Weekend Reading for Financial Planners (Oct 29-30)

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 29th/30th:

DOL Releases First Batch Of FAQs On Fiduciary Rule (Greg Iacurci, Investment News) - On Thursday, the Department of Labor announced on its blog that the first of three FAQs (answers to Frequently Asked Questions) was being released to provide additional clarity on how advisors and financial institutions must comply with the new Best Interests Contract and level fee fiduciary requirements. The DoL's series of 34 questions-and-answers cover a wide range of common issues and concerns that have been raised about the conflict of interest exemptions. Given that the FAQs were just released, the industry is still absorbing the latest implications. Though one realization that has already emerged is that back-end signing bonuses, common when brokers are recruited to a new broker-dealer, will be prohibited going forward, as the forgiveable loan structure - at least when it's based on assets or revenue production - is deemed too much of an enticement towards conflicted recommendations. Notably, "front-end" upfront recruiting payments for changing broker-dealers would still be permitted, but the risk of an upfront payment for the recruiting broker-dealer means 300%-of-production recruiting bonuses may soon be a thing of the past. In the meantime, the DoL indicated that there will be a total of three FAQs coming (this was the first), and the next will come "soon after the first", which likely means in just the next few weeks. Stay tuned.

Commonwealth Financial Eliminates Commission-Based Retirement Products In Wake Of DoL Rule (Investment News) - Earlier this month, the first news hit that Merrill Lynch would be eschewing commissions altogether in retirement accounts in order to be a level fee fiduciary and avoid the substantial compliance obligations (and potential future lawsuits) of the full Best Interests Contract Exemption. Now, more companies are announcing their DoL fiduciary plans, and Commonwealth Financial has emerged as the second broker-dealer - and the first independent broker-dealer - to state that it will be eliminating commissions in IRAs and qualified plans, stepping away from the complexities and liability exposure of the full BIC and choosing instead to follow the simpler level fee fiduciary requirements. Notably, Commonwealth is already one of the most heavily fee-based broker-dealers, and the company stated that less than 10% of its revenue is derived from commissions on retirement accounts. And commission-based products will remain available in taxable brokerage accounts. Nonetheless, with other wirehouses and independent broker-dealers including Morgan Stanley, Ameriprise, and Raymond James all announcing this week that they will continue allow commissions after the fiduciary rule takes effect - albeit under the burden of the full-BIC compliance obligations - the expected separation of broker-dealers into level fee fiduciaries vs full-BIC firms is now underway. The real question, though, will be what the final compliance procedures looks like for each firm, and whether level fee fiduciary broker-dealers like Merrill Lynch and Commonwealth end out losing advisors who move to another full-BIC broker-dealer to maintain their commission-based business (despite the compliance procedures), or whether those broker-dealers end out attracting away all the business in the long run as advisors eventually decide it's worthwhile to give up commission-based business for easier compliance oversight (and an AUM model that's actually worth more as a business in the long run anyway).

FINRA May Liberalize Social Media Policy Guidelines (Jed Horowitz, AdvisorHub) - This week, FINRA's vice president for advertising regulation Thomas Pappas publicly acknowledged that the regulator is working on drafting new guidelines for brokers on social media, specifically aimed at relaxing certain books-and-records requirements for at least some types of social media activity. For instance, some messages are clearly just broad-based branding messages and shouldn't realistically need extensive supervisory vetting and storage, such as "our firm is sponsoring a Veteran's Day Marathon". More generally, FINRA acknowledges that there is still a difference between education and communication with clients and prospects, and the kind of advertising that truly should be subject to more extensive supervisory oversight. After all, the reality is that social media can be an especially effective tool for the kind of rapid and clear communication between advisors and clients that is ultimately a positive for the end investor. And pressure is growing on broker-dealers, as more and more advisors adopt social media tools, which means "social media due diligence" on what a new broker-dealer would allow, or not, is an increasingly important issue in the recruiting process. As of now, though, there's no specific timeline from FINRA on when the new guidance will be issued and applicable, beyond acknowledging that they're working on it, and that it's coming.

Top Reasons For Independent Advisers To Consider A Merger Instead Of An Acquisition (David Grau Sr., Investment News) - While the labels "Mergers" and "Acquisitions" are often used together, or even interchangeably, they ultimately mean very different things. An "acquisition" typically entails the former owner of the acquired firm exiting and leaving when the sale closes, while a "merger" entails the owner of the merged entity becoming an ongoing part owner and active employee of the new joint entity for some years thereafter. In that context, what drives advisors to consider an actual merger, instead of merely aiming to be acquired? Grau suggests four common reasons for the path: 1) when you're not ready to retire yet, but your current younger advisers clearly are NOT going to be a viable succession plan for you (and therefore you seek out a merger partner that does have a strong next generation); 2) the lack of a continuity plan that could otherwise cause the business to crumble in the event of a major health or family problem; 3) those who simply prefer client service and business ownership, and want to rely on another firm's staff and resources to escape the operational drudgery (as hiring internal staff to handle the issues can just lead to even more management burdens for the founding owner/advisor); and 4) as a junior advisor who wants to partner up with more senior advisors for mentorship and personal growth opportunities, as while some young advisors who start out solo are happy and successful, some ultimately find solo entrepreneurship to be lonely and the process of gaining experience without a guide to be very challenging (and from the senior advisor's perspective, the merger brings a potential successor!).

The Long-Term Effect Of Lifestyle-Friendly Advisory Practices (Joni Youngwirth, Investment News) - A "lifestyle practice" is a low-growth advisory firm where the advisor, typically a solo founder, serves a small subset of profitable clients that require only a moderate workload and therefore few staff or management responsibilities (thus allowing the advisor to more easily build his/her lifestyle around the business). In the past, such lifestyle practices were typically found amongst advisors in their 50s and 60s (and even 70s), who had accumulated clients over time, and in the later years decided it was preferable to simply shed some clients (or allow them to attrition) and keep serving the remaining clients in a lean and profitable practice (and "die with their boots on"), rather than sell and fully retire and give it all up. However, with shifting preferences for work/life balance amongst younger advisors, there are now a growing number of 30- and 40-something advisors who are aiming from the outset to build lifestyle practices. Arguably, this societal shift towards building firms with better work/life balance is a plus, given the not entirely healthy reality of today's workaholic-obsessed culture. However, the challenge is that if the approach is widely adopted, the broader financial advisor community will become one where a high percentage of businesses are all in slow and steady decline; in addition, the lack of ongoing growth for lifestyle practices risks leaving younger generations in particular as being underserved, if established firms stop growing and are no longer interested in adding younger accumulator clients for the future. (Michael's Note: On the other hand, if younger advisors are the ones building lifestyle practices, perhaps the reality is that most young advisors will grow specifically by serving their younger peers, and in the future it will be older clients who struggle to find an experienced advisory firm that is actually still growing and taking on new clients!?)

Building A Specialty Business Within A Wealth Manager (Mark Hurley, Financial Advisor) - Deb Wetherby is the founder of Wetherby Asset Management, a San Francisco-based independent RIA with more than $4B of AUM, which despite its success already is still aiming to innovate by building out a new "specialty practice" within the firm focused on impact investing. Notably, Deb Wetherby started out as one of only 14 women brokers in Morgan Stanley's Private Client department, though being in the big firm environment, with its focus on money as a measure of success, was ultimately what led her to establish her own firm focused around a meritocracy of serving clients. And it was this focus on determining what clients really want, and hearing over and over again clients who said "I want my values to be reflected in my portfolio" (particularly amongst her high-net-worth clientele), that led the firm to establish its impact investing specialty (as distinguished from "just" screening socially responsible stocks). Notably, because impact investing itself is still a very deep investing niche, Wetherby's firm ultimately hired someone to help run the specialty, and in turn her primary role is simply to help identify and screen third-party impact investing managers, and develop a framework to effectively evaluate the available choices, and then help communicate the results back to clients (e.g., once a year the firm does an impact report on each of its investments, reporting characteristics like "You've helped build so many affordable homes, take so much CO2 out of the atmosphere, create so many jobs, etc."). Notably, in the end, only about a quarter of Wetherby's clients pursue impact investing with the firm; though arguably that's not a 'failure' of the initiative, but instead a great example of how a niche specialization can be added to a large existing firm in a way that is relevant to those clients who are interested, without undermining the positioning of the firm for those who don't fit the niche interest.

How The Next President Could Save Social Security (Dave Merrill & Chloe Whiteaker, Bloomberg Politics) - According to the latest Social Security Trustees' Report, the program will be unable to pay all of its promised benefits in 18 years. The reason is a familiar one - in the past, the excess of workers over retirees meant Social Security taxes were more than enough to pay benefits, plus generate a surplus (which is held in the Social Security Trust Fund and invested into government bonds); however, we're now starting to pay out more than we take in via taxes, forcing a partial liquidation of the Social Security Trust Fund, and by 2034 the Trust Fund will be fully depleted. From that point forward, most Social Security benefits will still be paid – from the taxes on then-current workers – but solvency would require an immediate 21% cut in benefits that year and going forward. Yet despite the looming shortfall in the mid-2030s, a substantive Social Security solvency plan has not been promulgated by either of the presidential candidates during this election cycle. The solutions, though, are actually not hard to determine, as ultimately Social Security is simply a giant actuarial math problem that can be calculated. One option would simply be to add more workers, so there are more people paying into the system, though this alone isn't likely realistic, as it would require nearly quadrupling U.S. immigration, or more-than-doubling the birth rate across the entire country. And the shortfall is severe enough that even proposals that were popular in the past, like investing the Social Security Trust Fund into equities instead of government bonds, isn't enough; if the Trust Fund implemented a conservative 40/60 portfolio, the equities would need to earn over 20%/year for the next 75 years to maintain solvency! So what are the more viable alternatives? Likewise a combination of raising the full retirement age (as high as 75 would fully solve the problem), increase FICA taxes (from 12.4% to 14.98% would be sufficient), or cut benefits (if we cut now, it's "just" a 16% cut required for solvency). Realistically, though, it will likely be a moderate combination of all of these and more, such as increasing the Social Security wage base (on which FICA taxes are applied), gradually raising FICA tax rates over time, reducing the Social Security COLA, and gradually raising the retirement age.

Don't Let Pro Rata Rules Trip Up Your Retirement Plan (Christine Benz, Morningstar) - "Pro rata" is a Latin term that means "in proportion", and in the context of retirement accounts, it's the rule that determines how much of a retirement distribution is taxable or not. The distinction is relevant because in a retirement account, any so-called "after-tax" or nondeductible contributions are treated as a nontaxable return of capital, while any other distributions – whether of prior pre-tax contributions, or growth of any type – is fully taxable when withdrawn. Accordingly, an account that has both after-tax contributions plus growth, potentially on top of pre-tax contributions and additional growth, must use the pro-rata rule to determine whether or how much of the after-tax dollars are included in each withdrawal. The pro-rata rule states that anytime a withdrawal occurs, the ratio of after-tax contributions to the total account balance determines how much of the distribution is a return of principal or not; thus, for instance, if the account has $500,000 of total value, of which $100,000 is attributable to years' worth of after-tax nondeductible contributions, then $100,000 / $500,000 = 20% of each distribution will be a nontaxable return of those contributions, and the other 80% will be taxable. And notably, the calculation is done in the aggregate across all of an individual's retirement accounts, which can indirectly foul up strategies like the "backdoor Roth contribution" that entails making a nondeductible contribution and later converting that contributions (but ideally, only that contribution), unless the other IRA dollars are rolled out of IRAs (e.g., back into an employer's 401(k) plan, which is not aggregated with IRAs). It's also notable that the pro-rata rule applies to 529 college savings plans as well, in situations where the owner takes a non-qualified withdrawal and needs to determine how much is a return of prior contributions and how much is earnings that will be subject to income taxes and the 10% penalty.

How to Use Reverse Mortgages to Secure Your Retirement (Wade Pfau, Advisor Perspectives) - In his recent new book "Reverse Mortgages: How To Use Reverse Mortgages To Secure Your Retirement", retirement researcher Wade Pfau explores the unique "tenure option" of the reverse mortgage. The tenure option provides a guaranteed stream of cash flows through the reverse mortgage, which can in some cases be a viable alternative to an immediate annuity. The caveat, though, is that annuities can provide guaranteed income streams for life, while a reverse mortgage's tenure option only provides payments as long as the person has "tenure" in the home (i.e., continues to live there)... which means selling the home, or even just moving out for more than a year, would end the payments. The good news of the tenure option, though, is that the retiree only grows their reverse mortgage loan balance by the actual payments made (plus accrued interest), and without any upfront commitment on capital, while all their remaining capital remains available if unused; by contrast, with an immediate annuity, the entire lump sum is committed immediately (and may be lost if the individual dies early, unless remaining capital is returned under a cash refund guarantee). In fact, the tenure reverse mortgage's limited exposure is actually quite similar to buying an immediate annuity with a cash refund guarantee. Another important distinction is that an immediate annuity pays a mortality credit from the pool of annuitants, while a reverse mortgage does not (although living long enough for the reverse mortgage balance to exceed the home, as a non-resource loan, is actually similar to a mortality credit). And ultimately, annuities are priced based on available bond interest rates and mortality tables, while the reverse mortgage tenure payments are calculated based on a fixed age-100 life expectancy (to be conservative about not 'overpaying'), and an interest rate that is a combination of the 10-year LIBOR swap rate plus a lender's margin and a 1.25% mortgage insurance premium. So what happens when all of these factors are blending together? As it stands now, reverse mortgage tenure payments are slightly higher than immediate annuity payments (about 7.1% for the former, vs about 6.1% for immediate annuities, for a 65-year-old), and ironically, due to reverse mortgage formulas, lower interest rates actually support higher tenure options (suggesting that if/when as interest rates rise, immediate annuities will eclipse reverse mortgage tenure payments). Overall, then, Pfau finds that tenure payments are best suited for couples who plan to remain in an eligible home, are less risk averse (i.e., more risk-inclined, as the reverse mortgage has more potential to compound problematically), and have shorter life expectancies (and don't want the risk of an early death with an annuity). Additionally, these factors all look even better when interest rates are low.

Loneliness Often Follows Sudden Wealth (Alina Dizik, BBC) - While so many long for accumulating significant financial wealth, the reality is that achieving it, especially very suddenly, can actually be surprisingly isolating. Sudden wealth can disrupt marital dynamics (e.g., if the previously-breadwinner spouse is suddenly no longer the financial driver of the couple), and can stress friendships as well (as unfortunately, some people may become jealous and say or do ugly things). After all, most of us don't exactly spend time thinking about how to prepare and handle the social relationships around us, should sudden wealth occur. And new wealth may attract "new" friends and new closeness from family members, some of whom may simply be congratulatory, while others are seeking to attach themselves to the newfound money, which in turn leads to suspicion by the newly wealthy and yet another reason to pull back and isolate themselves a bit. Furthermore, these are dynamics that occur even if the suddenly wealthy person themselves remains well grounded, which isn't always the case; sometimes the newly wealthy may change their own behaviors, engaging in reckless spending or suddenly disengaging from previous interests, which in turn can create a rift with their existing social network of friends and colleagues. Even for those who don't specifically mean to isolate themselves, the freedom of newfound wealth and a desire to enjoy it can still lead to friction; for instance, most people can't say "let's go on a vacation to Mexico tomorrow", but a suddenly wealthy person really might have that option (but no one to enjoy it with). The end result: often the suddenly wealthy end out cultivating relationships with other entrepreneurs or wealthy people (where they already have their own money, so there's less fear or suspicion about ulterior motives), or end out focusing time on a smaller circle of friends who have been determined to be 'real' friends despite the wealth (but with whom the wealth can reasonably be enjoyed).

Why Financial Planning Research Doesn't Matter [And What To Do About It] (Brad Klontz, Journal of Financial Planning) - Many financial planners complain that academics rarely do research that's relevant to us as financial planning practitioners... yet Klontz points out that it's the sheer disinterest from practitioners that may be dissuading academics from developing and presenting research to/for them in the first place. After all, academics are human beings too, and when even actual breakthrough research is more celebrated by other academics than practitioners, is it any wonder that many in the academic community have been unenthusiastic about working with and for the needs of practitioners? Notably, the reality is that in other disciplines, there is a clearer practitioner-researcher link; in fact, Klontz points out that in the field of clinical psychology, the practitioner-scientist model is common, where even practitioners are trained in both doing and consuming research (as how else would we know if an intervention for patients is effective or not!?), though even in psychology there's often a struggle to generalize laboratory research to real-world settings. Fortunately, though, the academic-practitioner gap is starting to narrow, from articles in the Journal of Financial Planning itself (a peer-reviewed research journal that targets practitioners), to the academic research track at the FPA BE conference, and the upcoming CFP Board Research Colloquium. That being said, Klontz offers several additional recommendations to further bridge the gap: Academics need to "leave campus" and focus less on studying college students (the common test subjects for so much academic research) and focus more on the types of clients that financial planners typically serve; the research does still focus too much on individual personality (traits of individuals about their money/wealth and associated behaviors), rather than the actual practice of financial planning (and what practitioners should do to impact those individual personalities in a positive way); and both practitioners and academics need to spend more time together, as the actual number of practitioner-academics is relatively rare, and is exactly why events like the FPA's Academic Track and the CFP Board's Colloquium are so important for advancing the research and the practice of financial planning.

1% For You Is 100% For Them (Aaron Klein, Medium) - Recently, Klein bought a tuxedo, as he has enough formal events in the near future that it made sense to buy the tuxedo, rather than just rent it. And on his way out of the store from this very formal purchase, the salesman shook his hand and said "you're gonna look good." Which Klein notes is a somewhat odd thing to say – as a salesman selling a tuxedo for a high-end formal event, it would seem more appropriate to say not "good" but "great" or "amazing" and talk up the excitement of the upcoming event. Of course, it's possible that the salesman had simply been saying "you're gonna look great" all day, and that it felt natural to mix in a "good" for a change of pace. But from Klein's perspective as the consumer, what the salesman may have said 60 times that day was still the one and only interaction with him. In other words, that one moment was 100% of the customer experience for that particular customer. And it's an important issue to remember, especially in a service business. You and your team may have dozens of interactions with current and potential clients every day, but for most of them, that's their only interaction with you. Which means changing up an excellent process, even once, might feel like a refreshing change of pace for the provider, but risks undermining the once-and-only experience for the client that day. Or stated more simply: make every customer experience count, because from the customer's perspective, that interaction is their entire experience.

I hope you enjoy the reading! Please let me know what you think in the comments below, and if there are any articles you think I missed that 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. 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!