Weekend Reading for Financial Planners (Oct 12-13)

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 October 12th/13th:

How Investors Lose 89 Percent of Gains from Futures Funds - This rather scathing article from Bloomberg Markets is the result of investigative journalism into Managed Futures funds; analyzing returns from data filed with the SEC, Bloomberg found that 89% of the $11.51B of gains amongst 63 large managed futures funds were consumed by the underlying fees, commissions, and expenses of the funds over the past decade (2003 thru 2012 inclusive). An example from Morgan Stanley showed that MS Spectrum Technical fund (a managed futures fund) generated $490.3M of gains and money-market interest income on its $797M assets amongst 30,000 investors, but consumed $498.7M of fees, expenses, and commissions, such that investors in the aggregate had lost $8.3M after a decade. The total costs including transaction costs and trading commissions that can drag up to 4% of returns, and when including charges by general partners and fund managers, Bloomberg found investors paying as much as 9% in total fees each year. Unfortunately, these costs have received little attention in recent years, due in large part to the fact that so many managed futures funds operate as a "black box" where sometimes not even the firms distributing the funds know the details of what the underlying trading strategies actually are (or when they change). In addition, Bloomberg found that some fund managers trade ahead of or opposite their own funds as well, activity that is actually disclosed in some prospectuses, albeit so far into the fine print that few may have ever noticed it. So why have investors poured into managed futures funds? In part because of the marketing suggesting that it is an effective diversifier; but Bloomberg found that most such research all comes from one data provider, BarclaysHedge (no relationship to London's Barclays PLC), and the BarclaysHedge data generally does not include fees, and only uses information voluntarily provided by managed futures traders (who, not surprisingly, are likely to only volunteer their good results and stop sharing data if/when they lose money). Bloomberg also notes that ultimately, even managed futures' effectiveness as a diversifier or standalone asset class is questionable, as without knowing what the underlying black box strategies are, there's really no way to know at any particular time whether the fund will be correlated with stocks or bonds, or not. And unfortunately, because the composition of a managed futures fund is a large base of Treasury Bills and some futures contracts, as interest rates have declined, the ability of the funds to use the interest income from Treasuries to offset fees has declined, resulting in an ever bleaker outlook going forward than the past 10 years of performance has delivered.

Wirehouse Evolution - This article looks at the ongoing struggles that the wirehouse channel has faced in recent years, and how it is beginning to shift to respond. The numbers are rather negative; according to Cerulli, the total advisor count in wirehouses has declined from almost 57,000 in 2007 to under 52,000 today, now accounting for only about 16% of all financial advisors, and Tiburon Research estimates that the wirehouses lost about $90 billion of assets last year, as their market share continues to erode at 1%-2% per year in the aggregate. Yet the wirehouses still oversee a whopping $5 trillion in assets, which means the outflows are still little more than a trickle and have certainly not hobbled the firms. Instead, the firms are beginning to evolve and adapt, providing more quasi-independent options to their advisors in a manner similar to many independent broker-dealers, shifting away from pure investment management and investment products into more holistic wealth management, and investing firm resources into teams and technology support. While the evolution is still slow, the bottom line is that the wirehouses are evolving, and their sheer size means they will still be a force to reckon with, especially in the wealth management space for higher net worth clientele where they appear to be focusing their efforts.

Upping The Ante - In Financial Advisor magazine, technology consultant Joel Bruckenstein looks at how independent broker-dealers are updating and changing their technology tools and offerings to meet the demand of advisors. At Raymond James, the focus has been on CRM (built around Microsoft Dynamics), a custom version of MoneyGuidePro, an integration of MGP into the Raymond James client access portal (so clients who are interested can experiment with their plans directly), and an upgraded portfolio management software platform built around FolioDynamics. At LPL, the focus on been on electronic documents (including the widespread implementation of DocuSign and eSignatures to allow straight-through processing of common client paperwork, even from an iPad!), a revamp of the client portal (which advisors can brand to themselves), a mobile app for advisors to interact with and manage their client data from iOS or Android mobile devices, and a new trading and rebalancing software platform. At smaller privately-owned broker-dealer United Planners, the focus has been on integration, and the firm's connectUP back office links to many outside "best of breed" technologies like Redtail CRM, FinanceLogix (FP software), and Albridge (account aggregation), and LinkUP which helps to build automated workflows across the various platforms (and maintaining household data consistently across CRM and portfolio software and FP software). At Wells Fargo, the focus has been on mobile apps and mobile productivity for advisors, and an attempt to increase its advisors' social media footprint (especially around LinkedIn). At Commonwealth, the firm has been working on deeper integrations across its software, and also building out its mobile apps for advisors. The bottom line: the clear trends at large firms is towards deeper integration (both a challenge and an opportunity), mobile devices and productivity, and more sophisticated trading and rebalancing platforms.

Are You Turning Off Younger Clients? - From last month's issue of Investment Advisor magazine, this article looks at some of the differences at communication styles between Baby Boomers (born 1946-1964) and younger members of Generations X (born 1965-1981) and Y (born 1982-2000), where what appear to be minor differences can lead to significant problems if left unrecognized. Or viewed alternatively, if an advisory firm wishes to target and grow a clientele with Gen X and Y, it's time to adopt different ways of communicating and approaching them, or risk turning them off at the outset. The article relies heavily on the work of Cam Marston, author of "The Gen-Savvy Financial Advisor" and a generational consultant. So what are some of the key differences? Gen Y is the generation of helicopter parents, the boom and bust of consumer credit, and has come of age in the Great Recession, they are very comfortable communicating with older generations (their parents are their friends) but are very distrustful, and can be hypersensitive to criticism and tend to need more positive feedback; they are also entirely accustomed to communicating digitally, and are very keen on work/life balance, but with technology their boundaries of when "work" and "personal" time occurs have blurred. Gen X, on the other hand, is more mid-career already (given their age), and in the midst of being married (or divorced) and raising children; they've often been dubbed the "slacker" generation, but in practice they simply have, like Gen Y, blurred the lines between work and home life. Gen X tends to be very independently minded - this was the generation of latchkey children - and are much more interested in results than an advisor's pedigree or experience or designations. Communication techniques that boomers prefer - like face-to-face - may still be relevant to these younger generations, but are more likely to supplement communication than spans digital tools as well.

Retirement Planning’s Probability Problem - In Research Magazine, Bob Seawright looks at how, despite the industry's increasing shift towards probability-based retirement planning, that most human beings are remarkably bad at intuitively understanding probability. In situations with limited instances - like a weather forecast - we're often too hasty to judge a conclusion right or wrong, such as an 80% chance of rain, without actually waiting long enough to see if the (weather) forecaster's predictions really do average out to 80%. Alternatively, when there are a large number of instances - such as 100 coin flips - we tend to find patterns, and while we might recognize that a coin that comes up heads 100 times in a row is a pttern that might indicate the coin is unevenly weighted, the odds of having such an outcome are actually no greater than any other precise 100-flip sequence... we just notice the pattern. Overall, the real issue Seawright highlights is that because we so misunderstand probability, we fail to recognize that improbable events actually should occur with at least some frequency, instead extrapolating short-term patterns into long-term expectations that belie the probabilities themselves. In fact, in one experiment, rats were actually more successful at recognizing probabilistic outcomes (like food that has a 60% chance of being on a certain side of the maze), while humans are so pattern-seeking that it takes us significantly longer to detect the same probabilities as the patterns fool us. Ultimately, Seawright's conclusion isn't that we should eschew probabilistic approaches because of these issues, but he does suggest that we may need to prepare our clients for those "low probability" outcomes because, despite our best probability descriptions of the risk, clients may be underestimating the likelihood those bad outcomes will really happen.

Sequence-of-Return Risk: Gorilla or Boogeyman? - In the Journal of Financial Planning, retirement researcher and financial planner Jon Guyton looks at the phenomenon of "sequence of return" risk, which is the danger that clients are unlucky enough to get an unfavorable sequence of bad returns that so depletes their portfolio (on top of ongoing withdrawals) in the early years that their assets don't last through retirement (even if the returns average out in the end). Yet Guyton suggests that perhaps concerns about sequence of return risk have been overstated. A look at a Year-2000 retiree - arguably an excellent example of sequence-of-return risk, given the tech and market crash that occurred right out of the gate in the first several years - finds that in reality, things aren't going so bad. After 13 years, an initial $1.2M portfolio that started at $48,000 of withdrawals (a 4% initial withdrawal rate) is still at $1,083,000, and with inflation adjustments the withdrawals are up to about $66,000, resulting in a current withdrawal rate of about 6.1%... which is certainly higher than the start, but not necessarily in danger given that retirement is already nearly half way over and there are only 17 years remaining in the original 30 year time horizon. Furthermore, if the retiree implements a series of more dynamic rules that Guyton suggests, that trims spending modest in bad years and adjusts asset allocation in overvalued environments, the Year-2000 retiree is faring even better, with a portfolio that's higher than the original starting balance after 13 years and therefore a current withdrawal rate of only about 5%. The bottom line: sequence of return risk may matter, but even environments like the past 13 years aren't necessary destructive (i.e., it takes an even worse sequence to really severely threaten retirees), and fairly modest adjustments along the way can have a significant impact on further mitigating the risk.

Avoiding Post-ATRA Trust Tax Rates - With the American Taxpayer Relief Act, the top tax bracket was increased from 35% to 39.6% beginning in 2013; at the same time, under the Affordable Care Act, a new 3.8% Medicare surtax also started in 2013. Although these rules generally only apply to individuals at fairly high levels of income, in the case of trusts the top tax bracket - including both the 39.6% rate, the new 20% long-term capital gains and qualified dividend rate, and the 3.8% Medicare surtax - all begin at only $11,950 of taxable income. Fortunately, when cash is distributed from a trust to beneficiaries, the income tax consequences flow along with it - the trust receives a tax deduction, and the income is reported on a Form K-1 to the beneficiaries, at their individual tax rates. As a result, significant tax savings are potentially available by distributing any trust income in excess of trust expenses (which might include transaction costs, appraisers, accounting and legal fees, and fiduciary and/or investment management fees), and the results are even better if beneficiaries are in very low tax brackets, and/or if the income can be spread amongst multiple beneficiaries to keep them all in lower tax brackets. However, if the beneficiaries are children, the trust income may be subject to the kiddie tax, and if the parents have high income the net result may be the same as simply leaving the income subject to trust tax rates. Notably, trusts can actually distribute income up to 65 days past the end of the trust's tax year (up to March 6th for calendar year trusts) to claim the distribution deduction for the prior tax year. Notwithstanding the tax benefits, though, it's important to comply with the trust's own provisions, which may limit distribution of income and/or principal for tax purposes (especially if the original goal/purpose of the trust was asset protection); in addition, if not otherwise stated, tursts may characterize capital gains as principal and not income under the Uniform Principal And Income Act (UPAIA) and therefore limit how much "income" can be distributed.

Proactive Strategies for Mitigating the Medicare Surtax - From the Journal of Financial Planning, this article looks at strategies to manage the new 3.8% Medicare surtax on net investment income that first took effect this year, and applies broadly to dividends, (taxable) interest, rent, royalties, capital gains, and taxable income from passive trade or business investments, once income exceeds thresholds ($200,000 of AGI for individuals, $250,000 for married couples). As noted earlier, for trusts the 3.8% Medicare tax applies at the top trust tax bracket, which kicks in at only $11,950 of taxable income. So how can clients manage the tax? Above-the-line deductions and exclusions can bring down income and potentially reduce exposure to the tax, and make sure that any deductions that can legitimately be applied to a business are applied as such (specifically to reduce passive income subject to the tax). Notably, income from Social Security, employer retirement plans, and withdrawals from IRAs are not subject to the tax, but can push other investment income over the threshold, so clients may wish to do systematic partial Roth conversions at lower tax brackets to whittle down the size of pre-tax accounts to avoid being pushed into the Medicare tax threshold in the future (though beware that conversion income itself do count towards AGI in the year of conversion). Other strategies to avoid the tax include income shifting through gifting; assets transferred to children are subsequently taxed and their tax brackets (which may be lower than the parents and not subject to the tax), and tax-free growth and distributions in Section 529 plans avoid the tax altogether. For trusts, as discussed above, the primary technique is simply to distribute income out of the trust - if not otherwise violating the provisions of the trust - to have income taxed at the beneficiaries' tax brackets (where the thresholds are $200,000/$250,000 of AGI) and not the trust's tax bracket (where the surtax kicks in above $11,950 of taxable income).

Managing Life Insurance Policies: An Analytical Approach Built on Standard Actuarial Techniques - This article from the Journal of Financial Planning, by actuary Bill Hezzelwood of Actuarial Analytics, provides a framework to understand how to analyze existing life insurance policies, especially when trying to decide whether to keep a policy or fund more to ensure it will remain in force. The issue is increasingly important as insurance companies have innovated around life insurance design, making the situation far more complex than it was when all cash value and death benefits were guaranteed in the world where all permanent insurance was whole life. The basic approach is to analyze the policy based on an internal rate of return calculation, based on the known/anticipated cash flows, adjusted for the actuarial likelihood of those cash flows occurring - or more specifically, to compare the actuarially weighted present value of future cash inflows against the present value of the requisite cash outflows necessary to sustain the policy. Of course, the caveat is that to accurately do the analysis, it's necessary to model the client's anticipated mortality year by year, which requires an actuary to analyze the client's individual health and circumstances. Nonetheless, the outcome of the analysis results in a series of anticipated internal rates of return based on death in various years, which can then be compared against available investment alternatives to determine an appropriate decision; notably, if the analysis is done based on the client's individual health circumstances, the approach will correctly reflect the underlying increase in the value of the policy if held until death, which may actually make the policy more appealing to keep if there has been a decline in health.

Pricing Wars: How To Compete In An Evolving Industry - In this Investment News article, Joe Duran of United Capital makes the case that AUM fees are going to decline significantly in the coming years, to the point where a rebalanced passive asset allocation strategy is going to end out around a fee of 0.5% of assets; in point of fact, Duran notes that this trend is really already underway, and the "typical" 1% AUM fee today is really just a progression from what was 2% from brokerage firms in the 1990s on its way to a commoditized low cost end point. In prior years, many independent firms "started" at 1%, which insulated them from some of the price declines and put pressure on the brokerage firms, but now the tables are turning as custodians and online startup platforms are rolling out drastically cheaper offerings that threaten the profit margins on typical AUM firms. So what's the way out of this downward price competition spiral? Duran suggests that it will be advisory firms increasingly charging outright for advice itself, but that being able to justify the necessary price will require firms to significantly upgrade their client experience, services, staff, and training. In other words, as core investment management becomes increasingly commoditized, high quality financial planning services will become the driver of client value and the way to stay differentiated.

Depths And Breadths - In Financial Advisor magazine, industry veteran and luminary Dick Wagner looks at how our world has been changing its relationship with money in recent decades, from simply being an ordinary medium of exchange, store of value, and tool of accounting, into what Wagner calls "the most powerful and pervasive secular force on the planet" for which "money mastery" will become a 21st century survival necessity. Unfortunately, for most of money's rise since World War II, consumers have been ill-equipped to handle the changes - a gap that Wagner believes financial planners are uniquely capable of filling. Fortunately, financial planning has been on a positive track to rise to the challenge, taking many of the key steps necessary to establish itself as a profession, including an expansion of its body of knowledge, establishing a code of ethics, and creating "The Test" that requires mastery of the knowledge to pass. However, Wagner suggests that ultimately The Test and its supporting garden of knowledge are still incomplete, lacking in a holistic cohesive theory and framework, and overall the profession still has not managed to clearly articulate its mission and purpose in the world - is financial planning just about money and finances, or any/all human experiences around money, and is it just about the facts and knowledge, or should it be a full-fledged profession? Wagner suggests that if the goal is to become a profession, financial planning will have to move beyond just The Test and embrace the creativity and complexity that requires a far more expansive knowledge base, spanning not just financial matters, but many aspects of the social sciences and liberal arts. Ultimately, Wagner predicts the outcome of this journey is the creation of "finology" - a comprehensive body of knowledge, like psychology and sociology - that embraces money, human value,  the forces of money in our world, an overall study of money systems, and how our minds and brains interact with money issues. The bottom line: financial planners may be what we are, but finology is the accompanying comprehensive body of knowledge our profession needs to craft to truly become a financial planning profession.

Money Can Buy Happiness - This article on Advisor Perspectives is a review of the book "Happy Money: The Science of Smarter Spending" by Elizabeth Dunn and Michael Norton, which essentially shows that in delving into the research, it turns out there really are some ways that money can buy happiness, if spent properly. One of the key insights is that the act of buying life experiences, or outright giving away money, results in more happiness than just buying material things - an insight that planners can share with clients to help facilitate their own spending decisions. In fact, Dunn and Norton's research suggests that perhaps the primary reason why happiness doesn't increase with wealth is not because money can't buy happiness, but because people often misjudge what will lead to happiness and make poor spending decisions. In addition to spending on experiences and on others, the research also finds that using money to buy time (which is then freed up to pursue passions and activities that promote wellbeing) and trying to periodically treat yourself (the key being incremental pleasures rather than a sustained lifestyle change) also help, as does a philosophy of "pay now and consume later" (as the waiting period from payment to consumption actually heightens the enjoyment when the consumption actually occurs). Notably, buying bigger/better/new houses and cars were especially ineffective at promoting any sustained increase in happiness, despite the huge portion of our spending often consumed by those items (extended periods watching TV scored poorly as well). While this doesn't necessarily mean clients should eschew their homes, cars, and televisions entirely, the fundamental point is that investing time and dollars in experiences and relationships is likely to yield far more happiness value.

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 new Bits & Bytes weekly video update on the latest tech news and developments, or read "FPPad Bits And Bytes" on his blog!

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!