Executive Summary
Enjoy the current installment of "weekend reading for financial planners" – this week's edition kicks off with the big news that the first independent study on the SEC's proposed Form CRS disclosures on the relationship differences between working with an advisor or a broker... finds that not only do consumers fail to understand the differences in obligations between the two as "explained" by Form CRS, but they misinterpret Regulation Best Interest as being comparable to a fiduciary standard when it's not, and couldn't even articulate the differences in costs and services between brokerage versus advisory accounts after reading Form CRS in depth.
Also in the news this week was fresh buzz about the potential for "Tax Reform 2.0" legislation, including a push to make all of the "temporary" sunsetting provisions of the Tax Cuts and Jobs Act permanent... with the caveat that the legislation (or what is actually a combination of three different bills in the House) is viewed as likely being dead-on-arrival in the Senate, and that, realistically, any further momentum on tax reform won't likely happen until 2019 at best (and then will depend on the outcome of the midterm elections).
From there, we have several more articles about the Tax Cuts and Jobs Act and recent IRS guidance and planning strategies, from a discussion of the new Kiddie Tax rules and how they work for dependent children, to new IRS guidance on some of the 529 college savings plan provisions of TCJA (in particular, that any type of public, private, or religious school counts for the new opportunity for up-to-$10,000/year of tax-free distributions for K-12 expenses), and a look at how a 50-year-old crackdown on Controlled Foreign Corporations (CFCs) may suddenly be experiencing a revival as a proactive tax planning strategy in a world where top individual tax rates are 37% but the top corporate tax rate (including on CFCs) is "just" 21% now.
We also have a few practice management articles, including: how to tell when advisory firm owners may be "starving" their advisory firm's growth opportunities by taking too much out of the business (hint: if the owners extract more than 40% of revenue in some combination of compensation and profits, it may be getting "over-milked"); how to formalize the structure of a firm-wide compensation plan for employees so they better understand their upside career opportunities; why the biggest blocking point to better advisor technology is no longer the lack of advisor tech innovation but the struggles of individual advisory firms to effectively adopt the software; and why large financial services firms should consider establishing a "Chief Planning Officer" (CPO) role to better shepherd the transition from traditional financial services product sales to an advice-centric planning business.
We wrap up with three interesting articles, all around the theme of working with couples where the wife outearns the husband: the first explores how marital strife and divorce rates appear to be higher amongst the nearly one-third of couples where the wife earns more; the second covers another recent research study finding that when wives earn more, they tend to downplay her income while overstating his income to narrow the perceived gap (even when reporting to government entities like the Census Bureau!); and the last provides some recommendations of what to consider and bear in mind when providing financial advice to and working with couples where she earns more (and the importance of not making any assumptions about their money dynamics based on who happens to be the primary breadwinner).
Enjoy the "light" reading!
Individual Investors Mystified By SEC's Best-Interest Disclosures In Independent Study (Tracey Longo, Financial Advisor) - When the SEC issued its proposals for Regulation Best Interest and new Form CRS, it requested feedback and comments about the efficacy of the new "Customer/Client Relationship Summary" (CRS) disclosure in particular, and whether it would actually help consumers better understand the nature of their relationship with their advisor or broker. Accordingly, a coalition of organizations, including AARP, the Consumer Federation of America, the CFP Board, and the Financial Planning Coalition, hired an independent disclosure design firm - Kleimann Communications Group - to conduct an independent usability study and gauge investors' reactions to the SEC's proposed Form CRS samples. And after a series of 90-minute one-on-one interviews with study participants... the conclusion was that few could define the "fiduciary" term, few know what the obligation would be, and most thought that the broker's "best interest" standard would be best at "increasing their money and meeting their goals." Other notably adverse conclusions of the study, despite the fact that the investors had "favorable" conditions of actually being given thorough time to read all the documents, included: investors did not understand the legal disclosures regarding the different standards that would apply to brokerage versus advisory accounts and thought they were ultimately the same thing; even after reading the form, investors could not articulate the differences between brokerage versus advisory accounts and the distinction between the services associated with each; investors could not figure out what each service would cost and which would cost more or less for their individual circumstances; most of the investors didn't understand that the conflicts discussed could actually impact them adversely; and all investors expected that any advice given would be in their best interests anyway (regardless of any conflicts of interest). Notably, the SEC's public comment period for the rule already closed on August 7th, after the regulator declined to extend the comment period to allow more time for usability testing for Form CRS, but the organizations proceeded to conduct the study and submit the results to the SEC anyway, in the hopes that they will be considered before any final rule is issued.
"Tax Cut 2.0" Legislation Unveiled By House GOP Ahead Of Election Push (Laura Davison & Allyson Versprille, Bloomberg) - This week, House Republicans introduced legislation intended to expand and/or make permanent various provisions from last year's Tax Cuts and Jobs Act, in what has been dubbed "Tax Cut 2.0" or "Tax Reform 2.0." The 2.0 proposals are actually a series of 3 separate bills: the first is H.R. 6760, the "Protecting Family and Small Business Tax Cuts Act of 2018," which would make both the individual tax bracket changes and the new Section 199A pass-through business deduction permanent, along with extending the 7.5%-of-AGI medical expense deduction threshold through 2020 (it's currently set to lapse back to 10%-of-AGI at the end of 2018); the second bill is H.R. 6757, the "Family Savings Act of 2018," which would create a new Universal Savings Account (USA) that would permit up to $2,500/year in contributions that could later be distributed tax-free for any purpose (i.e., a form of mini-Roth IRA that isn't limited to just retirement), along with expanding 529 plans to cover apprenticeship programs, homeschooling expenses, and up to $10,000 in repayments for qualified education loans; and the last is H.R. 6756, the "American Innovation Act of 2018," which would expand deductions for startups by allowing them to expense up to $20,000 (up from the current $5,000, and with a broader range of startup and organizational expenses that qualify). Notably, though, there is little expectation that Senate Republicans will take up the measure at this point, and is being viewed instead as a way to center more of the election debate about the prospective benefits of last year's Tax Cuts and Jobs Act legislation by focusing the conversation on the fact that those tax cuts are still scheduled to lapse/sunset after 2025 and forcing Democrats to publicly "vote against individual tax cuts," although the fact that the legislation would also make the $10,000/year SALT cap on state income tax deductions permanent, it has ended out being divisive even within the Republican caucus. Which means even if the House proposal comes to a vote in the coming month, any substantive changes or extensions to TCJA aren't likely to come until 2019 at best (and the direction of that legislation will depend on the outcome of the midterm elections).
Understanding The Taxation Of Dependent Children's Income: Kiddie Taxes After TCJA (Randy Gardner & Julie Welch, Journal of Financial Planning) - The tax law has long applied special rules to the income of children, recognizing on the one hand that, as with any income, it should be taxed (under the usual graduated tax brackets), but on the other hand, the fact that tax brackets start out lower may create incentives for families to shift and split income, especially from passive assets, in order to use (and potentially abuse) those lower tax brackets. Accordingly, the tax law has different treatment for earned income of dependent children - from tips and wages, to babysitting and dog-walking and lawn mowing - versus the treatment of unearned income (i.e., interest, dividends, and capital gains). Generally, earned income of children is taxed at their own (typically low) tax brackets, but unearned income is taxed at the parents' income (after allowing a $1,050 standard deduction, and another $1,050 to be taxed at the child's tax rates). However, under the Tax Cuts and Jobs Act, this "kiddie tax" of subjecting a child's unearned income to his/her parents' top tax rates has changed, and children's unearned income is now taxed at the trust tax brackets instead (which can reach the top tax bracket far more quickly due to compressed trust tax brackets!). Given these dynamics, Gardner and Welch offer several planning strategies: for children with earned income, self-employed parents should hire their children (which provides a deduction for the business at the parents' rates and taxes the income at the kids' rates); for children with unearned income, pay careful attention to which brackets it will or won't fall into, and consider whether it may be better to more aggressively try to shelter that income under the new kiddie tax rules (from buying municipal bonds, to zero-dividend stocks or tax-managed mutual funds, or leveraging a 529 plan). Notably, though, because (for children age 18 or older) the kiddie tax rules only apply if the child is claimed as a dependent, parents may increasingly want to simply let young-adult children file for themselves (if the child can provide more than half of his/her own support), especially since the dependent exemption is gone anyway.
IRS Provides Guidance On New 529 Plan Rules After TCJA (Investment News) - The Tax Cuts and Jobs Act made a number of changes to 529 college savings plans, and the IRS recently issued Notice 2018-58 to provide important clarifications regarding the new rules. Specifically, the new guidance clarifies that the TCJA provisions allowing up to $10,000/year to be paid for a beneficiary for K-12 expenses as Qualified Higher Education Expenses (QHEEs) includes any elementary or secondary school, public or private or religious. In addition, Notice 2018-58 also re-affirms that 529 college savings plans can now be rolled over to a 529A ABLE account for a special needs beneficiary, and clarifies that the rollover can occur either to a 529A plan for the same beneficiary or for a special needs beneficiary who is a member of the same family (given that the 529 plan itself could have been rolled to another family member and then moved to a 529A plan anyway), though the maximum dollar amount to be transferred in any particular year is still capped at the annual gift tax exclusion amount (currently $15,000/year, and aggregated with any other 529A contributions that year) and the rollover must occur within 60 days of the prior distribution. Third, IRS Notice 2018-58 clarifies, as a part of the PATH Act of 2015, that students who receive a tuition refund from a school may re-contribute those dollars back to a 529 plan and treat the entire amount as a recontribution of principal (as it's not administratively feasible to track how much of a partial tuition refund should be allocated to principal versus growth anyway).
Tax Loophole From 1960s Could Let Wealthy Tap 21% Corporate Rate (Joe Light, Bloomberg) - Back in the 1960s, President Kennedy signed into law IRC Section 962, which provides that certain "Controlled Foreign Corporation" (CFC) entities would be taxed annually to the owners anyway (or alternatively, as a corporation at the corporate rate), as a means of preventing wealthy individuals from trying to shelter their income in a foreign entity to avoid annual taxation in the US. The fact that corporate tax rates were still lower than individual tax rates meant the CFC rules did provide at least a small amount of tax relief through the remainder of the 1960s and 1970s, but by the 1980s the top corporate tax rate was moved to be roughly in line with the top individual tax rate, making Controlled Foreign Corporations irrelevant... until the Tax Cuts and Jobs Act cut the corporate rate to 21% while leaving the top individual tax rate at 37%. As a result, those with substantial passive investment holdings, from stocks and bonds to real estate, suddenly have an incentive again to hold those investments in a CFC to defer taxes... which are still due when the income is withdrawn from the corporation, but otherwise remains untaxed as long as the growth is kept abroad (and may potentially be eligible for preferential corporate dividend tax rates as well, depending on the outcome of a now-ongoing Tax Court case). Of course, most investors don't have enough wealth to offshore their passive investment holdings for an extended period of time just to get tax deferral... and there is still a prospective layer of double-taxation (at the corporate level, and again for the shareholder when withdrawn as a dividend), but for a subset of ultra-wealthy individuals with the time for long-term, tax-deferred compounding growth, CFCs appear to be back on the table as a tax deferral strategy again.
Are You Starving Your Advisory Firm? (Brent Brodeski, Financial Planning) - One of the popular virtues of the AUM model in general, and the RIA business structure in particular, is that it allows for the creation of a saleable enterprise (in ways that a broker-dealer book of business cannot) and ultimately makes possible for the owner to harvest substantial value when they're ready to sell the business and retire. The caveat, however, as Brodeski notes, is that many advisory firm owners don't treat their firm as a growing enterprise into which they reinvest, and instead operate it more like a "cow" that can be milked for (admittedly lucrative) current cash flow... but strangling off growth and any increases in enterprise value in the process. Which is challenging not just because stagnant growth itself can impair the valuation of an advisory business, but also because a lack of growth for the firm results in a lack of growth opportunities for its advisors... and as a result, such firms often also struggle to attract next-generation advisors (who in turn are usually necessary to attract next-generation clients), which means the firm paints itself into a corner with aging advisors serving an aging client base, further impairing the value of the firm. So how can advisors know if they are "over-milking" their firms? Brodeski suggests that if the firm owners, in aggregate, are taking out more than 40% of the firm's revenue (between compensation in the business, perks, and profit distributions from the business), they are likely "over-milking" the business. So what should firms shoot for instead? In order to achieve sustainable 15%/year growth, Brodeski suggests targeting (as percentages of revenue): 20% - 30% for non-advisor employees; 10% - 20% for non-owner advisors; 7% - 10% for technology; 4% - 7% for marketing and branding; and 2% - 3% for process development to systematize the firm and make it more scalable and efficient (which in turn helps to support cost-efficiencies in all the other categories).
Recipe For Compensation Success (Kelli Cruz, Cruz Consulting Group) - As advisory firms grow and the various roles in the firm get more targeted and specialized, it becomes increasingly necessary to formalize a standard compensation structure across the entire firm. Accordingly, Cruz articulates a step-by-step process for creating a standard firm-wide "compensation plan," comprised of the following key elements: 1) determine the firm's "compensation philosophy" (e.g., do you want to "lead" the market by paying more than competitors, "match" the market by paying competitively to what others pay, or "lag" the market by trying to pay less and maintain higher margins at the risk of higher turnover), and consider the kinds of behaviors you're trying to incentivize (e.g., individual performance vs teamwork, high-value vs high-margin, etc.); 2) rank the positions of the firm in terms of the value of each job (e.g., client-facing roles that impact the end-client tend to have higher compensation opportunity), and while some advisory firm owners may prefer a more egalitarian non-ranked non-hierarchical approach, the reality is that employees need a framework to know not only why they're compensated what they are, but what their upside opportunities are (which means knowing where they are on the ladder, so they know what they can climb towards); 3) establish ranges of market compensation for each position on the ladder, which means seeking out industry benchmarking reports on reasonable compensation ranges for various roles to ensure that each is compensated appropriately; 4) decide on individual compensation levels based on how each person fits within their available compensation range (e.g., at the bottom 25% end for those who are inexperienced or new to the role, median for average employees, and at the top of the range for the most experienced team members); and then 5) make adjustments for the relevant "special ingredients" (e.g., adjustments up or down for geographic cost-of-living adjustments, special compensation opportunities for rising stars, etc.).
The Human Factor Is The Biggest Challenge To Advisor Technology Adoption (Bob Veres, Financial Planning) - The pace of technology change is accelerating, both broadly in the world, and within the financial services industry in particular. In just a few decades, we've gone from big-box computers with giant floppy disks to a smartphone that can access most of the knowledge of mankind in seconds, and one need only walk around the annual T3 advisor technology conference exhibit hall to see a wide range of new solutions coming out every year. Yet ultimately, as Veres points out, new advances in technology are only as effective as human beings can adopt them and adapt to them... and in this regard, the financial services industry still doesn't score well. In many firms, the adage is simply "if it ain't broke, don't fix it," which in a world where most advisory firms still have phenomenally high retention rates, creates little urgency to make technology changes. And in other firms, there may be a desire and willingness to make some change, but the sheer complexity and cost burden of switching from legacy systems to new ones is a blocking point. Even then, software vendors themselves often note that the average advisor only uses a small fraction of the capabilities the system provides (e.g., firms that still use their CRM as little more than a cloud-based Rolodex instead of a total practice management tool). And in the end, many firms struggle to effectively adopt their technology simply because they've never defined their systems and procedures internally in the first place, as it's impossible to embed a workflow into technology when the firm still relies heavily on one-off behaviors from key staff members. The key point, though, is simply to recognize that as technology tools proliferate, advisory firms are reaching a crossover point where, in the past, the limiting factor of advisor technology was really that the tech itself wasn't very good or capable or integrated, but increasingly in today's world, the blocking point isn't the technology itself, but the firm's ability to actually adopt and implement it effectively.
Why More (Large) Financial Services Firms Need A Chief Planning Officer (Kevin Keller, Financial Planning) - While financial planning is on the rise, and more and more financial services large and small are shifting from an investment- or product-centric focus to a planning- and advice-centric focus, the leadership of most firms - especially amongst the larger financial services firms - remains rooted in the traditional ways of doing business. In other words, Keller suggests that if firms really want to focus on being in the financial planning and advice business, they need to appoint a "Chief Planning Officer" (CPO) at the executive level with the authority to better reorganize business strategy around financial planning. The role would be responsible for instilling a culture of financial planning advice in what are often still sales-based cultures, including establishing processes to ensure the firm's recommendations meet the fiduciary standard, revising hiring and onboarding processes to find advice-centric (not sales-centric) advisors, focusing the firm's continuing education and certification programs (ostensibly to include CFP certification!), and overall to institutionalize financial planning within the firm. Notably, many smaller independent advisory firms are founded by financial planners and thus have a financial-planning-centric focus at their core, larger and longer-standing institutions often still have executive leadership that has carried over from legacy models... which, again, is why a dedicated CPO executive position is necessary to ensure that financial planning itself has an advocate in the process of organizational change.
When She Earns More: As Roles Shift, Old Ideas On Who Pays The Bills Persist (Tara Siegel Bernard, New York Times) - The United States has experienced a substantial shift in gender roles over the past 50 years... so much, in fact, that women now outnumber men in college and collect more degrees, which in turn is leading to a rising share in the number of women who earn more than their husbands (as much as 1/3rd of all married couples today, according to Pew Research), such that men are taking on increasing levels of responsibility at home. Yet 70% of adults still reportedly agree with the statement "for a man to be a good husband or partner, it's 'very important' that he be able to support his family." In other words, while society is becoming more accepting of the idea that women don't have to be the homemakers, there is less of a shift away from the attitude that it's up to the men to be the providers. The end result is that at least some studies are finding that couples where women earn more experience greater relationship strife and are more likely to split up, and another study found an even greater likelihood of divorce with couples where the husband wasn't employed at all (though those who were employed and merely earned less didn't show the higher divorce rate). On the other hand, there is some evidence to suggest that attitudes may be shifting generationally, as a third recent study found that the higher divorce rate for women who outearned their husbands was only present for couples married in the 1960s and 1970s, but not those married in the 1990s or later. Nonetheless, the important implication, both for couples themselves, and the financial advisors who work with them, is that financially-related marital stress may well be lurking beneath the surface for couples where the wives outearn their husbands, if only because gender role attitudes have not fully adapted to modern changes in income dynamics and family roles, and that it's important to talk carefully through shared goals and how family financial decisions will be made.
When Wives Earn More, Couples Tend To Downplay Their Income (Jillian Berman, Marketwatch) - According to 2015 data from the Bureau of Labor Statistics, about 38% of wives earn more than their husbands. But in a recent paper from the U.S. Census Bureau, it turns out that when women earn more, they tended to slightly underreport their income (as collected by the Census Bureau and then compared to Social Security earnings records) by 1.5 percentage points, while simultaneously overreporting the husband's income by 2.9 percentage points. However, the effect notably was not present in scenarios where the husband was earning more than the wife. Which suggests that couples, where the wives earn more, may still be feeling significant societal pressure regarding their income disparity... given that even when reporting to official government entities, couples where wives outearn their husbands are answering the questions in a way that downplays and minimizes the income gap between them, and across the entire population, is actually a very substantial behavioral reporting bias amongst the couples. Affirming the finding was another study recently found that it couples are materially more likely to report that the husband earns slightly more than half their income than slightly less, suggesting again that couples, where the wife earns more, may be slightly underreporting their income and overreporting a husband's (or alternatively that wives are actually taking jobs that earn slightly less). In the context of financial advisors, this suggests at the least that when working with couples where the wife earns more, it may be a good idea to actually check out a tax return and not rely on stated income alone from the couple in a data gathering meeting... and to understand the prospective marital tension that may be present given those income dynamics.
When She Earns More: Tips For Working With Couples (Kathleen Burns Kingsbury, Investment News) - In the span of just 50 years, the percentage of married couples with a higher-earning wife has quadrupled, representing a substantial shift in gender roles and the money dynamics of couples... and creating potentially sensitive money conversations both for couples themselves that may not have fully adapted to their new financial roles, and the financial advisors who work with them. Based on the recent Farnoosh Torabi book "When She Makes More," Kingsbury provides a number of suggestions for effectively working with couples where she earns more: 1) be curious about how the couple makes, manages, and invests their wealth, and be cautious not to make assumptions about how the couple handles its money based solely on who the primary financial breadwinner is; 2) ask open-ended questions to understand the couple's money dynamics (e.g., "as a couple, how do you earn income and pay expenses?" or, "when faced with a large financial decision, what role does each of you play in the process?" and even, "how is this similar or different than how your parents managed money as a couple?" to understand where the couple themselves may be struggling with different roles than what they grew up experiencing); 3) be certain to collaborate with and build trust with both partners; 4) be cognizant not to impress your own unstated biases about genders or breadwinners when engaging with a couple (e.g., the male isn't always the driver of financial decisions, but that doesn't necessarily mean the primary breadwinner female is going to be, either); and 5) be cognizant of (or seek to learn more about) the unique stresses that couples with women breadwinner clients may be experiencing (particularly from the female's perspective given the male-dominated population of financial advisors).
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.
Is this correct? I thought the kiddie tax was based on the stricter reqt of whether the kid earned more than half of support, not just whether they were a dependent or not: “Notably, though, because (for children age 18 or older) the kiddie tax rules only apply if the child is claimed as a dependent, parents may increasingly want to simply let young-adult children file for themselves (if the child can provide more than half of his/her own support), especially since the dependent exemption is gone anyway.”