Weekend Reading for Financial Planners (Sep 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 September 12th/13th:

Advisor M&A on a Tear in 2015 (Jamie Green, ThinkAdvisor) - According to the latest study from Schwab Advisor Services, the pace of Mergers and Acquisitions (M&A) for independent RIAs is on a tear this year, with 37 major deals (more than $50M in AUM acquired) in the first half of 2015 (compared to only 29 last year) and total AUM acquisitions of almost $50B (compared to only $33B in 2014). And although the average deal size now up to a whopping $1.3B in AUM, the acquisition deals ran the gamut in size, and more than 2/3rds of them were for firms below $1B of AUM. Though in general, interest seems to be growing for firms that have more fully institutionalized their business model (which tends to be of greater interest for buyers, is associated with higher sales multiples for sellers, and is most commonly found in larger firms). In terms of the buyers, the market continues to be approximately 40% acquisitions by other RIAs, another 40% acquisitions by 'strategic acquirers', and the remaining 20% a mixture of banks, international acquirers, and other categories. Notably, though, Schwab Advisor Services still points out that the "vast majority" of RIA firms are still not looking at M&A as their preferred succession or exit strategy, and that such deals are still the 'second option' alternative to accomplishing an internal succession plan instead.

ETF Makers Mostly Have $500M+ RIAs To Thank For Growth (Lisa Shidler & Brooke Southall, RIABiz) - A recent study by Broadridge Financial Solutions finds that RIAs added a whopping $496B in ETF assets over the past 12 months (ended June 30th), outpacing the larger (by total AUM) wirehouse channel that added only $397B to ETFs last year. And within the RIA community, the largest holders of ETFs are the small subset of the largest RIAs with over $500M of AUM, that are using ETFs for their equity exposure (equity-based ETFs represented 88% of the net increase in total ETF assets, while fixed-income ETFs experienced only a 15% net increase, and commodity ETFs assets used by RIAs were actually in net decline over the same period). Notably, though, the research finds that smaller RIAs tend towards using mutual funds over ETFs, ostensibly because large firms construct their own asset allocation portfolios using ETFs, while smaller advisory firms are relying on mutual funds to serve that diversifying and portfolio construction role. Though even in the mutual fund context, the research notes that RIAs are also in the lead over broker-dealer wirehouse channels, which are more likely to use separately managed accounts in lieu of mutual or exchange-traded funds. In the meantime, the article also notes that if the DOL fiduciary proposals come to pass, driving down the level of commission-based activity and driving more advisors towards fee-based AUM pricing (an environment that favors cheap ETFs upon which advisors may add their own fees), the potential for the ETF marketplace looks poised for continued growth.

8 Issues to Address in Your Advisory Contracts (Chris Stanley, ThinkAdvisor) - Investment advisory contracts must meet certain requirements under Section 205 of the Investment Advisers Act regarding types of permitted and prohibited compensation, but Stanley notes that they are also important legal contracts simply for defining the roles and responsibilities between the advisor and client. Accordingly, there are actually a number of key "boilerplate" provisions and clauses that should prudently be included in any investment advisory contract, including: Entire Agreement (the agreement only includes anything actually written in the agreement, thus avoiding disputes based on oral agreements that one side late denies); Waiver (even if one party doesn't pursue the other for a breach in one instance, they reserve the right to dispute the contract if that breach occurs again in the future); Counterparts (if the advisor and client do not physically sign the same copy of the contract, the respective signed copies are still deemed part of a single contract [or just use a digital signature service and it's a moot point!]); Notices (requirements to notify the other party in the event of a termination, dispute, etc.); Severability (a breach in one part of the contract does not render it entirely void); Successors and Assigns (should one party die or have a succession/transition event, what provisions of the contract do/don't apply to the alternative party?); Force Majeure (if the contract is disrupted due to an extreme act of God, the other party gets a reasonable break!); Governing Law (if there's a dispute, in which state's courts will it be resolved?). Ultimately, of course, an advisory agreement should be further customized to the specifics of a particular advisory firm, but Stanley emphasizes that such customizations should only occur after these important 'boilerplate' protections are in the contract first!

Treasury Dept. Proposes AML Rule for Registered Investment Advisers (Kenneth Corbin, Financial Planning) - The Treasury Department's Financial Crimes Enforcement Network (FinCEN) recently expressed concern that the current exemptions from Anti-Money-Laundering (AML) rules for registered investment advisers (RIAs) may have created a 'loophole' that criminals and terrorists could exploit to move money through the U.S. financial system. Accordingly, FinCEN is looking to extend AML provisions (currently a part of the Bank Secrecy Act) to SEC-registered investment advisers, including those working with certain hedge funds and private equity funds. The proposal would require affected advisors to begin filing currency transaction reports to log the movement of money through clients' accounts, and submit suspicious activity reports to Federal authorities (with the SEC responsible for oversight on whether RIAs are complying with the rules). For the time being, RIAs would not be required to maintain a formal customer identification program for AML purposes, although FinCEN indicating requirements for such a requirement could also be coming in the future. In response to the proposal, the Investment Adviser Association raised concerns that the depth of the requirements could be quite burdensome for RIAs (especially smaller firms), and noted that given AML procedures already in place at banks and broker-dealers, it's not clear how helpful an additional layer of rules for RIAs would really be. At this point, the proposal is simply that - a Notice of Proposed Rulemaking filed for public comment - and it still remains to be seen whether or how FinCEN will move forward; concerned advisors can participate but submitting a public comment (the comment period closes on November 2nd).

A Message From the SEC—Listen Up! (Tom Giachetti, Investment Advisor) - Recently, a large independent RIA with over $1B in AUM and in operation for more than 25 years received a whopping $150,000 fine from the SEC, along with a 12-month suspension from compliance or supervisory duties for the firm's president, who was also assessed a personal $45,000 fine. And notably, the fines were not a result of any discoveries of direct client harm, but simply the fact that the firm had willfully failed to engage in proper compliance processes. In fact, the firm's president had declared that since the firm's primary responsibility was serving clients, that the next time the SEC came to audit the firm, it would simply respond to and comply with the SEC's concerns at that time; accordingly, the firm knowingly left the Chief Compliance Officer with inadequate resources (and almost no training) to execute the CCO role. Yet when the SEC arrived, it was deeply troubled by the fact that firm employees were not pre-clearing trades with the CCO, that employee personal transactions and holdings weren't being collected/tracked, that there was no evidence of best execution reviews, nor any process to ensure compliance with the firm's Code of Ethics. Ultimately, the only actual client-harm scenario discovered were that certain clients were in investor share classes of a mutual fund when they were eligible for (and should have been in) institutional share classes. But the fact that the firm wouldn't have even known if bigger problems were afoot, because it was not executing its compliance oversight duties, led the SEC to levy its substantial punishment in fines and suspension. The bottom line point: from a compliance perspective, it's not just about doing the right thing for the client, but also about being able to document and prove that the right things are being done for clients, rather than just taking it on faith that every employee is always fully compliant and risking being unaware if a problem is actually occurring.

QLACs: A New Tool For Retirement Income (Mark Miller, Morningstar) - A deferred income annuity (DIA) is a form of annuity that retirees buy at or near their retirement age (e.g., age 65 or 70) with payouts that begin much later (e.g., at age 80 or 85), with payouts typically continuing "for life" thereafter (however long it may be). The purpose of using DIAs is to gain some additional "leverage" in lifetime annuity payments by creating a waiting period before they begin; for instance, $100,000 buys an immediate annuity paying $7,704/year of lifetime income for a 70-year-old male, but nearly twice that amount or $15,457/year if the payments aren't scheduled to begin until age 80 instead (and the $100,000 principal is returned if the buyer doesn't survive the time period). In the context of retirement accounts, DIAs have presented a conflict - payments might be delayed until age 80 or beyond, but normally Required Minimum Distributions must start at age 70 - so last year the Treasury issued new rules for "Qualified Longevity Annuity Contract" (QLAC) solutions that can be owned for up to 25% of an IRA or 401(k) plan and not run afoul of the RMD obligations. Notwithstanding the Treasury's implied blessing, though, DIA sales (including QLACs) have been sluggish (as predicted on this blog last year when QLACs were first made available), at only $551M in the second quarter of 2015, down 23% from the year-earlier period and a miniscule fraction of the $7.4 trillion held in IRAs (plu another $6.8 trillion held in defined-contribution employer retirement plans). Notwithstanding the slow adoption by consumers, though, a growing number of academics, as well as policymakers in Washington, are finding that combinations of QLACs (or DIAs in general) plus portfolios may be capable of generating far more later-years' income than a comparable fixed-income portfolio could achieve on its own.

Why 4% Could Fail (Wade Dokken & Wade Pfau, Financial Advisor) - A new white paper co-authored by Wade Dokken of Wealthvest and popular retirement researcher Wade Pfau suggests that the "real" safe withdrawal rate in today's marketplace for today's retirees, after accounting for everyone from the impact of investment costs and today's stock and bond market levels, is only 2.1% for a 30-year time horizon and as low as 1.49% for a 40-year time horizon with a 40% stock allocation (and even those spending targets actually have a 10% probability of failure). Notably, the idea that the optimal safe withdrawal rate may be lower than 4% is also borne out in the international data, where the 4% rule would have survived just fine in some countries (e.g., Canada, Denmark, New Zealand, and South Africa) but failed catastrophically in others (e.g., Italy, France, Belgium, and Germany), but the pessimism of today's environment is amplified by high current P/E levels (which are predictive of lower long-term returns for retirees going forward) and the fact that we simultaneously have especially low bond yields as well. And the combination of lower returns for stocks and bonds, longer time horizons, and the drag of investment costs, all compound in an especially unfavorable manner for retirees, thus leading to the materially lower projected withdrawal rates (even worse than the already-low returns that established the 4% rule), according to the researchers. Notably, though, the study's inflation assumptions result in projected real returns that are even worse than what investors could buy from TIPS bonds today, which suggests the analysis may be unnecessarily gloomy. For those who are interested, the full white paper can be downloaded here (registration required).

What Advisors Need To Know About In-Plan Roth Accounts (Jeffrey Levine, LifeHealthPro) - A "Designated Roth Account (or "DRA") is a separate account established inside of a 401(k), 403(b), or governmental 457(b) plan (including the Federal Thrift Savings Plan) to hold "Roth"-style retirement funds in an employer retirement plan. Yet notably, while a designated Roth account is a "Roth" for most purposes - including that contributions are after-tax and future "qualified distributions" can be tax-free - the rules for DRAs are not identical to Roth IRAs. For instance, since a DRA is a Roth account under an employer retirement plan, it means all the usual employer retirement plan rules do still apply, while can actually be helpful; e.g., loans can be taken from designated Roth accounts under a 401(k) plan but not a Roth IRA, ERISA creditor protection applies to employer-retirement-plan-based DRAs, and employer retirement plans don't limit contributions for high-income individuals the way that a Roth IRA does. On the other hand, while a Roth conversion to an IRA can be recharacterized if the individual changes their mind, there is no such thing as a recharacterization of an intra-plan Roth conversion from an employer retirement plan to its DRA (so be certain you're doing it for the right amount the first time, and/or do if permitted the conversion to a Roth IRA that has more flexibility!). Another notable (and not so favorable) difference is that when taking distributions from a Roth IRA, favorable ordering rules apply that allow after-tax contributions to be withdrawn first (tax-free and penalty-free), but with a DRA under an employer retirement plan, all distributions are pro-rata (so a portion of each withdrawal will be treated as growth, and then potentially subject to taxes as a non-qualified withdrawal and an early withdrawal penalty to boot!). And ultimately, for those who keep their DRA balance into the later years, required minimum distribution (RMD) rules apply to the Roth dollars in the employer retirement plan too (unless eligible for the still-employed RMD exception as a less-than-5% owner of the business); fortunately, though, this outcome can at least be avoided, by rolling over the DRA dollars to a Roth IRA before age 70 1/2. Though bear in mind that for any rollover from a DRA to a Roth IRA, the 5-year clock for distributions to be qualified (i.e., tax-free) is based on the age of the Roth IRA, not the age of the DRA, and it's not possible to carry over the time period from an existing DRA to a Roth IRA.

Brigitte Madrian’s Power Of Suggestion And How It Improved Retirement (Michael Finke, Research Magazine) – In 2001, Dr. Brigitte Madrian published a now-famous paper in the Quarterly Journal of Economics entitled “The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior” that provided the first empirical evidence that automatic enrollment into 401(k) plans has a tremendous impact on participation and retirement savings. At the time, the reigning presumption was that making employees enroll by default would be ‘irrelevant’, and that the rational employee who wanted to save for retirement could/would simply enroll themselves and save as desired; as a result, even many of Madrian’s own (economic) colleagues were not supportive of the research. Yet it was hard to explain away what the data clearly showed: employees overwhelmingly do follow whatever default savings rate and investments are set by the employer. The finding was so strong, that within just a few years, the Pension Protection Act of 2006 enshrined the research into law by opening the door for automatic enrollment into employer retirement plans. And despite some ongoing criticism about whether the auto-enrollment approach is too paternalistic, subsequent research on the behavior of savers in the nearly-10-years since the law are further affirming that younger workers participating through automatic enrollment really are saving more than their predecessors did at similar ages (although now questions have arisen of whether the default savings rates were actually set too low and should have been even higher!). This past month, Madrian received the 2015 Achievement in Applied Retirement Research Award from the Retirement Income Industry Association (RIIA) in recognition of the impact of her research in this area.

The Retiring Advisor (Mitch Anthony, Financial Advisor) – The conventional view of retirement is that most/all of us should cease working at some specified age (e.g., age 60 or 65), and that the primary function of our working years is simply to save and accumulate enough to make that transition a reality. Yet a growing base of research suggests that retiring, particularly based on an arbitrary age target, may not really be such a good idea – not because of the financial issues, but the emotional and personal fulfillment that comes from engaging in meaningful activity (“work” in its best sense). And the issue is not just a matter of what advisors counsel their clients in working towards retirement, but also whether advisors themselves should retire in the first place. In fact, Anthony suggests that because financial advising itself can be such an emotionally and psychically rewarding career that most advisors should probably never fully retire, but just keep dialing down their hours to a minimum of no less than 8 hours per week (which ensures that at least 5% of the advisor’s waking hours are still being spent in the fulfilling work of serving clients). And of course, the reality is that an advisor who still works into later years, in a profession that is very lucrative, has the opportunity to earn into their later years as well. So as the average age of advisors comes ever-closer to the “traditional” retirement ages of 60-something years old, perhaps it’s time to question whether advisors should be eschewing the retirement concept altogether… and in the process, perhaps setting an interesting example of what retirement “should” be for their clients as well?

When An Advisor’s Job Crosses Into Unknown Territory (Bob Veres, Financial Planning) – While clients begin to work with an advisor for a wide range of reasons, virtually all of them can ultimately be tracked back to some kind of personal or financial transition, which leads the client to a pain point for which they decide they need professional advice and support. Yet despite the fact that virtually all advisors gain clients at the time the client is going through a major life transition, there is remarkably little training for financial planners in how to actually help clients navigate through them! Until now, thanks to Susan Bradley’s “Sudden Money Institute”, an organization that started out in training advisors how to work with clients who experienced “sudden money” events (e.g., sale of a business, winning the lottery, major life insurance payout, etc.), but now has expanded into training advisors to help clients through any range of major life transitions. In fact, the organization has now rolled out a “Certified Financial Transitionist” designation, which is granted to advisors who complete a yearlong curriculum focused on how to help clients navigate difficult transitions (which starts by showing clients how to triage through decisions by sorting them into three categories: decisions that must be made immediately, those that can be put off but only temporarily, and those that really don’t need to be processed until later after they have time to stabilize). The underlying philosophy of the program is that while technical expertise may be necessary to address client problems, the reality of helping people manage change is that it’s really all about helping clients sort through emotional stages first. For the time being, Sudden Money’s “Certified Financial Transitionist” (CFT) designation is effectively a post-CFP program for experienced practitioners to gain more education about how to better work with clients… although arguably, its framework might eventually become part of the core training that all practicing financial planners go through in the future!

The Evidence-Based Financial Planner (Dave Yeske, Journal of Financial Planning) – For most of the history of financial planning, the professional “best practices” that have emerged have typically been based not on a rigorous process of scientific validation, but on tradition and intuition. And Yeske suggests that this is a serious problem for the advancement of financial planning as a profession, and that it ultimately needs to engage in a more robust dialogue between practitioners and academics (and that practitioners themselves need to better learn how to identify, evaluate, and implement the findings of research-based writing). Accordingly, Yeske notes that the FPA has been forging a partnership with the Academy of Financial Services (the oldest association devoted to the interests of financial planning educators and researchers), and created a new “FPA Theory in Practice” Knowledge Circle to further facilitate conversation. And of course, the Journal of Financial Planning (available through the FPA) itself is one of the longest-standing publications dedicated to advancing research in financial planning. Yeske has also created a new college level short course for advisors, entitled “Evaluating Research: Understanding and Using Applied Research in Your Practice”, which will be available virtually through Golden Gate University’s eLearning platform for $199 (and eligible for 15 hours of CFP CE credit as well). Ultimately, the goal is to shift financial planning from a profession that was built on tradition and practitioner intuition (and a lot of ‘school of hard knocks’ lessons from working with clients) into one where the profession’s best practices are truly “best” – because they’ve actually been scientifically validated as such!

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 the latest from his FPPad "Tech Tour" - an interview with yours truly - and the rest of his Tech Tour video series is available here!