Weekend Reading for Financial Planners (Mar 22-23)

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 March 22nd/23rd:

The Adviser Industry Is Shrinking (And Why That's A Good Thing) - This article by industry consultant Tim Welsh looks at the ongoing angst of the financial services industry, as the latest research from Cerulli Associates suggests that nearly 1/3rd of all advisors may retire in the next decade, which can have ripples impacting everything from the availability of advisors to provide advice to consumers, to asset managers and insurance companies that distribute products through advisors, to the broker-dealers and custodian platforms on which they build their businesses. At the same time, we are witnessing the rise of technology solutions, the "robo-advisors" (though Welsh suggests it's time to call them something else) of which there are now more than 100 in various forms and structures (up from just a dozen a few years ago). Undoubtedly, most of the technology solutions will fail to gain traction, as solving the "distribution issues" of how to reach consumers is incredibly difficult in financial services; nonetheless, the handful of companies that succeed may become extraordinarily large in the process (Financial Engines is now managing nearly $90B for 800,000 401(k) participants!). As these platform increasingly offer solutions like sophisticated algorithmic investing, personalized asset allocations, efficient low-cost investment solutions, and automated rebalancing, all for 25 basis points or less, it may become more and more difficult for even the non-retiring advisors who provide similar solutions but at a far higher cost. Ultimately, though, Welsh suggests that these two trends will go hand-in-hand; the rise of the robo-advisors will serve a segment of the market that advisors have had difficulty reaching anyway, and at a lower cost, while advisors will have the opportunity to evolve their offerings beyond the basics of investing to include comprehensive financial planning and wealth management that remain in demand. The end point is that, just as TurboTax and LegalZoom didn't put accountants and attorneys out of business altogether - but did lop off the bottom end of their respective industries - Welsh suggests that this too is the likely path for financial services, with robo-advisors filling much of the void for the declining advisor headcount while the remaining survivors leverage the technology to provide the next stage of value for clients.

RIAs Warned of Heightened SEC Scrutiny - Compliance expert Tom Giachetti of Stark & Stark spoke at Fidelity's Inside Track conference this week, and had a stern warning for RIAs that the SEC is getting very aggressive on investment adviser exams, getting deep into the weeds to find potential compliance concerns. The increasingly aggressive approach from the SEC appears to stem from SEC Chairwoman Mary Jo White, a former prosecutor herself, who has stated that the SEC is aiming to pattern its oversight after former NYC Mayor Rudy Giuliani's "broken windows" approach, where no infraction is too minor to attract attention (in the hope that scrutinizing even small mistakes will firms all the more cognizant to watch out for making any big ones). The SEC is also looking not just at potential infractions themselves, but the role of the CCO (Chief Compliance Officer) within the firm, and whether the firm has truly endowed the CCO with the power to investigate and address potential issues within the firm (i.e., is the CCO truly a senior management position with authority within the firm?). Another big cautionary area is whether the RIA has custody - as many RIAs don't seem to realize what can trigger the custody rules, and if the SEC finds multiple instances where a firm has custody but isn't reporting accordingly and hasn't done the requisite audits, there may be an enforcement action against the RIA. Other areas to watch out include information security policies for client data, how firms marketing themselves (are advertised AUM figures accurate?), disclosure of conflicts of interest, and whether/how performance is communicated. While the SEC is still very understaffed - as has been publicized, almost 40% of the RIA under the SEC's pureview have never been examined - Giachetti notes the SEC has been hiring, including many former prosecutors, and cautions RIAs to take the SEC's warnings to heart.

Social Media Questions Remain Unanswered - This article from the IMCA Monitor by compliance attorney Les Abromovitz looks at the current landscape of social media compliance for RIAs. For the most part, Abromovitz suggests the big challenge for around compliance for social media is Rule 206(4)-1 of the Investment Advisers Act, more commonly known as the "Testimonials Rule" (or perhaps more accurately, the anti-testimonials rule!). In the context of social media, the concern is that clients who "Like" an advisor on Facebook. post (favorable) comments about the advisor's services; even comments from a non-client (which at that point would be a third-party endorsement, not a client testimonial) can still be potentially problematic, especially if the regulators believe there is quid pro quo involved or is otherwise misleading (which can arise even in situations where the endorsement is for an 'unrelated' service, as is common on LinkedIn). Notably, though, many of these situations are not outright forbidden, but merely cautionary that they might be deemed testimonials, and in fact Abromovitz suggests securities regulators will probably be focusing on the most egregious violations for now (e.g., an advisor who touts a thinly-traded stock in a pump-and-dump scheme), or where RIAs run aggressive broad-based social media campaigns that have a heavy advertising component (e.g., a campaign to get all clients to click "Like" on the advisor's Facebook page). Notably, even as the existing social media platforms have some ambiguity, Abromovitz notes that there are already new platforms emerging as well; for instance, advisors may have reviewed on Yelp, which Abromovitz notes may actually be acceptable because advisor's can't control the reviews or take down bad ones (though he also cautions against advisors outright campaigning for good reviews as that could be construed as soliciting testimonials, and having a large percentage of clients with reviews on Yelp may be a red flag for regulators). In the end, none of this means that a social media presence is outright banned, but Abromovitz does counsel that LinkedIn and Facebook profiles should be reviewed (and archived as "advertisements), content should be monitored, comments should be controlled to avoid testimonials, and ongoing use of social media for communication should be captured and archived as well (for a minimum of 5 years).

The Big Secret to Getting Client Referrals—and You’ll Hate It - This article from practice management consultant Angie Herbers looks at how to drive more client referrals, which is still the primary mechanism of growth for most advisors who don't have some unique marketing skillset (e.g., for radio broadcasting or public speaking) or a thriving niche. Yet most advisors struggle to gain referrals, despite no lack of popular ideas about how to do so (the most popular being "Just ask for them"). Herbers suggests that one of the most effective means of driving referrals is actually quite simple, yet drastically underutilized: client perks. It may sound corny, but Herbers insists that she's witnessed it work with great success amongst the advisors she works with; clients like free stuff, and affluent clients often love free stuff even more (no one said we're always rational!). So what kinds of client perks work? Herbers suggests a few, including: paying for identity theft protection; offering an account aggregation services (e.g., a website or app where clients can view their consolidated information all together, though sadly there's still a lack of many tools in this category that advisors can use!); setting clients up with a Platinum American Express Card (even if the clients pay the annual fee, but the advisor helps to get it set up, and becomes an expert in the AmEx perks and how to use them); subscriptions to Kiplinger's Personal Finance (you can buy a gift subscription for 12 issues for $12 for up to 100 clients; for more information, email Kiplinger circulation director Roseann Ciccarello!); Casino rewards cards (if you happen to be near a casino, anyway!); or even Berkshire Hathaway shares! The point here isn't to undermine all the other value you provide clients, too; but perks are "unexpected extras" and that's often what gets clients talking when it comes time for referrals!

How Edward Jones ‘Brutalizes’ Breakaway Brokers - This article from ThinkAdvisor is a striking interview with John Lindsey, a former broker with Edward Jones who built a $170M practice over the span of 16 years, becoming one of the firm's top producers, who then went through a very high-profile lawsuit with the firm when he left - including being sued for $5M - but was ultimately vindicated when FINRA and an arbitration panel dismissed his case (after proving that Edward Jones attorneys had lied in their accusations about what he had done). Lindsey notes that unfortunately, the tactic is not uncommon - he states that Edward Jones often sues advisors who try to leave, suspending their U-4, trying to restrict them with injunctions, driving up legal fees, pushing towards FINRA arbitration (notwithstanding the fact that Edward Jones managing partner Jim Weddle is on the FINRA Board of Governors!), and then trying to get the advisor to walk away and 'merely' settle for tens of thousands of dollars. In addition, the firm typically requires settling advisors to sign a release that the advisor can't say anything about it, so there are few public stories; Lindsey's is a notable exception, because he fought the suit and won, so he does not face such limitations in discussing the details of his own case. Lindsey overall is fairly negative about the company (not surprisingly), though he notes that at its size and as a top producer, he was mostly able to stay away from the "corpocracy" and do what he needed to get done. The line in the sand for Lindsey was actually his succession plan; he was 59 years old, and wanted his Series-7-licensed-and-CFP daughter to come on board and be his succession plan over the next decade. However, Edward Jones has a policy that there can't be more than one advisor in an office, and wouldn't allow his daughter to be added, even as a succession plan; the only option was for him to retire quickly in 3 years, and even then his daughter could only take over half his clients (the other half would be given to some other advisor Lindsey had never met). After pushing the issue for two years, Lindsey ultimately left, and went to a firm that would allow him far more freedom over his business. Lindsey chose to leave behind some of his clients (client he didn't enjoy working with anyway), but got the bulk that he wanted; in the process, he transitioned from about $170M of AUM with 500 households, down to a core of about $130M with 160 households in his new practice, and states he has no regrets about leaving.

Wirehouses Sweeten Succession Deals For Retiring Advisers - As more and more advisors reach retirement age, the pressure is growing on succession planning, both for independent advisors, and for the wirehouses, which have recently begun to significantly revamp their succession programs for wirehouses advisors as Cerulli estimates as many as 30% of them will retire in the next decade. This year the "big four" wirehouses (Merrill Lynch, Morgan Stanley, UBS, and Wells Fargo) have all updated their programs, and although the details vary from one to the next, the general approach is pretty similar: advisors who meet certain criteria can get a share of total revenue from their book of business for up to five years after they retire as a form of "sale" payout, with payments as much as 250% of the advisor's revenue (depending on length of service, size of the book, depth of their team, portion of clients in AUM fee-based accounts, and age of clientele). Payouts are generally structured as salary compensation, may include some obligations to stay involved for a limited number of years, in addition to the fact that the wirehouses are encouraging those advisors to have a team in place for transition (and that the teams should be getting developed in advance). Consultants note that ultimately most of the payouts that actually occur are somewhat lower than what independent advisors typically sell for (not all wirehouse advisors are at the top of the succession payout grid), and are also often less favorable for tax purposes (paid as ordinary income rather than capital gains treatment); on the other hand, given that there are risks to going independent in terms of how many clients will really transition, and the emotional and financial toll that may be involved, many wirehouse advisors may simply decide that the wirehouse succession plan is "close enough" to maximizing value. To say the least, though, the wirehouses are now significantly reducing the "gap" between independent advisors who can sell their practices, and wirehouse advisors who may not formally "own" their clients but can still harvest significant value from the practice they've built when it's time to exit.

Morningstar's Current View on PIMCO - Two months ago, PIMCO made the surprise announcement that now-former CEO and co-CIO Mohamed El-Erian would be departing the firm, and later in January there were additional changes to the PIMCO leadership ranks announced as well. Yet while there have been a number of headlines about some of the behind-the-scenes "drama" at PIMCO, the fundamental question remains: has El-Erian's departure, Gross' behavior, or the leadership changes, had any material positive or negative impact on PIMCO's investment process and culture that could impact PIMCO investors? The Morningstar conclusion at this point is that while there has been a lot of turmoil at PIMCO (and in fact, a number of high-level lesser-reported departures from PIMCO have been underway for several years), its "bench" remains quite deep (with 240 people in portfolio management roles around the world, 70 considered key contributors with a median of 17 years of experience), and it has been restructuring already, with six new deputy chief investment officers appointed in the wake of El-Erian's resignation, and a restructuring of how its investment committee operates (with rotating leadership of meetings), and the operational management of the firm remains strong with its current CEO and President. Nonetheless, Morningstar has reduced its overall PIMCO Stewardship grade to "C" from "B" (graded from A to F), and PIMCO's "Parent Pillar" score (one of the pillars of Morningstar's Analyst Ratings) is reduced to Neutral from Positive; these downgrades may be further reflected in some individual fund ratings in the coming month.

The Problem With Forward P/Es - Recently, a number of market analysts have been declaring that markets are reasonably or even favorably valued based on forward P/E ratios, with a recent note by Jeff Saut of Raymond James suggesting a forward P/E of a mere 13.4X earnings next year. Yet as the author notes, historically when discussing valuations they have typically been based on actual as-reported earnings, not merely "operating" earnings and certainly not forward earnings. While in theory the use of forward earnings is appealing - after all, companies in the end should be valued based on what they will earn, not what they have earned - the problem is that analysts are persistently too optimistic about forward earnings. One study finds that for the past 20 years, forward operating earnings estimates have been wrong by an average of 33%! In part this may simply be due to persistent over-optimism by analysts, but the author suggests the problem may be even worse in today's environment, as profit margins have expanded in recent years due to productivity shifts that cannot sustain at their current rate indefinitely, and a return to more normal profit margins could cause earnings to miss by an even wider margin. This in turn is why measures based on trailing reported earnings and so frequently used instead; while they're not perfect, they still tend to be less wrong than forward earnings, and in fact some measures like Shiller's CAPE (cyclically-adjusted price/earnings ratio) have an astonishingly good track record at predicting 10-year returns. So why all the talk lately about forward-earnings and the discounting of measures like CAPE? The author suggests that sadly, "it is always at the point of peak valuations where the search for creative justification begins." Notably, this doesn't necessarily mean it's time to be excessively bearish or bail out of the markets either (most of these measures are better long-term than short-term indicators); but the bottom line remains that while there's discussion that "this time it's different" that trailing earnings measures like CAPE are now wrong and forward earnings are best, history would suggest the case is actually still the opposite.

How Reverse Mortgages Improve Sustainable Withdrawal Rates - On Advisor Perspectives, advisor and actuary Joe Tomlinson looks at some of the recent research on reverse mortgages, which shows that despite their popular use as a resource of last resort, are increasingly shown to be effective at earlier points in the retirement plan. One of the leading studies in this area is by Pfeiffer, Salter, and Evensky in the Journal of Financial Planning entitled "Increasing the Sustainable Withdrawal Rate Using the Standby Reverse Mortgage" which found that safe withdrawal rates can be enhanced by setting up a reverse mortgage as a standby line of credit, to be tapped for retirement expenses when investment returns are poor (and then replenished when markets recover). The key distinction here is that reverse mortgages do not have any required payments, which allows flexibility when funds are withdrawn to wait on any repayments until the market recovers and the retiree wishes to repay. The maximum borrowing limits for a reverse mortgage - whether drawn as a lump sum, or made available in the future as a line of credit - are called "Principal Limit Factors" (PLFs), and vary based on interest rates and age (declining significantly as interest rates rise). This reality is why the Pfeiffer et. al. research suggests that taking out a standby reverse mortgage may be a good idea sooner rather than later; simply put, clients who wait on reverse mortgages may be stuck being able to borrow far less in the future, if interest rates rise in the meantime. Of course, the trade-off for this is that taking out a reverse mortgage - even as a line of credit with no current borrowing - has some non-trivial upfront costs, and to the extent money is borrowed there can be ongoing interest charges as well. Nonetheless, the results show that while these costs do slightly reduce median remaining wealth at death (in the subset of scenarios where there's anything else), the standby reverse mortgage can significantly improve the survival rate of the portfolio in the first place, both by unlocking more equity in the home than waiting and borrowing later, and by helping to manage the sequence risk of the portfolio withdrawals themselves by reducing portfolio distributions in down years (which may be even more helpful given our current potentially-problematic-low-return environment).

Why We're Awful at Assessing Risk - From Morgan Housel at The Motley Fool, this article makes a good point about how bad we are at assessing risk by using a recent example: the disappearance of Malaysian Airways flight 370. While the event is certainly tragic, and the disappearance of 239 people is hardly trivial, Housel notes that in just the 6 days since the time since those 239 people disappeared, around the world 10,500 have likely died from malaria, 4,000 have died from traumatic injuries, and 16,500 from tuberculosis, and in just the US alone 9,900 have died of heart disease, 600 from car accidents, and 250 were murdered (using annual averages). Yet we're not very afraid of those events, and they certainly haven't been in the news the way Flight 370 has. This leads to significant distortions in our perceptions of risk, as we often focus on events that are statistically insignificant but rare, and fail to focus on the deadly serious but common risks all around us. Research has shown that overall, we have a strong tendency to overestimate risk when a danger has the following qualities: it's potentially catastrophic, it's unfamiliar, isn't not perceived as well understood, it's outside of our control and could impact us involuntarily, it impacts people we can identify, it's man-made, and it involves children. And notably, almost all of those describe not just risks to our mortality, but investment risks like a market crash as well. Thus just as in the health context, where we focus on airline crashes but ignore the real big things like poor diets and lack of exercise, in the investment context we focus too much on dreading a big market crash and too little on the real 'risks' we should focus on and can control: fees, trading too much, and not saving enough. In the long run, these three often cause far more long-term financial harm than the high-profile market crash we may be paying far too much attention to.

Why a Fed Governor Bought a Home When He Knew the Market Was Teetering - From financial planner Carl Richards' "Behavior Gap" column in the New York Times, this article takes an interesting look at a lesser-discussed part of the recently released Federal Open Market Committee minutes from their 2008 meetings: that just as the housing market was teetering, Fed governor Frederic Mishkin was in the midst of house-shopping with his wife. As Mishkin details, the Fed already knew that housing was slowing, and that there were emerging downside risks, including the potential that negative price movements could get worse if expectations shifted to anticipate further price declines (which leads people to stop buying and wait for prices to get cheaper, exacerbating the decline). Yet while Mishkin was openly acknowledging the risk, in the end he states "As somebody who stupidly is just going to contract on a new house because I have to please my wife, I actually thought exactly along these lines and was thinking about pulling out but then decided that my marriage was more important." While Mishkin declares his actions as "stupid", Richards suggests that in reality Mishkin was simply recognizing that sometimes, our financial decisions are trumped by life decisions, like deciding that a marriage is "more important." That doesn't make our financial decisions "irrational" but simply acknowledges that in life, there are often more factors in play. In fact, Richards ultimately concludes that many decisions we may externally deem to be "irrational" are in fact quite reasonable when viewing all the facts and circumstances (not just the financial ones), and when examined by the individual's own perspective. That's not to say that we don't make some sheerly irrational decisions from time to time as well; as Richards suggests, though, we can at least try to "test" our irrationality, make sure we know why we're making a certain decision (even if it's less-than-perfect from an economic perspective), and then decide whether it's still the right decision to proceed.

What Financial Planners Can Learn From Top FBI Hostage Negotiators - This article by Dutch financial planner Ronald Sier starts out by looking at poor trust is in financial services, and reflects on the fact that this perception means clients (when we can get them at all!) typically come to the table with a significant dearth of trust. Ultimately, Sier suggests that the best way we can overcome this trust deficit is to establish a relationship with prospective clients quickly, to begin to build that trust. In examining how to do this, Sier draws on the lessons to be learned from FBI hostage negotiators - as negotiators are put in some of the most extreme situations imaginable where they must create instant intimacy and connections in real life-and-death situations. So how can you accelerate the speed at which you and the prospective client "click" in the first place? By making yourself vulnerable, putting yourself into some kind of emotional or psychological risky position, as that openness tends to be reciprocated and then results in a faster "click" and forms a deeper connection. In fact, one study found that just pairing off strangers for 45 minutes but prompting them to talk about personal information that makes them vulnerable led to astonishingly close relationship bonds after such a brief time. So how is this done in practice? Sier draws on insight from the book "Click: The Magic of Instant Connections" to recognize that there are five different types of communication with clients, from 'least' potential to click to most: Phatic (unemotional questions like "How are you?"); Factual (e.g., "what do you do for a living?"); Evaluative (statements that reveal views about situations, like "the price of gold is probably going down"); Gut-level (more personal statements that tie to feelings, like "I'm so glad that you are my client"); and Peak (statements that share innermost feelings). For further ideas, you may want to check out the book itself that Sier recommends (I know I intend to!).

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!