Executive Summary
Enjoy the current installment of “Weekend Reading For Financial Planners” – this week’s edition kicks off with a (Twitter-based) breakdown of the final text of President Biden’s latest “Build Back Better” Act, which is perhaps more notable from a financial planning perspective for what parts of the previously proposed tax legislation it doesn’t include (forgoing increases to the top marginal ordinary income and capital gains tax rates, restrictions on IRA contributions and Roth conversions for high earners, and reduced estate tax exemptions), than what it does (such as applying new surtaxes to income over $10 million and $25 million, and subjecting S corporation profits to 3.8% Net Investment Income Tax for high earners)… though still more changes could be in store, as Congressional Democrats debate raising or eliminating altogether the State and Local Tax deduction limit as part of the final comprehensive budget bill.
Also in the industry news this week:
- Democrats introduced the Social Security 2100 Act this week, which would increase Social Security benefits for almost all recipients, while also raising tax revenue by applying FICA taxes to incomes above $400,000, to stave off the projected depletion of the Social Security Trust fund
- The SEC released a Risk Alert highlighting deficiencies regarding everything from fee calculations to marketing disclosures on various ETFs and mutual funds (albeit mostly smaller ones that are marketed toward and used by retail investors, not advisors)
From there, we have several articles focusing on inflation, including:
- Why the U.S. is not likely to be facing hyperinflation, despite increased speculation to the contrary as ‘regular’ inflation has ticked higher
- How today’s economy differs from the high-inflation and low-growth stagflation era of the 1970s
- An analysis of how stock returns have (or, in practice, really have not) correlated with inflation over time
We also have a number of practice management articles, including:
- How ‘scope creep’ causes advisors who charge fixed fees to end up doing more work for the same fee (and what to do to avoid it)
- How client segmentation is often recommended to improve efficiency, but can actually restrict a firm’s growth if there are too many client segments
- A case study of a financial advisor who charges a moderate ($1,000/year) annual retainer fee to provide ‘factual’ financial education on demand (but not more expensive, personalized advice)
We wrap up with three final articles around the theme of financial advisor business models:
- How the increased number of functions that TAMPs perform for financial advisors (and the reality that not all TAMPs perform the same functions anymore) may be making the term ‘TAMP’ obsolete
- Why, despite competition from independent channels and fee-only RIAs, the number of large wirehouse brokers has stayed fairly constant (while their assets under management have actually increased)
- How the SEC has failed to keep up with the “Great Convergence” of the financial product sales and advice industry, and why it needs to clarify who should be permitted to hold themselves out as a financial advisor
Enjoy the ‘light’ reading!
Authors:
Breaking Down The Final Version Of The Build Back Better Act (Jeffrey Levine, Twitter) - On Thursday, the U.S. House of Representatives released the final text of the Build Back Better Act, mirroring a new framework announced by the Biden administration earlier that day. Over the course of six weeks of negotiations, the bill was significantly scaled back from the proposed version that was released by the House Ways and Means Committee in September, to secure the votes of moderate Democrats needed for the bill’s passage. Among the items in that version that did not make it into the final text were increases to the top ordinary income and capital gains tax brackets, restrictions on Roth contributions or conversions for high-income earners (meaning that – at least for now – the ‘Backdoor Roth’ strategy is preserved), new RMDs on mega-sized IRAs, reductions to the estate and gift tax exemption, and rules curtailing the use of grantor trusts. The tax increases that are in the bill mainly apply to specific high-income individuals: for example, the bill would make S corporation profits for individuals earning over $400K (single filers) and $500K (married filing jointly) subject to Net Investment Income Tax (NIIT), and all Modified Adjusted Gross Income (MAGI) over $10MM would subject to a new 5% surtax (with an additional 3% surtax for MAGI over $25MM). Among the bill’s other tax-related provisions are an extension of the expanded Child Tax Credit and monthly prepayments of the credit through 2022 (though an extension of the expanded Child and Dependent Care Credit was left out of the bill), expanded Affordable Care Act Premium Tax Credits, establishing a new hearing benefit for individuals covered by Medicare, and applying wash sale rules to cryptocurrency assets (which could previously be sold for a loss and immediately rebought while capturing a tax deduction for the loss). And while the bill notably does not include any of the much-discussed changes to the current $10,000 State And Local Tax (SALT) deduction limit, this provision could conceivably still be added before the bill’s final passage. Ultimately, compared to the originally proposed version of the bill, the final version gives financial advisors a little more breathing room to discuss potential strategies with clients who could be affected, as the most significant and immediate provisions of the original proposal – such as the top capital gains rate increase and new grantor trust rules – have been eliminated from the final version. Still, though, this version of the bill seems likely to be close to the one that Congress will vote on, given how many proposed additions have come and gone in recent weeks (like the short-lived Billionaire’s Tax proposal), it would not be surprising to see a few more changes in the final stages of negotiating before the bill ultimately becomes law.
Congress Has A New Plan To Fix Social Security: The Social Security 2100 Act. Here's How It Would Change Benefits (Lorie Konish, CNBC) - The condition of the Social Security Trust Fund has recently received a lot of attention following the release of the Social Security Trustees Report that estimated, based on current projections, that the trust fund would be depleted by 2033 (one year earlier than estimated in the previous report). Just under two months after the release of the report, Democrats in the U.S. House of Representatives have introduced a reform bill titled the Social Security 2100 Act, which would both increase benefits for current Social Security recipients and attempt to strengthen the trust fund to remain solvent until at least 2038. For current recipients, the proposed legislation would increase all benefits by about 2%, set a minimum benefit of 125% of the federal poverty line for lower-income workers whose benefits would otherwise be less than this amount (which would equal $16,100 for a single person or $21,775 for a two-person household), and tie cost-of-living-adjustments to the Consumer Price Index for the Elderly (CPI-E), which could lead to higher annual adjustments (due to, among other factors, a higher weight towards medical expenses) than the current formula. The bill also contains many items that will be of interest to financial advisors, such as elimination of the Windfall Elimination Provision (WEP) and Government Pension Offset (GPO), which currently reduce benefits for some retirees with government pension payments, and an increase in the income thresholds above which Social Security income is at least partially taxed, from $25,000 to $35,000 for individuals and $32,000 to $50,000 for couples. Meanwhile, to pay for the higher benefits and address the trust fund issue, the bill would impose Social Security payroll taxes on earnings over $400,000 (creating a ‘donut hole’ where earnings between the current Social Security wage ceiling of $142,800 and the new $400,000 threshold would still be free from Social Security tax). While the proposed changes would be significant – both for retirees currently receiving benefits as well as workers (particularly high earners) paying into the system – the bill has a long road ahead to becoming law and, given the ongoing negotiations on the Build Back Better and infrastructure bills as well as another debt ceiling debate on Congress’s schedule before the end of the year, there may simply not be enough time in this year’s session to debate on and pass the bill.
SEC Risk Alert Highlights Flawed Disclosures By ETFs And Mutual Funds (Melanie Waddell, ThinkAdvisor) – In November 2018, the SEC announced that it would be conducting examinations on mutual fund and ETF companies to assess “industry practices and regulatory compliance in certain areas that may have an impact on retail investors.” In a Risk Alert issued this week, the SEC released the results of those examinations, as well as its own observations on the issues it encountered. After examining 50 fund complexes (i.e., a group of mutual funds managed by the same company) covering over 200 funds and nearly 100 advisors to funds, the SEC found that some funds had inadequate compliance policies and procedures in place for their investment management and trading processes (like monitoring the concentration and risk of the fund’s investments and seeking best execution for trades within the fund), as well as managing conflicts of interests (such as when an advisor to an index fund also creates and licenses the index itself), calculating fees and reviewing fee calculations for inconsistencies with fund literature and disclosures, and providing appropriate disclosures in advertising and sales literature about the funds’ potential risks and any changes to the fund’s investment strategy that could potentially create a misleading perception of the fund’s historical performance. Notably, though the SEC notes that it sent deficiency letters to some funds, and that many funds revised their policies and procedures in response to the examinations, the Risk Alert does not name the specific funds that had issues, nor does it give any indication of whether the issues it found were widespread or concentrated among a few funds. However, the report does note that the examinations focused on certain types of funds (like those that track custom-built indexes and smaller or infrequently traded ETFs) that are more commonly used by retail investors, meaning that larger, more established funds that financial advisors are more likely to recommend were probably not included. Still, the examinations serve as a reminder that, as retail investing has exploded in popularity in recent years, investors ought to be extra-cautious in their due diligence of funds that have sprung up to capitalize on the trend.
Why Hyperinflation Might Not Be Coming (Cullen Roche, Pragmatic Capitalism) - Inflation in the United States has been on the rise, with overall prices increasing by 5.4% on an annualized basis in September. This has led to some speculation that hyperinflation – generally agreed to be a continuous increase of 50% or more in the rate of inflation – could be on the horizon. But according to Roche, hyperinflation tends to occur when governments print money after major geopolitical events, such as in countries that lose a war, have large foreign-denominated debts, or have a major regime change. And the United States is not facing these kinds of events that could lead to hyperinflation. However, Roche thinks that the Federal government’s pandemic-associated fiscal stimulus (and pandemic-related supply chain issues) could lead to relatively high inflation, at least into mid-2022. However, at that point, improving supply chains, and a fiscal headwind caused by the wind-down of pandemic-related government spending, will drive inflation lower. In the longer term, Roche thinks several factors are likely to keep U.S. inflation low, including an aging population, improvements in technology, inequality (because higher-income individuals tend to spend a smaller percentage of their income than do lower-income individuals), and globalization. But while hyperinflation might be unlikely, even moderate inflation can impact client spending (perhaps without them even realizing it!) and financial advisors can consider whether retired clients might need to increase the amount transferred to their checking accounts on a monthly or annual basis.
Are We Living In A 1970s-Style Economy? (Robin Powell, The Evidence-Based Investor) - Americans have experienced a period of relatively modest inflation and economic growth for the past 30 years. Of course, economic conditions have not always been this way, as America in the 1970s experienced ‘stagflation’, a damaging combination of stagnant economic growth and high inflation. Like the 1970s, inflation today is on the rise in the United States, driven in part by a surge in energy prices. At the same time, the pandemic’s Delta wave and slowing government spending could stymie previously lofty growth projections. And the combination of both raises the specter of low-growth, high-inflation ‘stagflation’ once again. However, amid these other factors, inflation expectations are likely to be the determinant of whether inflation remains high or returns to pre-pandemic levels. But if price increases lead to higher wages, which then lead to higher prices – known as a wage-price spiral – then the Federal Reserve might be tempted to withdraw monetary stimulus and slow the process. Furthermore, an October International Monetary Fund report suggests such a ‘wage-price spiral’ is simply unlikely to occur. Also, Powell cites several key differences between the 1970s and today that could further dampen inflation expectations, including declining labor power (potentially limiting wage increases that could drive inflation higher in a wage-price spiral), and the transition away from fossil fuels (reducing reliance on energy sources with high price volatility). Still, while pundits might not be expecting a period of sustained high inflation and low growth, advisors could consider whether they have clients who experienced the stagflation of the 1970s, and therefore might be more sensitive to increased inflation. In addition, even ‘just’ higher near-term inflation could negatively impact recently retired clients, who are particularly susceptible to sequence of return risk (where higher inflation, even if only in the early years, still lifts their required spending for all of their retirement years to follow).
How Inflation Does [Or Doesn’t] Impact Stock Market Returns (Ben Carlson, A Wealth Of Common Sense) - With inflation increasing during the past several months, some investors might be concerned that inflation could eat away at the purchasing power of their portfolios if they do not receive sufficient returns from their investments. Also, this could be a particular issue for retirees, who do not stand to benefit from wage increases that often come alongside increased inflation. For those invested in U.S. equities, though, there has been no clear pattern between the returns on the S&P 500 index and the rate of inflation during the past century. In fact, the index has returned an average of 9.4% in years when inflation was as high or higher than it is currently, which is quite close to its long-term average return (although inflation-adjusted returns in these years were lower). The logic behind this trend is that, during inflationary periods, companies have maintained profits by raising prices on consumers in response to higher input prices. For example, in the 1940s and 1970s, two periods of high inflation, companies saw higher revenue growth (from higher prices) in addition to higher wages (as workers demanded higher incomes to keep pace), which combined still led to some of the highest earnings growth on record. The end result may not beat the grind of inflation, but it does at least help to ensure that equity returns tend to keep pace with inflation. In addition to the potential strength of equities in an inflationary period, advisors seeking inflation hedges could use Treasury Inflation-Protected Securities (TIPS), or Series I Bonds, which include an inflation-adjusted rate of return and special tax treatment. This could also be a good time to encourage clients waiting to invest significant cash holdings to get invested, given that cash is the asset class that tends to be most consumed by declining purchasing power due to inflation!
Scope Creep: The Number One Problem In Fixed Fee Advice (Tony Vidler) - The ongoing fixed-fee financial advice model can be beneficial for financial advisors and their clients: for advisors, the approach provides more certainty of business cash flow (as compared to the AUM model, where revenue can vary greatly depending on market volatility), and allows advisors to focus on delivering ongoing value rather than searching for new clients (as compared to the hourly model, where engagements tend to be on a one-time basis and there is a more constant grind to always find the next new client). For clients, this fixed-fee model provides cost certainty and transparency, while splitting the payment for the advisor’s services into smaller portions that might be more palatable than a larger single payment for a one-time engagement. However, one issue that can arise with fixed-fee arrangements is that the ongoing fee is typically calculated based on the original scope of that engagement… but the nature of ongoing advice means that the scope of work may change as client’s needs evolve, which means that, unless a new engagement is agreed upon, the originally-agreed-upon fee can eventually drift out of alignment with the services the advisor is providing as the relationship evolves. When this happens, the advisor has a choice to make: either continue to escalate the ‘scope creep’ and ratchet up the work above and beyond the fee they are being paid (at the risk of confirming in the client’s mind an expectation what was once ‘above and beyond’ is now normal), or communicate with the client to reinforce the original scope of work and remind them when the advisor is doing more than that. Because, while it isn’t necessarily a bad thing to do extra work for a client on occasion – indeed, such actions can create goodwill and further improve the advisor-client relationship – doing so without proactive communication can create and reinforce unrealistic expectations of additional work without higher fees… and ultimately lowering the value of the advice in the client’s mind as the single ongoing fee encompasses more and more work.
Client Segmentation: Why Clarifying And Limiting Our Business Actually Helps It Grow (Jennifer Goldman) – Many financial advisors and consultants advocate client segmentation – the practice of dividing a firm’s clientele into groups based on the level of service provided to each – as a way for a firm to serve different types of clients more efficiently by matching the demands each client makes on the firm’s capacity to the fee it pays. But this is often more easily said than done, because actually identifying and developing the client segments that work best for the firm can itself be a demanding process. Because, in essence, every additional client segment can (and perhaps, should?) be thought of as a separate business model within the firm, each with its own needs for staffing, technology, marketing strategies, and service models. Furthermore, the firm needs to decide on the fee structure for each segment that best reflects the value received by those clients. As a result, firms that segment their clients with the goal of serving those clients more efficiently could end up adding more staff in order to serve their multiple segments, which can ironically make the firm less efficient if the additional staff results in lower profitability per client… which is exactly the opposite of the intended result of client segmentation! Ultimately, firms considering client segmentation need to decide whether it is truly in the best interests of the firm and its clients, or whether other strategies (such as offboarding clients that are not an ideal fit for the firm, instead of trying to have an alternative ‘downscale’ segmented offering for them) would be better options. Because the decision to segment clients should be driven by the firm’s desire and capacity to deliver its clients the best possible service at every level, and the fewer segments the firm serves, the better service it can deliver to its ideal targets without adding additional capacity, and the less demanding that service will be on the firm’s resources and employees.
The Adviser Trialling An Admin Support Retainer For $1,000 Per Year (Tahn Sharpe, Professional Planner) - Many people hire financial advisors because of the high value of personalized, professional advice, and are willing to pay the fees for that advice because they find it to be worth the value that they receive. Others, however, may have less of a need for individualized advice – or may not need it on an ongoing basis – and are therefore unwilling to pay ‘full freight’ for an ongoing engagement… but they may still value having a reliable source of information for financial questions that come up in their everyday life. There is a potentially large market of people currently unserved by financial advisors who do not need comprehensive financial planning, but may nevertheless be willing to pay a smaller fee for access to a professional on-demand who can give them more direct and reliable factual information than a Google search can provide. With this untapped market in mind, one advisor in Perth, Australia has launched an ‘admin-only support’ service where clients pay a retainer of $1,000 AUD per year for access to on-demand ‘factual information’… with the caveat that the arrangement covers only general (and not personalized) information that is “objectively ascertainable” (i.e., does not include any specific recommendations or opinions). While the service is still in its infancy (and regulatory questions could potentially hinder it in the United States, depending on how blurry the line between ‘information’ and ‘advice’ becomes), it could represent a way for advisors – particularly those more interested in sharing their own ‘nuts-and-bolts’ financial knowledge to educate, rather than building and developing full financial plans – to reach a potentially large market of people who value (and can pay for) factual information but don’t feel the need for (a more expensive) ongoing comprehensive advice relationship?
Why ‘TAMP' Is No Longer A Useful Term (Scott MacKillop, Advisor Perspectives) - Comprehensive financial planning entails a wide range of responsibilities, from retirement planning to risk management and investment planning. Many financial advisors would prefer to outsource the often-time-consuming portfolio management responsibilities to have more time to focus on the other aspects of the planning process. For these advisors, Turnkey Asset Management Programs (TAMPs), which traditionally allowed advisors to outsource all aspects of investment account management and administration to an outside company, have been a useful tool since their creation in the 1990s. Since then, the number of TAMPs, and the services they offer, has expanded to the point where MacKillop suggests the term TAMP is no longer useful (and is a bit of confusing jargon for both clients and advisors). In addition, MacKillop (the CEO of the TAMP First Ascent Asset Management) argues that what many companies referred to as TAMPs do not even provide the full-service solution the term originally implied. As a result, MacKillop instead suggests a new range of terms that more specifically describe the functions these companies perform, including “full-service portfolio management platforms” (firms that provide both model portfolio solutions and ancillary support services); “customizable portfolio management platforms” (which provide portfolios with input from the advisor); “portfolio strategists” (asset management firms that offer its portfolios through a platform or model marketplace); “model marketplaces” (firms that give advisors access to model portfolios but leaves selection and implementation up to the advisor); and “managed account technology infrastructure providers” (firms that enable enterprises to offer outsourced portfolio management programs to their affiliated advisors). Whether or not MacKillop is successful in his quest to provide more specificity to the wide range of TAMP-like services available, the point remains that there is an ever-widening range of TAMP (and TAMP-like) services to choose from, which means advisors considering whether to use the services of a TAMP in the first place do need to get clearer on what they’re really looking for in order to know which offering to choose!
Why The Wirehouse Advisor Is Still Alive And Kicking (Timothy Welsh, ThinkAdvisor) - The wirehouse model – where large brokerage firms have affiliated branches and advisors operating nationwide – has faced a torrent of negative developments in recent years. From the growth of discount brokers, to the 2007-2009 financial crisis, to the increased options their representatives have to go independent, pundits have called for the death of the wirehouse model. Yet, despite these factors the wirehouse channel continues to grow, going from $8 trillion in 2018 in assets under management to over $12 trillion in 2020, and the total number of wirehouse brokers has continued to hover around 50,000 for years (while the ‘breakaway broker’ movement is still only measured by the ‘dozens’ who leave every year, amounting to barely 0.2%/year who leave for independence!). Welsh credits the wirehouses’ ability to adapt over the years for their resiliency. When faced with discount brokers, which dramatically reduced transaction costs and new options for independent advisors who wanted to unbundle advice from product sales, the wirehouses developed the ‘wrap account’ model, combining investment advice and management for one fee. This ‘fee-based’ model was confusing for consumers, but a boon for the wirehouses in staying competitive with the shift from commissions to AUM model. The slower-moving wirehouses also faced a technological disadvantage from the more agile independent channel, but have improved on this front as well, as seen by the digital offering from Merrill Lynch’s Merrill Edge and Morgan Stanley’s acquisition of E-Trade. Some wirehouses have also taken steps to improve the quality of life for employees, from banning trainee brokers from making cold calls to shifting to a salary-based, rather than commission-based compensation model. And so, while fee-only independent models in the RIA channel do continue to attract former wirehouse brokers, the wirehouses’ history of adapting to challenges suggests that their anticipated demise continues to be overstated, and that they will remain a powerful force in the industry for many years to come.
Has The SEC Abandoned Consumers? (Bob Veres, Advisor Perspectives) - According to the Securities and Exchange Commission (SEC), parts of its mission are to protect investors and promote a market environment that is worthy of the public’s trust. Over the past century, the SEC has taken a variety of actions to help investors understand the types of financial professionals they are dealing with and what kind of activities these individuals can perform. The basis for many of the SEC’s actions is the Investment Advisers Act of 1940, the rationale for which, Veres argues, was to protect the public from the marketing encroachments of the financial services industry. In particular, the legislation sought to separate consumer-focused advisors providing advice, from brokers focused on the sale of financial products. However, as the financial product sales and advice industries (and the titles financial professionals use) have evolved and converged over the years, Veres suggests that the SEC has not kept up. With this in mind, Veres endorses two petitions for rulemaking filed in September with the SEC by the XY Planning Network that call on the regulator to clarify who exactly should be permitted to hold themselves out as a financial advisor, and when an individual should be required to use the title of broker versus (investment or financial) adviser. And so, Veres sees the petitions as an opportunity for the SEC to leverage the 1940 Act to issue rules that will clarify for today’s consumers whether the financial professional they are working with is truly in the business of advice (which has a natural fiduciary obligation to clients), suggesting that the SEC should act if it truly wants to live up to its own mission of protecting investors!
I hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think I should highlight in a future column!
In the meantime, if you're interested in more news and information regarding advisor technology, I'd highly recommend checking out Craig Iskowitz's "Wealth Management Today" blog, as well as Gavin Spitzner's "Wealth Management Weekly" blog.
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