Weekend Reading for Financial Planners (May 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.

House Passes Bill Making Big Changes To U.S. Retirement System (Anne Tergesen & Richard Rubin, Wall Street Journal) - This week, the House passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 in a bipartisan 417-3 vote, which is expected to be taken up soon in the Senate (and/or adjusted to match one of the Senate's own version of the legislation, either the Retirement Enhancement and Savings Act or the Retirement Security and Savings Act), before likely heading to President Trump's desk for signature in the coming weeks. Key provisions of the SECURE Act include: eliminating the current age cap (70 1/2) for contributing to a traditional IRA; increase the age at which RMDs begin to 72 (up from 70 1/2); requiring employers to disclose to employees on their 401(k) statements the amount of sustainable monthly income their balance could support; making it easier to convert employer retirement plans into lifetime annuities to fund that monthly income amount (by providing clearer protections for employers to avoid liability if they choose such annuity providers who later have financial difficulty, given that only 9% of 401(k) plan sponsors today offer an in-plan annuity option); creating the potential for Multiple Employer Plans (MEPs) for multiple small businesses to group together into a single 401(k) plan for cost efficiencies; allowing up-to-$5,000 of penalty-free distributions from retirement accounts to cover birth/adoption expenses; allowing tax-free withdrawals of up to $10,000 from a 529 college savings plan to repay student loans; repealing the 2017 change to the Kiddie Tax that caused unearned income of children to be taxed at the trusts-and-estates tax brackets (instead of the old rules where the Kiddie Tax rates were the parents' marginal tax bracket); and a proposal that would largely eliminate the "stretch IRA" rules for retirement accounts and instead require inherited account balances to be distributed within 10 years of death (or potentially just 5 years under the RESA version, with certain exceptions for surviving spouses and minor children). Ultimately, there is still some possibility that individual provisions of the SECURE Act may be altered as they make their way through the Senate, but the legislation appears likely to pass in some form in the near future. Stay tuned!

SEC Sets June 5th Date For Vote On Regulation Best Interest (Mark Schoeff, Investment News) - After months of wondering when the SEC would move forward on last year's Regulation Best Interest proposal after receiving such extensive feedback, this week the SEC announced that Regulation Best Interest will formally come up for a vote on June 5th, including both Reg BI itself, and the supporting Form CRS (Client Relationship Summary) that would be provided. Notably, though, the SEC's vote also includes discussion of a new provision, dubbed an "Interpretation of 'Solely Incidental'", as the issue has increasingly become a flashpoint around the regulation of advice from broker-dealers (which, under law, are already supposed to registered as Investment Advisers and be fiduciaries if their broker advice is anything more than "solely incidental" to the sale of brokerage services). Fiduciary supporters are hoping that the SEC addressing the solely incidental rule may finally re-assert a more "bright line" separation between brokers and advisors, though it remains to be seen whether the SEC will actually clarify the solely incidental rule in a way that further separates sales from advice, or muddies the waters further instead. With the caveat that the SEC already lost a lawsuit once (to the Financial Planning Association) over the issue of trying to expand exemptions for broker-dealers to avoid the fiduciary duty of RIAs back in 2007, which also raises the question of whether the SEC may trigger another lawsuit from fiduciary advocates if it goes too far in reinterpreting the "solely incidental" rule in a manner that undermines Congressional intent to separate sales from advice, even as FINRA has openly acknowledged that the SEC's Regulation Best Interest is trying to "preserve the broker-dealer model... [and] save the broker-dealer business as we know it."

New Department Of Labor Fiduciary Rule Set For Release By December (Melanie Waddell, ThinkAdvisor) - Following on the heels of the SEC's announcement that its Regulation Best Interest proposal will come up for a vote on June 5th, the Department of Labor issued its own Notice of Proposed Rulemaking that it will be reviving its own DoL fiduciary rule... albeit with a goal of just issuing a proposal by the end of the year, which, in turn, would be put out for Public Comment and likely not adopted until 2020 or beyond. The move was widely anticipated, as Labor Secretary Acosta had already indicated to Congress that the DoL intended to re-propose its fiduciary rule, albeit after the SEC came out with its new Regulation Best Interest, recognizing that parts of the original ERISA fiduciary rule (created in the 1970s) are no longer relevant in the modern era, but the Department of Labor does want to ensure its rules are coordinated with the SEC's own version (a criticism that was levied against the prior DoL rule). However, fiduciary advocates have raised concern that, with fears that the SEC already appears to be working on a "watered down" fiduciary rule for broker-dealers (as literally, Regulation Best Interest is not a full fiduciary rule for broker-dealers in the first place), a DoL fiduciary rule that "coordinates" with the SEC risks resulting in a watered down version of ERISA fiduciary standards as well, particularly with respect to previously-controversial provisions like the original DoL fiduciary rule's private right of action (that would have allowed class action lawsuits against broker-dealers that couldn't be forcibly waived into private arbitration). At the least, though, the fact that the DoL is both planning to re-propose a fiduciary rule but is waiting until the SEC issues theirs, means the final DoL proposal will end out being shaped by the debate (or any potential legal challenges) against whatever the SEC's Regulation Best Interest rules turn out to be.

Vanguard Jilted RIAs 16 Years Ago, But Now CEO Tim Buckley Is Green-Lighting RIA Custody Again (Oisin Breen, RIABiz) - For most of the past 20 years that the advisory industry has increasingly shifted towards index mutual funds and ETFs, Vanguard has been content to be the asset-manager-of-choice for various index fund and ETF solution, capturing more than $1 trillion of advisor assets. But with the company's launch of its own RIA - Vanguard Personal Advisor Services, which now has over 600 CFP certificants and has added almost $130B of assets under management in barely 5 years but is seeing growth slow as the initial wave of existing Vanguard clients have already been cross-sold - Vanguard CEO Tim Buckley has revealed that the company is looking to revamp is Vanguard PAS technology into a solution that other RIAs can use in the next few years, likely bundled as part of an offering for Vanguard itself to become an RIA custodial and compete against the likes of Schwab, Fidelity, TD Ameritrade, and Pershing. Notably, the endeavor is not the first time Vanguard has flirted with RIA custody - it had an early RIA custody offering in the late 1990s and early 2000s, but ultimately exited the offering with just $10B of AUM to TD Waterhouse in 2003, given the complexities of serving RIAs, to instead focus on its "core strength" of asset management. Yet while Vanguard has an incredibly strong brand with advisors for its asset management business, it's not clear that RIAs will necessarily come to Vanguard as a custody and technology platform, nor does the company have much experience directly serving the demanding independent RIA community. On the other hand, even if Vanguard gets limited market share of RIAs itself, or other RIAs can't adopt its "robo-advisor" technology successfully to grow themselves, the Vanguard move still has the potential to disrupt the existing RIA custody marketplace and its revenue-sharing shelf-space payment model, if Vanguard expands its platform of offering no-transaction-fee trading options for all mutual funds and ETFs (as it has done for its retail customers) in a world where many advisors are still frustrated that competing RIA custodians charge more to trade Vanguard's own funds (along with DFA funds).

LPL Financial Jumps Into The Full-Service Brokerage Business Via Acquisition (Brooke Southall, RIABiz) - This week, LPL announced that it was acquiring Allen & Company, a small, full-service broker-dealer that employs about 30 advisors with $3B of client assets, which will be consolidated onto the LPL custody/clearing platform (from their current relationship with First Clearing)... which is significant, not because of the acquired platform assets, but because Allen & Company is a full-service employee broker-dealer model (akin to the wirehouse model). In other words, LPL will now have a non-independent employee option (i.e., a "captive broker-dealer") for advisors to join the firm, shifting away from its current "pure" independent model as a way to attract wirehouse breakaway brokers who may prefer to remain in the employee model (just with a different firm like LPL instead of their current wirehouse). The move doesn't appear to be a signal that LPL itself is moving away from the independent model, per se - and somewhat paradoxically is calling it "the next generation of the independent model" - but simply that LPL recognizes that not all advisors want the burdens and responsibility that come with a fully independent model, and instead may want an employee model option... which LPL will now be able to provide, both to attract breakaways and even to acquire and roll up other hybrid broker-dealers that are similarly operating on the employee model.

SEC Gives Final Nod To First Nontransparent ETF Strategy (Bernice Napach, ThinkAdvisor) - After years of efforts and applications with the SEC, this week, Precidian Investments announced that it had been granted approval from the SEC for its nontransparent ActiveShares ETF structure, and American Century Investments announced that it had filed with the SEC to trade "semi-transparent" ETFs that will utilize the ActiveShares methodology. The significance of the approval of nontransparent ETFs is that it paves the way for more actively-managed ETFs, allowing asset managers to leverage the tax advantages that the ETF structure has over mutual funds, but without having their trades communicated "too transparently" in real-time status to the markets (which for large active managers could lead to markets trying to front-run sizable manager trades). Accordingly, while the new ETFs will ultimately have to reveal their detailed holdings, the ETF holdings will only be disclosed quarterly with a 60-day lag (akin to most mutual funds). Critics, however, have noted that with less transparent ETFs, it's not feasible for market arbitrageurs to help ensure that ETFs are trading as close as possible to their intrinsic NAV, raising concerns that such active ETFs may have wider bid/ask spreads and/or may more frequently trade at a premium or discount (with no way to even know if the current price is a premium or discount). Nonetheless, with the growth of ETFs relative to active mutual funds already, asset managers have been anxious to start offering their actively managed funds in ETF form, and the SEC's approval is likely to lead to a wave of new actively-managed non-transparent ETFs in the coming months, starting with more asset managers offering Precidian's ActiveShares framework (now that it's approved) given that Precidian already has contracts signed with nearly 2% of the active US equity mutual fund market), with more providers likely to enter the market soon. In fact, a recent Cerulli Associates survey of 35 asset managers found that 46% indicated they would build non-transparent ETF capabilities within a year if/when the SEC approved the structure... which it now has. The only question: whether investors will actually want to buy them.

The Hidden Danger Of Zero-Fee ETFs (Ron DeLegge, Financial Advisor) - With the ever-growing focus on the cost of mutual funds and ETFs, and larger and larger ETF providers reducing their costs lower and lower to compete, the past year has witnessed the emergence of "zero-fee" ETFs, from Fidelity's zero-expense-ratio funds to SoFi's zero-fee index ETFs (which technically have an expense ratio of 0.19%, with a fee waiver in replace until at least June 30th of 2020) to Salt Financial's launch of a "TruBeta US Market ETF" with a negative expense ratio (paying shareholders $0.50 for every $10,000 invested, again reverting to a 0.29% expense ratio either after the fund reaches $100M of AUM or on April 30th of 2020). Yet the caveat is that the internal expense ratio of an ETF isn't the only cost to consider in evaluating the efficacy and true total-cost-of-ownership of an ETF. Other factors to consider - that will likely take on increasing importance as expense ratios become less relevant - include: bid/ask spreads to trade into or out of the ETF (which for popular widely-traded ETFs like SPY may be just a penny or two, but can be a much higher cost for other newer, less popular, or lower-volume ETFs... in fact, the SoFi Select 500 ETF has a 0.39% bid/ask spread, and the SoFi Next 500 is at 0.20%); tracking error between the ETF's purported index and what the index actually earns (which is not always done perfectly by all asset managers, and newer no-fee ETFs have little track record to determine the manager's efficacy at minimizing tracking error); and "fee stability" recognizing that many of today's no-fee ETFs are waiving the fees only temporarily, after which fees may rise to normal (or even above-average costs), at a time that investors may have gains and may no longer be willing or able to move out of the ETF (and/or if higher bid/ask spreads exist, it may be both more expensive to hold and more expensive to leave the ETF at that point).

Cash, Core (And Core-Plus) Bond Funds, And Other 'Meh' Diversifiers (Christine Benz, Morningstar) - With various equity asset classes down in 2018, and the Barclays Aggregate Bond Index basically flat, in many investors' portfolios, the best performing holding was cash. Yet despite the effectiveness of cash as a diversifier last year, over the long run, it has been less effective as a diversifier against equity risk... except as it turns out, most other traditional "core" bond holdings haven't been much better diversifiers, either! The reason is that most "core" bond holdings are comprised primarily of investment grade corporate bonds (while "core-plus" funds often include some less-than-investment-grade or emerging markets bonds as well), which still have at least a moderate positive correlation to the S&P 500 anyway. Instead, the most effective diversifiers - that actually had negative correlations to stock returns - were old-fashioned U.S. government bonds, particularly intermediate government bonds (e.g., 3-10 year) or at least government-bond-heavy bond indices (like the iShares Core U.S. Aggregate Bond ETF). Logically, the diversifying effect of Treasuries makes sense - when there is trouble in the markets and the economy, investors tend to have a "flight to safety" and buy the perceived safety of government bonds, whose returns may be aided further by Federal Reserve actions to cut interest rates (to minimize a recession or reinvigorate the economy, and providing an additional boost to interest-sensitive government bonds in the process). Of course, the caveat to government bonds is that, in a strong economy where rates tend to rise, government bonds can lag as stocks rise. But then again, the fact that bonds tend to move in the opposite direction to stocks is arguably the whole point of effective diversification in the first place; after all, if the entire portfolio is uniformly expected to do well in the face of continued economic growth, that also means it's likely the entire portfolio will uniformly do poorly if the economy goes the other direction, too.

Is Direct Indexing Really The Next $100B Financial Advisor Opportunity? (Vijay Vaidyanathan, Wealth Management) - The past decade has witnessed the ETF disruption of the mutual fund industry, by offering a solution that was a little more cost-effective, a little more tax-efficient, and an effective "building block" that advisory firms could use to create their own differentiated portfolio solutions. But now, the growing buzz is whether the next disruptor - of ETFs themselves - is already arriving: "Direct Indexing," which ETF guru Matt Hougan declared as "the next $100B advisor opportunity" at the recent Inside ETFs conference. The essence of Direct Indexing is that, rather than buying index funds or ETFs, advisors can use technology platforms to buy all the underlying securities of the ETF directly (e.g., holding the 500 stocks of the S&P 500, rather than just buying an S&P 500 index fund), thereby eliminating the middle-man cost of the ETF or mutual fund, and introducing superior tax-loss-harvesting opportunities (at least when held in taxable accounts) by being able to harvest each individual stock of the index instead of just the index fund itself. Notably, large institutional firms have already been implementing Direct Indexing strategies (e.g., for ultra-HNW clients), but the expansion of FinTech platforms to facilitate the process is expected to soon bring Direct Indexing directly to the hands of advisors for their own clients. In addition, Direct Indexing creates the potential for the ultimate level of customization - the ability to add (or overweight) or remove certain investments (e.g., more solar stocks but fewer oil stocks, or removing the company or entire industry of stocks in which the client is already employed) to create the investor's own individualized customized portfolio. And for some advisors, the appeal of Direct Indexing may simply be that it's a new and different way to invest client portfolios, to differentiate from the increasingly undifferentiated landscape of other advisors already using mutual funds and low-cost ETFs.

Regulators Sound Alarm On Shift To Fee-Based Accounts (Mason Braswell, AdvisorHub) - While the Department of Labor's fiduciary rule has been vacated, the shift it drove - for broker-dealers to switch from traditional commission-based brokerage accounts into fee-based accounts instead - remains underway... and regulators are concerned that firms may now be acting too aggressively to switch clients over to fee-based accounts when it doesn't actually make sense for them. The issue has been highlighted by a recent class action lawsuit against Edward Jones filed last year, which alleges that the firm was pressuring its brokers to move largely-buy-and-hold investors into accounts charging as much as 2%/year for what those investors could have held at no ongoing cost by keeping their traditional brokerage account and simply not making any (new) trades. Of course, the irony is that regulators have been nudging the industry - sometimes quite forcibly, as with the Department of Labor's fiduciary rule - away from commission-based accounts and towards fee-based accounts, ever since the famous 1995 "Tully Report" pointed out that fee-based accounts are a best-practice to prevent abusive sales practices from traditional commission-based accounts (by removing the incentive for the broker to engage in a high volume of sales transactions and "churn" the account). Except when no trading is happening or is anticipated to happen, the opposite challenge of "reverse churning" - charging an ongoing fee for trading and then not actually trading - just manifests instead. In point of fact, this is likely a key reason why the SEC has been seeking to preserve the availability of the broker-dealer model... so that consumers who really are comfortable to manage their portfolios on their own with a buy-and-hold approach don't have to pay ongoing fees for ongoing services they weren't going to use, anyway.

Australian Royal Commission Report Nails Adviser Conflicts Of Interest (Vinay Kolhatkar, Cuffelinks) - In 2018, a Royal Commission (a public inquiry commissioned by the head of government to look into a serious public policy matter) in Australia dug into the ongoing conflicts of interest that were impacting the financial services industry and the delivery of financial advice to consumers. A high-profile issue in the US as well, the fundamental challenge - as explored in a Research Paper by Dr. Sunita Sah - is that conflicts of interest can lead to biased advice (even though the advisors are not always aware of the biases because they're created by the advisors' platforms instead), over time conflicts of interest can lead to a level of "moral disengagement" where advisors fail to self-regulate their own behavior as standards become compromised (for which they may blame others by pointing out that their platforms "ordered" them to do so), and academic research has long affirmed that pervasive conflicts of interest eventually become rationalized internally (to the point that even those who genuinely consider themselves to be "upstanding people and good moral agents" still end out engaging in the conflicted behavior). In other words, when conflicts of interest become too pervasive, "professionalism" alone is no longer a sufficient remedy. Nor, necessarily, is disclosure - an approach to conflicts of interest that has been increasingly popular here in the US, though research actually has shown that once people disclose such conflicts they may be more likely to engage in the behavior (since "the client was warned"), although such disclosure requirements can also lead a segment of the market to differentiate itself by not needing to make such disclosures (e.g., the "fee-only" community in the US that doesn't have to disclose its commissions because it doesn't take any commissions to disclose in the first place). Still, though, it turns out that even educating advisors about the risks of self-serving biases doesn't actually make them reduce their own biases - it only makes them better at detecting others' biases instead - and that consequently, realigning incentives (e.g., avoiding conflicts of interest altogether) becomes necessary as a remedy to the situation. (E.g., policies that restricted interactions between drug companies and physicians led physicians to prescribe less in expense-branded drugs and more cheaper-generic drugs instead.)

The Fateful Choice Facing CFP Fiduciaries At Broker-Dealers (Ron Rhoades, Advisor Perspectives) - Effective October 1st, the CFP Board's new Standards of Conduct will take effect, requiring all CFP professionals to make the decision about whether to act as a fiduciary at all times when providing financial advice or financial planning, or to relinquish their CFP marks. Which is important not only because of the CFP Board's fiduciary standard itself, but because the SEC has been signaling that it will continue to try to preserve the existing (non-fiduciary) broker-dealer model by not issuing a uniform fiduciary standard for RIAs and broker-dealers. The dichotomy creates a unique challenge for CFP professionals at broker-dealers, whose standards based on their CFP marks may be higher than what regulators impose on them or their firms... because the broker-dealers themselves may not be willing to accept the legal liability that comes with their CFP professionals having a fiduciary duty according to their designation, while eschewing any fiduciary duty as imposed by their regulators. And raising the question of whether, come October 1st, some broker-dealers may repudiate the CFP marks and the fiduciary duty they impose, and instead require their own brokers to choose to stay with the broker-dealer and drop the CFP certification they spent so much time and effort to acquire, or leave for another platform that is willing to let them keep using their CFP marks. The high-stakes showdown is a challenge for both sides: advisors, and their clients, may not necessarily want to change platforms in the first place; and for broker-dealers themselves that have been trying to shift towards a more financial-planning-centric approach, risking an exodus of CFP certificants who would be willingly recruited by competitors willing to embrace financial planning (and its fiduciary standard) could cost them more business than would be at risk due to fiduciary litigation anyway (and/or clients may choose to walk away from firms that suffer the bad PR of being branded as walking away from financial planning and a fiduciary duty to clients). Though in the end, to the extent that clients are bonded primarily to their advisors - not their firms - Rhoades notes that the primary choice will be in the hands of the advisor themselves, and raising the question for CFP professionals at broker-dealers across the industry: if your broker-dealer tells you to drop the CFP marks on October 1st because they won't honor the CFP Board's fiduciary obligation to clients, would you choose to stick with your broker-dealer, or stick with the CFP marks instead?

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.