Executive Summary
Enjoy the current installment of "weekend reading for financial planners" - this week's edition kicks off with the big advisor #FinTech announcement that Morningstar is acquiring the rebalancing software platform Total Rebalance Expert (tRx). Also in the news this week was the launch of a new advocacy platform (courtesy of TD Ameritrade) to make it easier for advisors to submit comments to their Congresspeople regarding advisory industry regulatory issues, and a new study from Cerulli suggesting that a whopping 25% of wirehouse advisors could leave for independent channels in the next 4 years as post-financial-crisis retention deals start coming up for renewal.
From there, we have a few practice management articles this week, including a discussion of the growing number of younger advisors looking to buy out the advisory firms of retiring advisors, an excellent article by Angie Herbers on the growth barriers that advisory firms face as their size (and complexity) increases, and an explanation of what "distributions-in-guise" are and why the SEC is cracking down on them (highlighted by a recent $40M fine against investment adviser First Eagle Investment Management).
We also have a couple of technical planning articles this week, from a new research study out of the Center for Retirement Research finding that one of the primary reasons people lapse their long-term care insurance policies is due to cognitive decline (a sad reality, as those are also the people most likely to need the coverage!), to a look at the concept of the "tontine" and why it may soon make a comeback as a retirement income solution, and a discussion of how market valuations not only tend to mean revert to historical average valuations to but mean invert to historical valuation lows (which has significant implications for forward market returns from today's valuation levels!).
We wrap up with three interesting articles: the first looks at the world of financial advice in the U.K., which implemented advisor reforms two years ago that included an outright ban on all investment commissions, and is now starting to yield some data about whether low- and middle-income consumers really are abandoned in a no-commission world (the early data suggests they're not abandoned, but advisors may end out needing to charge fees higher than what consumers are willing to pay!); the second provides a good reminder than virtually any business model for advisors presents some conflicts around the advice delivered, as the easiest course of action is always to give advice that rewards the current business model; and the last is a critique from the editorial team at Investment News regarding the recent proposed NASAA model fee disclosure rules for broker-dealers, which ironically would increase transparency of "miscellaneous" broker-dealer fees but require no actual transparency regarding the (typically much larger) fees, commissions, and other compensation that consumers pay to the broker themselves!
And be certain to read through to the end, and check out Bill Winterberg's video coverage of the recent tRx Unplugged 2015 conference as well!
Enjoy the reading!
Weekend reading for October 10th/11th:
Morningstar To Acquire Automated Portfolio Rebalancing Firm Total Rebalance Expert (Ali Malito, Investment News) - This week, investment research firm Morningstar announced that it would acquire Total Rebalance Expert (tRx), the automated portfolio rebalancing software created by financial advisor Sheryl Rowling. First created in 2008, tRx reportedly was used by more than 500 advisors across 175 advisory firms, and already included an integration (created earlier this year) to Morningstar Office. With the acquisition, tRx still plans to offer the software openly to all advisors (as Morningstar stated it is committed to open architecture, and will allow tRx to still operate as an standalone platform), but will likely develop deeper integrations with Morningstar Office. In addition, Rowling noted that with Morningstar's resources, she anticipated the firm can now push out enhancements faster, including supporting on investment valuations, dynamic risk evaluations, and real-time pricing integrations. Morningstar noted that the tax-aware rebalancing capabilities of tRx (including automating tax-loss harvesting and asset location strategies) were an important factor in the acquisition. The terms of the acquisition were not announced, and the deal will officially close in November, with Rowling will continue to oversee the direction of the platform on a part-time basis (as she continues to operate her own advisory firm as well).
TD Ameritrade Launches Website To Spur Adviser Advocacy (Mark Schoeff, Investment News) - As a part of its Fiduciary Advocacy Leadership Summit, this week TD Ameritrade Institutional launched a new advocacy website designed to make it easier for advisors to contact members of Congress and put adviser issues on the Congressional agenda. The "Take Action" site allows advisors who register to easily submit comments to their legislators related to ongoing industry issues, and provides template letters that advisors can use or adapt. The currently highlighted issue includes the low frequency of adviser exams by the SEC, which average but once every 11 years, and the template comment letter offers up suggestions to increase exam frequency from outsourcing to third party examiners to sending more advisers to state oversight or allowing the SEC to collect user fees from advisers to better fund exams. As prospective legislation for financial advisors unfolds, the site will highlight other legislative issues as well, but at a general level the goal is simply to make it easier for advisors to share a collective voice about the important advisor-related issues in Washington.
25% of Wirehouse Advisors Expected to Go Indie by 2019 (Emily Zulz, ThinkAdvisor) - After the financial crisis, wirehouses offered a wide swath of retention contracts to top financial advisors, but a recent Cerulli survey found that by 2019 a whopping 72% of those retention contracts will have expired. As they do, Cerulli projects that most advisors will decide to make a switch, with about half making an intrachannel move to another wirehouse (given some of the currently-very-generous wirehouse recruiting deals), and a quarter of wirehouse advisors likely to adopt some form of independence (either in the independent broker-dealer channel, as an RIA, or as a dual-registered hybrid). Cerulli predicts that the defection rate to the independent channel is likely to be so high because recent studies have shown that a desire for greater independence is currently the most important factor influencing advisor decisions about switching platforms. Notwithstanding the desire for independence, though, Cerulli also finds that relatively few advisors breaking away truly want to start their own firm entirely from scratch as a solo advisor (only 18% of those surveyed); instead, breakaway brokers are more likely to team up with an existing RIA or broker dealer (possibly under a super-OSJ arrangement) to gain access to operational infrastructure and a community of other advisors, or at least to create a firm jointly with other advisors rather than going at it entirely alone. Notably, while many wirehouse brokers are projected to break away from independent broker-dealers, Cerulli also finds that independent B/Ds themselves remain pressured, as more and more advisors migrate towards dual-registered status or become entirely independent RIAs on their own.
Deal Makers: How Young Advisors Pick Up Retiring Advisors' Clients Now (Andrew Welsch, Financial Planning) - With nearly 1/3rd of advisors projected to retire in the next 10 years (according to Cerulli), the number of succession planning arrangements and outright sales to third parties are beginning to rise, as younger advisors seek growth through acquisitions. Given the variety of advisory businesses, though, the details of the succession deals vary tremendously, depending on factors from the mixture of types of clients, size of the practice (both AUM and number of clients), client demographics, and the nature of the advisory firm revenue (with recurring-revenue fee-based businesses worth more than transactional commission-based firms). To facilitate such transactions, broker-dealer platforms have been retooling as well, offering everything from assistance in the business valuation to arranging access to financing (or in some cases, even financing the promissory note directly as long as the deal terms are reasonable), and some broker-dealers are even encouraging their young advisors to buy retiring advisors' clients from other platforms as a way to grow their own. Notably, because deal structures also vary by the arrangement and type of firm - for instance, wirehouse 'retention'/exit deals are taxed primarily as ordinary income, as are advisors in other employee-advisor arrangements, while independent RIAs may potentially be sold for capital gains treatment - the decision about where and how to structure the practice is also a material factor. Of course, it's important to remember that ultimately, the business value only transfers if the clients hand off successfully, so the most important part of the acquisition strategy is still the plan for transitioning clients and the business after the deal is signed!
Successfully Managing an Advisory Firm’s 6 Growth Barriers (Angie Herbers, ThinkAdvisor) - While most financial advisors believe their advisory firms and path are entirely unique, Herbers notes that in reality about 90% of advisory firms grow along a very predictable revenue curve, and end out hitting the same growth barriers at the same points and require the same solutions to overcome them. The six barriers that Herbers articulates are: 1) Adding (the first) staff member(s) as the advisory firm grows beyond the capabilities of the original advisor; 2) Crossing $750,000 in annual revenue, which typically requires deepening the staff support infrastructure to include professional staff and a non-founder lead advisor who can manage client relationships; 3) Crossing $1.2M in annual revenue, as the growing staff infrastructure makes it harder to manage and retain staff, and increasingly staff turnover begins to take its toll; 4) Reaching $3.3M in annual revenue, where the firm must institutionalize its marketing and growth approach because the typical owner-advisor "rainmaker" approach is no longer feasible; 5) Achieving $8.5M in annual revenue, where a new layer of organizational complexity kicks in as corporate business strategy, layers of management, and standalone financial management become relevant (and typically require professional managers, including a standalone CEO, COO, and CFO); and 6) Getting to $15M in annual revenue, where there are so many advisors and staff that the owners are completely removed from the actual deliver of client services, which makes it difficult to ensure that clients continue to be served consistently well. Notably, because these barriers are all related to organizational size and growth, advisory firm owners who struggle at these various points are not "mismanaging" the firm but simply hitting transition of the growth process; what defines the successful advisor is not the fact that the growth barriers appear, but how effectively those barriers are anticipated and navigated.
Why SEC Is Cracking Down on 12b-1 Fees and ‘Distribution-in-Guise’ (Chris Stanley, ThinkAdvisor) - The SEC recently announced a $40M enforcement action against investment adviser First Eagle Investment Management (and its affiliated broker-dealer FEF Distributors), the first such action in its new "distribution-in-guise" initiative. The issue relates to 12(b)-1 fees, which were created back in October of 1980 to allow fund managers to assess their marketing and distribution costs directly against fund shareholders (previously fund companies had to pay their own sales and distribution costs, which as the fund industry lost assets in the 1970s made it increasingly difficult for them to market and grow in the face of decreasing economies of scale). These payments helped to compensate advisors to sell mutual funds through the 1980s and 1990s, but the landscape shifted in the late 1990s with the rise of online brokerage platforms, the "one-stop supermarket shop" for investors to purchase mutual funds, but entailing unique costs for the platforms to manage a wide range of mutual fund holdings in a single networked or omnibus account. Some of these costs, such as those which would have otherwise been performed by the fund's transfer agent (so-called "sub-TA services") can be paid directly to the platform intermediary from fund assets. But in some cases, the services being received by the funds from their intermediary platforms were more akin to shelf space and other marketing/distribution initiatives, and therefore should have been treated as 12(b)-1 fees. In the case of First Eagle, the issue was that the fund was deemed to have been paying marketing-related expenses out of the fund, but did not have a 12(b)-1 plan properly approved by its Board of Directors to make such distribution payments, and instead were making "distribution-in-guise" payments as though they were sub-TA fees even though they weren't. Notably, the fund would have been fine for making the payments if they had been part of a properly approved 12(b)-1 plan; at this point, the primary scrutiny from the SEC is that if such payments are being made, they must be properly allocated (although notably if they are allocated as 12(b)-1 fees, they would be more transparent to consumers, and also ostensibly more scrutinized by the fund's Board of Directors in the exercise of their fiduciary duty to shareholders).
Why Do People Lapse Their Long-Term Care Insurance? (Wenliang Hou & Wei Sun & Anthony Webb, Center for Retirement Research) - One of the primary challenges of long-term care insurance for the insurance companies is that those who buy the policies rarely lapse them, often at a rate of no more than 1%-2% per year (which has significant implications for the proper pricing of policies). Nonetheless, compounded at 1%-2% rates over the span of a multi-decade retirement, more than 1/3rd of those who buy long-term care insurance ultimately allow their policies to lapse, forfeiting their benefits. This study from the Center for Retirement Research sought to understand why lapses occur, and found that it's rare for "strategic" lapses to occur (where people simply change their mind and decide the policy doesn't make sense anymore); instead, some lapses occur simply due to the "financial burden" of affording the long-term care coverage over the year, but a significant number of buyers are lapsing policies as a result of poor decision making due to cognitive decline in their later years or even just "forgetting" to pay the premiums (notably, policyowners who just "have a daughter" [who presumably helps watch out for the parents' finances] have a 14% lower likelihood of allowing their policies to lapse based on historical data!). These dynamics are especially concerning because the research also shows that those who are most likely to lapse their policies due to cognitive decline are also more likely to actually need care in the future, which means those who are lapsing are most likely to need the coverage! These dynamics suggest that ironically, long-term care insurance turns out to be "counter-productive" for many, who buy coverage, pay premiums, then lapse it just before they need it... which in turn suggests that options like having a "lump sum" premium option for coverage, so that it is fully paid up and can't be forgetfully lapsed later, might be a good idea for the industry to revisit in the future (although unlikely in today's era where companies are still concerned about getting LTC insurance pricing right and often have to raise premiums to correct prior pricing mistakes!).
It’s Sleazy, It’s Totally Illegal, And Yet It Could Become The Future Of Retirement (Jeff Guo, Washington Post) - Over 100 years ago, before Social Security, retirement accounts, pensions, or 401(k) plans, the most popular retirement strategy/product was the tontine - so popular, in fact, that according to a recent book about tontine history by Moshe Milevsky entitled "King William's Tontine: Why The Retirement Annuity Of The Future Should Resemble Its Past", by 1905 there were 9 million tontine policies active in a nation of only 18 million households, and tontines held a whopping 7.5% of all national wealth (and nearly 2/3rds of the total insurance marketplace). The basic concept of the tontine is relatively straightforward - multiple investors gather their money together into a common pool, and the entire group is paid at regular intervals... with the share of any deceased participants redistributed to the remaining survivors. Receiving this kind of "mortality credits" is similar to the structure of a lifetime annuity, but the key difference with a tontine is that the redistributed shares occur in real time, which means literally that the participants' payments just keep increasing as time goes by and more people pass away. The fact that tontine payments adjust as they go also means the pace of payment increases is not guaranteed, as it truly depends on how quickly the rest of the pool of participants pass away, but that also makes them far more efficient, as there are no required actuarial assumptions up front, and the money is simply paid out evenly as time goes, which means they can also never default or be underfunded (unlike traditional pensions!). Of course, the big caveat to the strategy is the morbid reality that the participants who survive effectively 'profit' at the death of others, and this somewhat 'sleazy' undercurrent to tontines helped to lead to their demise in the early 1900s (along with an explosion of fraud and fake tontines that were oversold in the early 1900s). Nonetheless, tontines have a rich history, including use as a government borrowing strategy in the Middle Ages in Europe (it was almost used to pay down the U.S. national debt after the Revolutionary War, too!), and given today's better regulation and oversight of insurance companies (reducing the fraud concern) and better actuarial science (allowing for more accurate and fair tontine projections), some retirement experts are making the case that they should be revisited as a potential retirement solution.
Valuations Not Only Mean-Revert; They Mean-Invert (John Hussman, Advisor Perspectives) - Hussman reminds us of the long-recognized but often-forgotten reality that investor memories are short, and after an extended bull market suddenly the shallowest of market pullbacks can seem like a 'financial crisis' despite being what is actually no more than a modest correction by historical standards. In fact, arguably one of the defining characteristics of 'true' bear markets is that prices decline significantly, making investments look cheap[er], and buyers scoop in to purchase them... only to find the market decline further, make new lower lows, a process that repeats until market participants "capitulate" and a true market bottom is reached. From the perspective of market fundamentals, what this means is that market valuations not only "mean revert" - falling back towards the average after becoming overvalued - they actually mean invert and fall below the historical average, as the true market bottoming process occurs. However, while the process of mean-inverting can sometimes occur quickly (e.g., 2008, where the market went from very overvalued to slightly undervalued in about 3 months, thanks to a 40% market decline), Hussman finds that it typically takes about 7 years for the market to work off half of its overvaluation, and an average of 12 years for any over- (or under-)valuation to be worked off entirely. Notably, relative to valuations earlier this year, these predictive long-term valuation models would imply a forward long-term average annual growth rate on the S&P 500 of only 1% over the next 12 years (from this past May 2015 peak, through 2027). However, those trends just relate to correcting overvaluation to average values; because markets actually tend to mean-invert to opposite extremes, Hussman finds that it typically takes nearly 20 years for markets to execute a full inversion cycle from a valuation peak to a valuation trough. Notably, this aligns well with the concept of "secular market cycles" also seen in history, where markets move in extended (often multi-decade) bull and bear market cycles from one valuation extreme to the next, before reverting back the other direction.
The DOL’s Fiduciary Rule: What We Can Learn from the U.K. (Joe Tomlinson, Advisor Perspectives) - While the industry has been actively debating the Department of Labor's proposed fiduciary rule, and whether it will limit access of low- and middle-income Americans to financial advice, Tomlinson notes that these kinds of fiduciary reform proposals are not unique to the US; in point of fact, the UK implemented a series of similar reforms in 2013 as a part of their Retail Distribution Review (RDR), including an outright ban on all investment commissions (and Australia implemented similar Future Of Financial Advice [FOFA] reforms in 2013 as well!). A study shortly after the rule was implemented, entitled "The Impact of the RDR on UK's Market for Financial Advice" found that AUM-centric advisors would need 150 clients with an average AUM of $240,000 to operate, but the UK marketplace only has about 30 clients with such a liquid net worth for every advisor in practice, implying there simply aren't enough high-AUM clients to go around and that the rest would have to either lower their minimums, or operate on a fee-for-service basis. Yet a related study, entitled "The Guidance Gap", found that most consumers reported they would not likely be willing to pay for advice if they had to, or at least not as much as advisors anticipated charging, with the typical consumer reporting an "appropriate" fee would be $80/hour but advisors indicating they would charge an average of $265/hour. Notably, while it will still take a few more years to see if these prospectively anticipated changes to the UK advice landscape actually occur as RDR players out, Tomlinson provides a number of potential suggestions about how the DOL might modify its proposals in anticipation of the issue, including: 1) expand consumer access to easier do-it-yourself "robo-advice" platforms; 2) expanding educational "guidance" programs for consumers to get the information they need to better handle their finances themselves; 3) expanding government programs like the Thrift Savings Plan (TSP) to include a "public" option (a more robust version of the MyRA proposal rolled out this year); or 4) establishing a government program to help subsidize the cost of financial advice (a possibility first proffered by Robert Shiller back in 2009). Ultimately, it's not entirely which of these will work, and to what extent, but the fundamental point is that if the early research from the UK is any indication, consumer aversion to paying financial planning fees may limit how much no-commission (or reduced-commission) financial advice can really be expanded.
Business Model Advice (Tom Brakke, The Research Puzzle) - This article provides a good reminder that ultimately, any and every investment-related firm that provides investment advice will have a natural tendency to have its views colored by the direction of its own business model, which in turn can impact the nature of its advice. From brokers who are incentivized to sell the products with the biggest commissions, to the fact that advisors will rarely recommend investment solutions outside of their own platform and capabilities, the presence of these conflicts of interest doesn't guarantee that the investment advice will be bad, but certainly it will at least be challenging to manage the conflict (with some harder to navigate than others). And the challenge extends beyond just what investments are or are not offered. Growing advisory firms will also face a natural tension between customizing advice for every client, and trying to standardize the advice across the firm as they seek operational efficiencies... which, again, may tend them towards the most 'efficient' advice that is also consistent with their business model. Similar challenges occur in the world of institutional investing as well, where decision makers often rely on outside providers to recommend solutions, even as those outside providers are also relied upon to give education about which solution is best (a scenario where it is again 'difficult' to give impartial education). Even large asset managers struggle with the challenge - when was the last time you saw a fund manager call his/her clients to suggest that the entire market is so overvalued that investors should just take their money elsewhere altogether? Of course, every business that does business will have some natural conflicts with customers or clients, but Brakke notes that the complexity of the financial services industry, and the multiple players involved, often makes it difficult to figure out who has which incentives in the first place.
Model Fee Disclosure Misses Mark (Editorial Team, Investment News) - Recently, a North American Securities Administrators Association (NASAA) working group, along with a bevy of supporting industry organizations and consumer advocates, announced a new model fee disclosure framework to help consumers understand and compare fees paid to broker-dealers. Yet while better fee disclosure is certainly nothing to complain about, the Investment News editors note that ultimately, the rule actually covers little more than "miscellaneous" broker-dealer fees such as account maintenance fees (for postage, transfers, minimum balances, etc.), cash management services (debit cards, wire transfers, etc.), and investment fees (not from investment companies, but for things like the re-registration of securities). In other words, the fee disclosure rules don't actually say anything about the commissions and other compensation being paid to the brokers themselves, which of course are really the overwhelming portion of fees/costs that investors will bear when working with a broker and his/her broker-dealer! In fact, the editors raise a legitimate concern that by pushing for disclosure and "clear transparency" of these miscellaneous fees, while not requiring better disclosure of broker commissions and other compensation, that consumers could be misled altogether - for instance, seeing that one firm charges $50 for an account transfer and another charges $100, and mistakenly failing to see the fact that the underlying commissions on products being purchased could have costs that are 100%, 500%, or 1,000% higher! Ultimately, the point is not to speak against fee disclosure and transparency, but to make the point that fee disclosure about some fees while allowing the total cost of doing business to remain obscured is not an effective way to protect the public (and that focusing on miscellaneous fee disclosures and ignoring commission disclosures may mean regulators are spending too much time on the trivial and not enough on what really matters and impacts investors).
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!
On cognitive decline: financial advisers are not immune from cognitive decline. Does your industry monitor and safeguard its members from practicing beyond their declining capacity?
As a former wirehouse broker turned independent, the benefit of greater independence is coming to an end. We use a lot of non-traded alternatives in our practice, but with the firm’s desire for more consistent revenue and protection against litigation, we are now being severely restricted in our use of these strategies. We are being aggressively pushed into a fee-based model. So, we’re now back on a level playing field regarding investment choices, but we lack the brand recognition and have to deal with the headaches of running a small business.