentum.

Who's In Charge Of Our Minds? The Interpreter (Shane Parrish, Farnam Street) - Modern neuroscience has discovered that our brain is not a fully unified system, but actually a collection of distinct modules that perform specific functions, and studies of split-brain patients (who have various forms of brain damage impacting only one part or side of their brain) are allowing us to increasingly understand which brain functions occur where, and how they interrelate. Of course, we still feel like we have a unified mind - by analogy, "if you look at an isolated car part, such as a cam shaft, you can't predict that the freeway will be full of traffic at 5:15PM", even though the reality is that all the car parts in the aggregate, and their use, leads to traffic, and traffic patterns themselves are predictable (even if you can't understand them from the underlying car parts). Yet with so much occurring in the brain, the question arises: how do we gain consciousness, and figure out what to pay attention to? The answer appears to be a small section of the left brain hemisphere, that has been dubbed "the interpreter", but its role is not exactly what one might expect. Because so many decisions and actions in our brains occur quickly and subconsciously, our "interpret" is often fooled, coming up with an explanation after the event has occurred - for instance, if you see a snake, you tend to quickly jump back, and your interpreter determines that you must have jumped back because of the snake, even though in reality your brain decided to jump back before even becoming fully conscious that it was a snake. In the normal natural context, the linkage is still close enough, but in today's modern world, the interpret often grossly misinterprets situations, and/or comes up with explanations to explain events that may or may not have been relevant (e.g., "why the market declined by X% yesterday"). In fact, the interpreter is highly prone to creating explanations based on whatever information happens to be available at the time. Which is important, because it means our minds are very much at the mercy of what they're being fed in the first place, and that it's important to surround ourselves with good information sources, or we risk coming up with especially erroneous explanations.

Expiring Vs. Long-Term Knowledge (Morgan Housel, Collaborative Fund) - Research tells us that the overwhelming majority of what we learn is soon forgotten; think about all the things you read a year ago, and how many of them you can even remember reading, much less the details of what was contained therein. Yet not all knowledge "expires" so quickly; some books remain timeless classics, and some knowledge, especially the "why" of various events (rather than just the "what") seems much more likely to stick around for the long term. From the perspective of learning, though, the challenge is that "headline" kind of information is usually the quick-expiring kind, while it's the material in books that tends to stick for the longer term. In the investment context, this is why books like Benjamin Graham's "Intelligent Investor" remains popular today, and has had an impact on many investors, but the details of any particular company's sales, profit margins, or cash flow from last year is quickly forgotten by even most hard core investors. In the investment context, this means it's more important to evaluate questions like "does the management team have the ability to navigate problems" rather than "what is the company's latest headline problem", but more generally, Housel makes the point that if you want to improve your knowledge and capabilities over time, it's important to expose yourself to the kind of material that tends to produce more long-term (sustainable) knowledge... which means less time reading headlines and watching (short-term) news, and more time reading books (and hopefully, this in-depth blog!), which are most likely to not just give you information, but change the way you think in a way that has a positive long-term impact.

Forget About Setting Goals, Focus On Systems Instead (James Clear) - We all have things we want to achieve, and for most the path starts with setting a specific goal. Yet Clear suggests that ultimately, what really gets us to our goals is not the goal itself, but the systems we create to achieve the goal. For instance, the coach's goal is to win a championship, but the system is to practice every day; the writer's goal is to write a book, but the system is a daily/weekly writing schedule; the entrepreneur's goal is to build a business, but the system is about sales and marketing and delivering the product. The reason the distinction matters is that goals on their own are often meaningless without putting in place a system to achieve them. Even more notable, though, is that systems appear capable of achieving great results, even without having a goal. For instance, as a blogger, Clear has ended up writing enough to fill two books in the past year, even though he never set out to write a single book. And Clear suggests that it may even be preferable to target systems and not goals, because goals can reduce our happiness (as we make ourselves unhappy until we achieve a goal, and then ironically upon achieving it, often just choose a new goal that makes us 'unhappy' again), are often counter-productive in the long run (e.g., the person who wants to get healthy by training for a marathon often stops training after the marathon, which means they end up with a yo-yo effect on healthy instead of a sustained improvement), and can lead to frustration if we don't set good goals (e.g., accidentally setting goals for things we can't control, like whether our AUM revenues grow even though they're heavily controlled by the markets). Notably, this doesn't mean it's necessary to eschew all goals - they can still be helpful to help us understand if we're on track - but it's the systems that allow us to actually make progress towards an outcome. Thus why, for new advisors starting in the financial services industry, the mantra has always been to focus on prospecting activity (a system you can control), and not the number of new clients you get (which can be more random), though clearly the lesson extends far beyond just finding new advisory clients!

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.