Weekend Reading For Financial Planners (November 11-12)

Fidelity: Advisors Gave Up Asset Growth For Client Retention In 2022

(Ali Hibbs | Wealth Management)

In years of strong market performance, financial advisory firms can see their Assets Under Management (AUM) grow whether or not they add client assets through organic growth (i.e., onboarding new clients or bringing on additional assets from current clients) or inorganic growth (i.e., gaining client assets through acquisitions), simply from the lift of markets alone. But 2022 was a very different year, with both equity and bond markets seeing sizeable declines, potentially putting a dent in client portfolios and overall AUM for many firms. Which raised the importance of organic growth for firms that sought to expand their AUM during the challenging market environment. 

According to the 2023 Fidelity RIA Benchmarking Study, organic growth played an important role in supporting Assets Under Management (AUM) for the 245 RIAs surveyed, though this figure saw sharp declines compared to 2021 for both relatively smaller and larger firms. The study found that firms with less than $1B in AUM had average organic growth of 3.2% (down from 8.2% in 2021), comprised of 3.3% growth in new assets from existing clients and a 4.2% increase in new assets from new clients but limited by 1.2% of assets withdrawn by departing clients and 3.1% of assets withdrawn by existing clients. Larger firms, with more than $1B in AUM, experienced a similar pattern, with total organic growth of 3.6% (down from 8.4% the previous year), boosted by 4.5% growth in new assets added from both new and existing clients and reduced by 2.0% of assets withdrawn by departing clients and 3.5% of assets withdrawn by existing clients. For smaller firms, referrals from current clients were responsible for 59% of new clients, while similar to Kitces Research findings, larger firms that had relatively higher growth were most likely to get clients from a range of 'other' sources beyond just referrals (e.g., business development, clients that came with newly hired advisors, and M&A activity).

At the same time, while RIAs have seen strong AUM growth over the past decade, profit margins have not necessarily kept up. For instance, the average Earnings Before Owner's Compensation (EBOC) has been relatively flat over the past several years, ticking higher from 54% to 56% between 2016 and 2022 for firms with less than $1B in AUM and from 46% to 49% for larger firms. Fidelity found that one reason, similar to recent Kitces Research, might be the tendency for firms to offer an increasing number of planning services to clients (that require additional advisor and staff time) without necessarily raising their fee schedules (and in fact, the study found that in 2022 70% of smaller firms and 89% of larger firms offered discounts of at least 0.1% to their standard fee schedules).  

Altogether, Fidelity's benchmarking study shows that while RIAs on the whole were able to weather the challenging market environment in 2022, firms that are able to generate more organic growth and serve these new clients efficiently (e.g., by not just offering 'more', but instead offering more tailored service models that might actually do less in total but the things most valuable to their particular target clientele) could be best positioned to grow into the future, no matter how markets perform!  

Model Portfolios Help Boost Investor Confidence, Natixis Says

(Edward Hayes | Financial Advisor)

As many financial advisors have shifted their service models from a focus primarily (or entirely) on investment management to comprehensive financial planning, they naturally have less time to focus on creating and managing customized portfolios for each client…and less need to do so, when their value isn't necessarily derived from the portfolio management side of their offering in the first place. Fortunately, these advisors have a range of options available to support a more systematized and standardized investment planning service to clients, from Turnkey Asset-Management Platforms (TAMPs) to 'home-office models' available to advisors working under the umbrella of a larger firm.

Another available option to support the investment planning process is the use of model portfolios, internal or third-party investment models that allow an advisor to spend less time constructing an asset allocation while retaining control and discretion to implement the trades themselves (typically using trading and rebalancing software). And recent research from Natixis Investment Managers (which offers model portfolio services) suggests that the use of model portfolios can potentially benefit advisors and clients alike.

Among surveyed firms that use model portfolios, 77% said they help their firm manage risk, and 69% said they add an extra layer of due diligence in the investment process. Further, 66% said models enhance their ability to tailor portfolios to client-specific needs, with tax-efficient models for high-net-worth clients, income models, and alternative sleeves among the types of models advisors were most likely to want to add. In a separate survey of investors, Natixis found that while 97% of clients invested in model portfolios said they trust their financial advisor, only 73% of other clients said the same. The firm suggested could be in part due to advisors allocating the time saved from using model portfolios to provide a more comprehensive service experience to their clients.

In sum, advisors appear to be increasingly turning to model portfolios (whether sourced from a home office, centralized within their own investment team to all their advisors, or via a model marketplace) that offer the opportunity to save time on building an asset allocation…while still allowing the advisor to craft client-specific advice and make client-specific portfolio modifications as appropriate. Which ultimately creates more scale for the advisory firm, and frees up time for advisors to focus on the services their target clients need the most (while also presenting an opportunity for advisors whose unique value proposition is investment management to differentiate themselves!). 

IRS Private Letter Ruling Opens The Door For Pre-Tax Advisor Fees To Be Taken From No-Commission VULs

(Business Wire)

Typically, expenses incurred for the production of income or the management of assets (e.g., an investment advisory fee) are a cost that can be applied against the income produced – in other words, deducted as a pre-tax expense. Unfortunately, though, under the Tax Cuts and Jobs Act of 2017, the entire category of "miscellaneous itemized deductions subject to the 2%-of-AGI floor" was repealed… which included the deduction for investment advisory fees, making them no longer able to be paid directly on a pre-tax basis.

However, the ability to pay for the cost of an advisor on a pre-tax basis is still preserved in situations where the fee can be paid directly from a tax-preferenced account or product (e.g., advisory fees deducted directly from an IRA or commissions subtracted directly from the net asset value of a mutual fund or the cash value of an annuity or life insurance). The caveat, of course, is that RIAs charging fees cannot receive commissions from mutual funds or annuities or life insurance in the first place, making it effectively impossible to charge clients on a pre-tax basis.

But the ongoing growth of RIAs (and the market opportunity it presents for insurance companies), and the potential that regulators could force a broader shift of all advisors towards a (no-commission) fiduciary duty, has in recent years led to a growing number of insurance carriers offering "fee-based" (i.e., no-commission) products, in the hopes of appealing to the commission-adverse RIA channel. These efforts (at least for annuities) were boosted with 2019 Private Letter Rulings (PLRs) that RIAs can sweep their annuity fees directly from the annuity contract on a pre-tax basis, potentially making no-commission annuities more feasible to RIAs who would now be able to charge fees for their annuity advice.

In a signal that certain life insurance policies could be eligible for similar tax treatment, Protective Life Insurance Company received a PLR in July regarding its no-commission advisory Variable Universal Life (VUL) product. The PLR states that the fees deducted from the contract are an expense of the contract and will not be treated as an "amount received" by the policy owner (i.e., will not be treated as a taxable distribution), and that the fees do not constitute compensation to the advisor for services related to any assets of the owner other than the advisor life contract (i.e., will not be treated as a commission to the RIA). Together, these PLR findings suggest that advisors providing advice on the underlying assets within a no-commission VUL could charge an AUM advisory fee on the VUL policy on a pre-tax basis.

In sum, just as the 2019 PLRs served as a boost for the growing marketplace for fee-based annuities, this most recent ruling could do the same with regard to the rise of no-commission VUL policies for interested advisors. Nevertheless, it's important to note that these are 'only' private letter rulings, not an actual change in the tax code, and that interested advisors (and insurance companies) will need to follow their stipulations closely to ensure their clients receive the potentially favorable tax treatment!

Tips For House Hunters Frustrated With The Frozen Real Estate Market

(Charlie Wells | Bloomberg)

Leading up to 2022, financial advisors and their clients had grown accustomed to a relatively low mortgage rate environment. In fact, until earlier this year, the average 30-year fixed mortgage rate had stayed below 5% since 2010 (and below 7% since 2001). But as the Federal Reserve has sought to raise interest rates this year to combat inflation, mortgage rates have reached higher levels not seen in more than 20 years, with 30-year fixed mortgages peaking above 8% earlier this year. Compounding the problem for potential homebuyers is that home prices have remained firm in many markets, making ongoing mortgage payments even more pricey.

In this environment, aspiring homebuyers have several potential options. For those with parents or other family members willing to support them, an intra-family loan might make sense, as the "Applicable Federal Rate" that a family lender is required to charge for the loan typically is significantly lower than market rates. And in addition to lowering the monthly cost for the borrower, such a loan can also provide an income stream to the lender (though the lender might first assess the likelihood that they will be repaid, and both parties could consider how such a loan might affect their relationship dynamics!). Alternatively, for parents who don't mind living with their children (and vice versa), the child could pay to expand their parents' house, creating enough living space for both parties (at a potentially lower price point than buying a standalone home), perhaps with the option for the child to eventually purchase the home outright (or with plans to bequeath it to them once the parents pass away).

Aspiring homebuyers also could consider "house hacking", either buying a property to live in full-time and renting a portion of it out or buying a vacation home with the intention of renting it out for much of the year. Nevertheless, while the monthly rent payments received can mitigate the currently higher costs of purchasing a home, this approach does require the homebuyer to also serve as a landlord (or to hire a management company to handle management issues), which can come at the cost of time and money. Another option, given the current limited housing inventory in many markets, is to start out by buying land on which their own home (which would likely require a smaller down payment and loan compared to a finished property, though the buyer would still be required to oversee and pay for the construction process).

Ultimately, the key point is that while buying a home in the current market can be financially challenging, advisors can add value by helping clients think creatively about potential ways to achieve their (or their children's) homeownership goals (as well as making them aware of the potential drawbacks of strategies that might seem like 'no brainers' on the surface!).

How Your House Makes You Miserable

(Anne Helen Petersen | Culture Study)

Buying a home has long been part of the "American Dream" as imagined in popular culture. Not only has homeownership been associated with stability, it also offers the ability to customize one's living space in a way that meets both the owner's functional needs and style tastes. At the same time, a home is also an asset that could be sold in the future to support a subsequent home purchase or to generate assets for other uses. And recent research suggests that these two understandings of a home often conflict, particularly in the modern age of ubiquitous home-related media content.

According to a study by Annetta Grant and Jay Handelman, many homeowners experience a "market-reflected gaze" (encouraged by home-related media and the view of the home as an asset) that dissuades them from customizing their home to reflect their unique tastes (that might not be shared by potential buyers) and instead leads them to follow popular trends to preserve its future resale value. Which means that when homeowners engage in an (often costly) remodeling project based on the design standards of the day, they might feel a sense of disorientation afterwards, as the end result reflects not their own vision, but rather a more generic style mirroring popular taste.

In sum, the dual roles of a house as a place to live and as an asset can often conflict, potentially leading individuals to see their home less as a reflection of their own tastes and desires and more as something to be 'optimized' to maximize its future resale value. Which suggests that advisors working with clients considering an 'HGTV-style' renovation can help them consider whether doing so will actually make them happier (and, given the potential construction costs and changing popular design tastes, wealthier) in the long run!

Why I Don't Own A Home

(Madeline Hume | Morningstar)

Buying a home is often portrayed as a sign of success and an inherently responsible financial decision. Because not only does a home represent a place to live, but it is also an asset that can appreciate in value. And while homeownership is out of reach for many individuals based on their financial circumstances, Hume is currently opting out of buying a home because for her, the investment math doesn't add up.

Hume would potentially be in the market for a 'starter' condo in the Chicago area that would likely cost about $500,000 and in which she would live for the next 5 years or so. And while she and her husband have saved enough for a down payment and could afford the monthly mortgage payments, several financial aspects of a potential home purchase are currently dissuading her. First is the fact that, given current elevated interest rates, she will accrue little equity in her home as a result of her regular mortgage payments, which would go primarily to interest during the time she owned the home. And while she could claim the mortgage interest as an itemized deduction, the higher post-Tax Cuts and Jobs Act standard deduction means that this would only save her a few thousand dollars each year. Other concerns include costs associated with buying, maintaining, and eventually selling the home and her skepticism that a condo would experience significant appreciation during her ownership period (potentially limiting the benefits of owning it as a leveraged asset).

Ultimately, the key point is that the decision of whether to buy a home is not necessarily a financial 'slam dunk' and can depend on local market dynamics as well as the buyer's plans (e.g., how long they intend to stay in the home), risk tolerance, and personal preferences (e.g., whether the potential qualitative benefits of homeownership outweigh potential financial risks)!

The Real Reason Your Midsize Firm Isn't Growing

(Angie Herbers | ThinkAdvisor)

When it comes to the potential for growth, midsized advisory firms (i.e., those with between $1M and $10M in annual revenue) have advantages compared to both smaller firms (which might have fewer resources) and larger firms (which might be less flexible and adaptable). Nonetheless, owners of these firms sometimes find themselves becoming overburdened with the work needed to take their firm to the next level, and some find it hard to achieve their desired growth targets.   

Reasons cited for growth struggles among midsized firms often include a lack of financial capital, outdated client experience, or difficulty in recruiting, training, and retaining talent. However, Herbers argues that the biggest and most common pain point for these firm owners is intellectual capital. Because while the firm owner might have many ideas for how to maximize their growth, the growing number of responsibilities on their plate means they might have enough time to deploy, implement, and manage these strategies. 

To help overcome this challenge (assuming the owner decides against hiring managers, which might not be financially feasible) Herbers stresses the importance of preparation for the firm owner. This includes taking a data-driven approach to find the key performance indicator that needs to be improved (e.g., increasing the firm's 'close' rate on prospects), deciding precisely what steps will be taken to manage the strategy (e.g., retraining advisors to try to close more prospects in 1 meeting), and finally, how it will be implemented (and who will lead this process).

Herbers concludes that for owners of midsized firms, expanding their leadership abilities is often the key to unlocking future growth, as doing so can not only allow them to better create and implement growth strategies, but also to do so in a way that balances their other responsibilities within the firm! 

Cash Burn Dilemmas: The Truth About Rapid Sales Growth

(The Onveston Letter)

When a company achieves rapid sales growth, observers might be tempted to assume not only that this growth can continue well into the future, and that (if the company is not profitable already) profitability is around the corner. 

However, while a rapid surge in sales might be seen as a victory for a company, it can also come with higher rates of cash consumption (to pay staff and suppliers to produce the product or service) and less time to regenerate cash supplies (given the growing amount of costs), and greater risk for stakeholders (e.g., the firm owner and investors). And while this problem is particularly acute for companies with strong sales growth that remain unprofitable, it can also affect profitable companies if the timing of their revenues and expenses is misaligned. Which means that for firms looking to see a sales boost, ensuring they will have enough 'fuel' (i.e., cash coming into the business) to support the coming rise in expenses can help prevent cash flow troubles from taking down an otherwise profitable business.

In the end, while financial advisory firms typically do not require a significant amount of capital to get started (and firms tend to have strong recurring revenue thanks to ongoing client fees), growing firms that might be spending on staff, technology, and office space still face the potential for a cash crunch (particularly if a market downturn led to reduced revenues). Which suggests that taking a thoughtful approach toward growth that keeps cash flow at the forefront could help ensure that growing firms survive and thrive well into the future!

LPL Study: How Advisors Can Triple Revenue From $1M To $3M

(Victoria Zhuang | Financial Planning)

One of the benefits of running a financial advisory firm is the ability to shape it based on the owner's strengths and preferences. Further, the wide range of firms and strategies they implement provides a rich data pool to help identify the best practices that drive firm growth.

Using data from a subset of advisors on its platform, broker-dealer LPL Financial identified key traits of the top 10% of advisors in terms of revenue generation. First, these advisors tend to 'operate like a CEO', which includes having a consistent focus on growth, a strategy for how to keep growing past natural resistance points, and being purposeful about organizational design (e.g., formally evaluating staffing levels regularly). The next trait was their ability to optimize their time, including by being willing to delegate tasks (either to employees or to an outsourced solution) and to leverage opportunities for automation. Those seeing the strongest revenue growth were also more likely to offer comprehensive planning services (rather than just investment management), with a particular focus on estate and tax planning. Finally, these advisors were more likely to incorporate their values into their business, including in their mission statement and written client selection criteria. 

Altogether, the LPL study suggests that advisors who take a step back from day-to-day client work and focus on the big picture of their firm, from staffing levels to the services they provide, might find that this investment pays off in the form of greater revenue going forward! 

Why 8% Mortgage Rates Aren't Crazy

(Telis Demos | The Wall Street Journal)

Given the run-up in broader interest rates and Treasury yields during the past couple years, it is unsurprising that mortgage rates have risen as well. However, mortgage rates have increased at a faster pace than have Treasury yields (to which they typically are correlated), leading to higher rates (and greater costs for homebuyers) than might have been expected.

For instance, the gap between the typical rate on a 30-year fixed mortgage and the 10-year Treasury note at the end of September was 2.8 percentage points, up from the 2017-2019 average of less than 2 points, suggesting that (in addition to higher rates more broadly) borrowers are paying an additional percentage point in interest than they would have just a few years earlier. One of the contributors to this phenomenon is reduced demand for government-backed bonds that pool many home loans into investments (leading to higher rates to entice investors), as both the Federal Reserve and big banks have reduced their buying. Though notably, this pattern could reverse if investors in mortgage debt believe the Fed's rate hikes are finished (which would reduce the duration risk of the securities), as the currently high yields could be attractive to investors.

In the meantime, homebuyers are facing the double-whammy of elevated rates and an increased spread between mortgage rates and Treasury yields. Though perhaps the Fed's recent decision to hold rates steady (and the subsequent drop in Treasury yields) could be the first sign that relief is in sight? 

Rising Rates Have Advisors Sprinting Toward Private Credit

(Gregg Greenberg | InvestmentNews)

When it comes to alternative investments, private equity often gets a significant amount of attention. But in the current elevated interest rate environment, private credit has become an increasingly attractive alternative for many advisors looking to diversify client portfolios.

Private credit has several features that could make it attractive to investors. First, because these loans are often structured as floating-rate debt, they have benefited from the rising rate environment, offering investors potentially attractive yields. In addition, given the relative illiquidity of these loans, investors can expect an "illiquidity premium" of between 1.5% and 3% compared to publicly traded leveraged loans, according to BlackRock. Further, these loans are also higher in a borrower's capital structure and are prioritized over other loans, reducing the risk of default to a certain extent.

Nonetheless, private credit investments come with several potential downsides as well, from default risk to their illiquidity (as client funds can be locked up for 10 years or more). Further, the returns of different private credit funds have varied significantly, raising the importance of due diligence on fund managers before investing. 

Ultimately, the key point is that while private credit offers potential return and diversification value for clients with a long-term investing horizon and with other liquid funds for short-term and unexpected needs, this asset class comes with its own set of risks and restrictions. Which means that advisors can play an important role not only in selecting the best funds for their clients, but also in ensuring that their clients understand the unique aspects of this potential opportunity!  

The New Kings Of Wall Street Aren't Banks. Private Funds Fuel Corporate America.

(Matt Wirz | The Wall Street Journal)

A company needing an infusion of cash for expansion (or perhaps to pay off a previous loan) might first look to their banking relationships to access a business loan. But in the wake of the 2008-2009 financial crisis, many banks either pulled back from lending or tightened their lending standards (often at the encouragement of regulators), reducing the amount of funding available to businesses. Which has opened the door for the expansion of a different funding source: private credit.

Private credit loans, which are often arranged by hedge funds and large asset managers, typically come with an interest rate higher than what a bank might offer (the current spread is about 2.39 percentage points, according to data provider Cliffwater) and stricter covenants on the borrower (e.g., prohibitions from selling new assets or raising new debt to get cash). But for cash-strapped companies (particularly those who might not qualify under banks' relatively tougher lending standards), taking out a private loan can be an attractive (or perhaps the only) option. 

On the other side of these transactions, the loans' relatively high interest rates make them attractive to a range of investors looking for yield, from large institutions like insurance companies to individual investors, which has led to a flood of cash into firms issuing and managing these loans (private-credit funds managed about $1.5T of assets in 2022, up from $726B in 2018, according to data provider Preqin). Nonetheless, while the loans have additional protections for the lenders, they still come with potential default risk, particularly given the fact that many of the borrowers are less creditworthy than other corporate borrowers (and because higher interest rates make loan repayments more onerous). 

In sum, the availability of private credit loans represents a potential lifeline for companies that might find it hard to borrow otherwise and a potential source of yield for those funding the loans (and fees for firms managing private credit funds), though a certain level of due diligence is likely necessary for investors (and their advisors) to find opportunities with reduced default risk so that their hunt for yield does not lead to losses down the line!

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We hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think we should highlight in a future column!

In the meantime, if you're interested in more news and information regarding advisor technology, we'd highly recommend checking out Craig Iskowitz's "Wealth Management Today" blog.