Weekend Reading for Financial Planners (Sep 14-15)

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.

XYPN Sues SEC To Overturn Regulation Best Interest (Sean Allocca, Financial Planning) - This week, as the deadline came and passed to challenge the final version of the SEC's new Regulation Best Interest that was published earlier this summer, two lawsuits were filed to challenge Reg BI; the first lawsuit came from a coalition of 8 state attorney generals led by the state of New York, claiming that the SEC failed to follow Congress' "express direction" under Section 913(g) of Dodd-Frank that any new standards applied to broker-dealers would be at least as stringent as the fiduciary standard of care that applies to registered investment advisers; and the second was filed by XY Planning Network, which claims that Reg BI gives broker-dealers an unfair advantage by allowing them to deliver identical comprehensive financial planning to consumers under a lower standard than RIAs simply because the plan is being delivered in connection with the sale of brokerage products. Ultimately, the crux of both lawsuits is that Reg BI preserves the ability of broker-dealers to provide financial advice without being regulated to the fiduciary standard that normally applies to advice, with the states claiming that the SEC should have followed the requirements of Dodd-Frank to enact a similar advice standard for brokers, and XY Planning Network suggesting that the SEC is inappropriately attempting to rewrite the RIA registration requirements under the Investment Advisers Act of 1940 by allowing financial plans to be delivered by brokers and dual-registrants and only applying the fiduciary standard based on whether the broker is also managing an investment account (not whether the broker is providing investment advice). The first question, though, will simply be whether the states and/or XY Planning Network can prove they can stand to sue the SEC in the first place; if they do, though, the progression of either or both lawsuits will raise the question of whether Reg BI will really be able to take effect next June 30th, or if akin to the SEC's broker-dealer exemption of 2005, and the Department of Labor's fiduciary rule, Reg BI will also end out being vacated as the great convergence of advice across broker-dealer and RIA channels continues.

Lincoln, Other Insurers Likely To Backtrack On New York Annuity Pullback (Greg Iacurci, Investment News) - Earlier this month, a number of major annuity carriers pulled their recently launched fee-based annuities from the state of New York, raising concerns about how the new disclosure requirements for fee-based vs. commission-based annuities would work under New York's new Regulation 187 best-interest standard for insurance and annuity sales; specifically, the insurers were concerned that commission-based agents would be required to show consumers a lower-cost fee-based alternative product that they weren't licensed to sell in the first place. This week, however, the New York Department of Financial Services (DFS) published additional guidance to alleviate some of the industry's concerns about the new disclosure rules, stating that advisors would only be required to show a comparison of both fee-based and commission-based products if they were actually dually-licensed to sell both, and further clarifying that it won't be necessary for insurers to show every possible alternative of their commission-based annuities, recognizing that product parameters are sometimes adjusted for individual broker-dealers and other distributors based on their negotiated override arrangements to the platforms (though the insurer must at least still disclose that they offer several versions of the product that may have different costs and benefits). On the other hand, consumer advocates are now raising concerns that if New York's disclosure requirements don't compel agents who only sell annuities to disclose that there are potentially lower cost or higher benefit alternatives to the same product based on how they're registered, it may simply incentivize annuity agents to narrow their registrations to ensure they can still sell higher-cost lower-benefit versions of the same product.

CFP Board To Grant Continuing Education Credit For Technology (Joel Bruckenstein, T3 Technology Hub) - Historically, the CFP Board has not granted continuing education (CE) credit for presentations on computer hardware and software, instead requiring that CE content must tie to the CFP Board's list of "Principal Knowledge Topics" under the CFP curriculum (which does not include technology and other practice management topics). However, the CFP Board's new Code of Ethics and Standards of Conduct taking effect in October recognize that certain elements of technology are now essential to ensure the delivery of financial planning itself; accordingly, technology topics that will now be granted CFP CE credit include strategies to protect client personal data and privacy, technology used to diversify portfolios, digital advice tools used to manage or help clients self-manage parts of their portfolio, cybersecurity and technology, and content on cryptocurrencies and blockchain. Notably, content on practice management (e.g., training on Microsoft Office), marketing or sales tools (e.g., CRM software), or other technology content that doesn't tie to the CFP Board's Principal Knowledge Topics will still not be permitted, nor will any other practice management topics. In addition, even technology content on the permitted topic list will only be granted if it specifically pertains to the client (e.g., "Practical Cybersecurity Steps For Your Firm" would still be denied credit because it is practice management for the firm, not specifically for the client). Ultimately, though, with the next CFP Board Job Task Analysis coming up in 2020, it's possible that more technology-related topics may be incorporated more directly into the Principal Knowledge Topics list for CE purposes in subsequent years, as technology itself becomes an increasingly essential part of the delivery of financial planning itself.

18 Enlightening FinTech Demos From In|Vest 2019 (Craig Iskowitz, Wealth Management Today) - At this summer's In|Vest FinTech conference, a key highlight was the series of advisor FinTech demos that allowed both existing platforms to show their latest tools and releases, and a number of newcomers to demonstrate their tools to the world of financial advisors for the first time. Notable highlights and themes included: a number of "chatbot" tools to facilitate either advisors interacting with clients for simple commands and requests, or even for advisors to request information from or interact with their own technology tools, with vendors like Jane.ai (now Capacity), Cognicor, and Clinc (which takes the "chatbot" theme quite literally as a voice-recognition-based virtual assistant technology for advisors); support for advisor process automation or giving advisors nudges about business opportunities, including Vymo (a "personal sales assistant" that sits on top of a CRM to help advisors focus on higher-ROI activities and clients), CopyTalk (mobile dictation), IFS Automation (supporting the automation of business workflows), and Appway (focusing on expedited and automated client onboarding solutions); investment-focus tools from Smartleaf (tax-optimized rebalancing), Refinitiv (investment analytics, trading, and risk assessment), DriveWealth (a 'robo' platform for advisory firms that enables fractional share investing), Trendrating (focused on helping institutional fund managers oversee their risk exposures), 55ip's TAMP model management platform, and Orion's new "direct indexing" ASTRO platform; 'traditional' financial planning software platforms with new tools and features, such as MoneyGuidePro and its Blocks planning modules, and Advicent NaviPlan's new retirement accumulation and decumulation planning tool; and newcomers (at least to the US) like Practifi, which is dubbing itself as a "business management platform" that goes beyond traditional CRM systems.

The Next Schwab? (Michael Thrasher, RIAIntel) - This week, advisor Jason Wenk (founder of the fast-growing FormulaFolios TAMP) unveiled his latest venture: a new "digital" RIA custodial platform dubbed Altruist. The goal of Altruist is to fully integrate what is currently a cobbled-together experience of most advisory firms between e-signature and digital onboarding, trading and rebalancing, and portfolio performance reporting, into a single modern built-from-scratch RIA custodial platform... in the hopes that doing so can improve platform efficiencies and slash the cost of the custodial platform for both advisors and their clients. Notably, though, Altruist isn't only a standalone custodial platform itself, but also an overlay portal that will integrate with other major custodians to replace the aforementioned parts of the existing advisor technology stack, at a cost of just $1 per account per month (after an initial 100 accounts which are free). For those who choose to trade with Altruist, though, the company has declared an entirely commission-free platform - i.e., no trading fees at all, not even for Vanguard and DFA funds that often incur higher costs at other RIA custodians - and will have its own native process for digital onboarding of investment accounts, and can handle fractional shares. Though in the end, the real question will be whether Altruist can actually persuade advisors to repaper accounts and transfer assets to its custodial services, or if the platform will end out simply being used as a lower cost portfolio performance reporting and trading solution that overlays other RIA custodians instead.

Cybersecurity Infractions On The Rise Among Advisors: NASAA (Melanie Waddell, ThinkAdvisor) - Based on state RIA examinations across the first six months of 2019, NASAA reports that cybersecurity deficiencies are now cropping up at more than a quarter (26%) of advisory firms, up from 23% last year, and at a time when deficiencies in nearly every other compliance category have been on the decline (though other deficiency types are still more common, including books and record violations at 59%, registration errors at 49%, and problems with advisory contracts at 44%). The primary cybersecurity deficiency issues found by regulators on examinations include a lack of any testing of the firm's cybersecurity vulnerabilities, a lack of procedures regarding securing or limiting access to devices, a lack of procedures related to internet connectivity, weak or infrequently changed passwords, and inadequate cybersecurity insurance (or not having any at all). Notably, NASAA itself offers an 89-item cybersecurity checklist that advisory firms can use to evaluate their preparedness and ensure they are in compliance with their obligations. Which would probably be a good idea for state RIAs to check out, as the rising pace of cybersecurity deficiencies suggests that RIA examiners will only scrutinize the area even further in the coming months and years.

End Of Era: Passive Equity Funds Surpass Active In Epic Shift (John Gittelsohn, Bloomberg) - The shift from actively-managed mutual funds to passive index funds and ETFs has been underway for nearly two decades, but last month finally marked the milestone turning point where the total assets in passive U.S. equity funds exceeded that of active U.S. equity funds, at $4.271T in index-tracking funds versus $4.246T in active stock-pickers (capping a year-to-date trend of $88.9B to passive U.S. stock funds and $124.1B of net outflows from active U.S. stock funds). The primary driver still appears to be cost - with the average passive U.S. equity fund charging only about 10bps, compared to 70bps for the average active fund. At the same time, though, the crashing cost of fund expense ratios with the shift to passive is itself driving a shift in business models, with firms like Vanguard going deeper into the advice business, BlackRock looking overseas outside of the U.S. for better growth opportunities, and Fidelity turning deeper to alternative revenue sources like securities lending. The trend also appears to be fueled by shifts in the financial advisor business model and value proposition as well, as advisory firms use index funds and ETFs as their new building blocks and charge clients themselves for selecting the funds and building and managing model portfolios (rather than delegating such responsibilities to mutual fund managers as was done in the past).

Michael Burry Trashes Index Funds – Are We Screwed? (Mr. Money Mustache) - Earlier this month, Michael Burry (made famous by Michael Lewis' "The Big Short" book for predicting the collapse of mortgage subprime CDOs in advance of the financial crisis) declared that he believes passive index funds are the next bubble, and that when the 'fad' passes, markets will be scrambling to determine the 'proper' prices of various stocks that are simply being 'blindly' purchased within index funds. More specifically, Burry suggests that passive investing can distort the prices of individual stocks (because we buy everything in a fixed ratio without considering the value of each company), the "exit door" is small (a lot of index fund assets are invested in fairly small companies whose thinly traded share prices would crash with a mass exodus from index funds), and some index funds use "complex bits" under the hood (e.g., options and other derivatives) that can break under stress. Except in practice, the criticism that passive indexing will distort the prices of individual stocks and undermine price discovery has been alleged against index investing for years and there's no evidence of any problem yet (with the majority of overall assets still in active funds and active trades outpacing passive ones by 22:1). And while a rush of investors heading for the exits could impair the price of small cap stocks, that's always a problem of small cap stocks any time investors all rush for the exits, and in practice the whole point of the indexing philosophy is not to actively trade (where too many investors might hit the exit doors at the same time in the first place). And while there may be some legitimacy to the concerns of certain "synthetic" index funds that re-create index exposures but don't actually own the underlying investments themselves, that is not the case for most traditional stock and bond funds (and may be concentrated in alternative funds that arguably deserve more due diligence scrutiny anyway). Of course, if enough investors eventually become passive, arguably the challenges of insufficient price discovery could emerge... except if they did, it would create trading opportunities for active managers, who would suddenly begin to outperform dramatically, leading at least some assets back to actively managed funds, to find a new equilibrium (which would still have a higher total market allocation to passive funds than already exists today where no such stock mispricing opportunities are evident).

Debunking The Silly "Passive Is A Bubble" Myth (Ben Carlson, A Wealth Of Common Sense) - Criticisms against index funds, like Michael Burry's belief that they are a passing fad, are not new; back in 1991, legendary hedge fund investor Seth Klarman wrote in his book "Margin of Safety" that "the prices of securities in the most popular indices will fall relative to those that have been excluded". Yet as Carlson points out, it's not clear what the purported alternative would be that's less problematic; would it really be better if investors were piling into higher-cost funds with less tax efficiency that have poor track records of beating the market instead? In addition, the reality is that relative to the total capitalization of markets, the portion held via ETFs is still only a miniscule portion of the overall market - at no more than about 10% - and mutual funds themselves only hold about 35% of stock market wealth (of which less than half is passive). Which means altogether, passive investment vehicles will own barely 25% of the total equity markets (and only an estimated 5% of global assets), with the remainder still owned by a wide variety of other investor types, including direct household ownership, foreign ownership, and government and private defined benefit plans. Not to mention that with so much focus on measuring active managers to index funds, the truth is that a huge proportion of mutual fund managers already own the bulk of the index (thus "hugging" the index and maintaining a relatively low active share in order to manage their own career risk of getting fired from a lucrative position as a fund manager), which means the shift already underway may simply be from closet indexing to visible indexing (but not a shift away from active towards indexing). And in the end, the reality is that the market in the aggregate still is the market, which means in essence that buying a passive index fund really just buys stocks in the exact proportions of the shares already owned by all active investors in the aggregate anyway (and it doesn't take very many active managers to sort out the basics of price discovery).

 The New Tax Math For People Living In High-Tax States (Brian J. O'Connor, The Wall Street Journal) - The Tax Cuts and Jobs Acts of 2017 put a new $10,000 limit on the amount of state and local taxes that can be itemized on Schedule A of the Federal individual tax return, curtailing how much in state and local income and property taxes high-income individuals and families can deduct. With the law being enacted in 2017, though, the first full tax year under the new rules was 2018, and with high-income individuals disproportionately filing for extensions, many won't actually see the impact of the new law until next month, when the October 15th tax-extension deadline passes and their total tax bills are trued up. And the fear - at least for states that have disproportionately higher tax rates than their peers, including New York, New Jersey, California, and Connecticut - is that once citizens start seeing how much their tax bills have risen because of the burden of their state and local taxes, they may consider moving to lower tax jurisdictions like Florida, Texas, or Nevada (all of which have a 0% state income tax rate). In point of fact, the trend has already been underway for some years, with Nevada long having seen annual inflows of California residents moving to the neighboring state to eliminate their state income tax bill, but the loss of the Federal deduction under the Tax Cuts and Jobs Act is being predicted by some to likely be the proverbial straw that breaks the camel's back. Of course, for those who want to move for better state income tax treatment, it's important to actually move, as states are also anticipated to increasingly scrutinize whether those claiming to no longer be residents of the state really took the necessary steps to change their domicile in an attempt to hold onto their tax revenue (with New York already claiming almost $200M per year through their state residency audit program).

Why Are America's Three Biggest Metros Shrinking? (Derek Thompson, The Atlantic) - In 2018, New York City lost 277 people every day (or more than 100,000 over the span of a year), while Los Angeles and Chicago lost 201 and 161 residents per day, respectively, as well. The emerging exodus of people out of large cities represents a dramatic reversal from just a few years ago when an "urban renaissance" was supposedly driving more and more consumers to big cities for the opportunities they offered. Notably, though, a deeper dive into the data reveals that the trend may not actually be new, as in reality, "domestic immigration" (i.e., people who are already in the U.S. and simply move from one city to another) has already shown net outflows of movers from New York, Los Angeles, and Chicago for the past 20 years. Cities continued to grow, though, because international immigration (i.e., those moving to the U.S.) still produced a positive net inflow to major cities, coupled with high-income firms that have been able to attract young highly-educated workers to cities. Yet these booms in high-income jobs are increasingly making cities, and particularly housing in cities, so unaffordable for everyone else that it may now be further exacerbating the trend to move away from those cities... thus why the cities seeing the greatest growth all have far better housing affordability (and in general, better weather with more sun!), such as Phoenix, Dallas, and Las Vegas. The shift is becoming so dramatic that the overall population growth of several major cities - including New York and Los Angeles - has stalled altogether, with smaller areas increasingly trying to replicate the appeal of big cities (dense mini-urban developments with local coffee shops and restaurants) at a fraction of the housing cost, and raising the question of whether the prospective net population declines of major metropolitan areas may be the canary in the coal mine of a broader shift underway... which eventually can drive subsequent shifts in everything from the concentration of certain sectors of the economy in various parts of the country, to the political leanings of states themselves.

Workers Are Fleeing Big Cities For Smaller Ones – And Taking Their Jobs With Them (Ben Eisen, The Wall Street Journal) - There is an emerging "renaissance" of small-to-mid-sized U.S. cities such as Portland, Austin, Denver, and Boise, that lie outside major metropolitan hubs, where individuals and families are moving to and then "telecommuting" back to do their high-income knowledge-worker duties from their former homes in expensive areas like Los Angeles or San Francisco. The challenge, though, is that some of those cities are growing so quickly, they're having trouble keeping up with the rising traffic congestion, and what can even be a rapid rise in the cost of purchasing a home (albeit from what is still a less expensive base) if the influx of new residents is greater than the rate at which local housing is built to accommodate those new residents. In addition, when workers relocate to a new (smaller) city but telecommute back, the city doesn't necessarily benefit from the broader economic opportunities that arise when new businesses actually build and invest into the local city and economy (because the firms aren't actually there, just some of their choosing-to-be-remote workers). It's also not clear how stable those remote jobs will be in the next downturn, and whether companies might favor retaining local employees over remote ones, causing potential spikes in the unemployment rate in distant cities that don't have the local business job capacity to cope. Still, though, the total volume of remote workers is limited, estimated at just 5.3% of the adults in metropolitan areas with 500k to 3M people, up only 1.6% from an average of 3.7% a decade ago. Which means in total, the remote worker trend is not likely to completely uproot the economics of mid-sized cities; nonetheless, the volume of workers moving, and the view that the pace may be accelerating, raises interesting questions of how workers will choose to balance where they live and what they do in the coming decade of the 2020s and whether further compounding really might begin to change the nature en masse of how people choose where to live.

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 Bill Winterberg's "FPPad" blog on technology for advisors as well.