Weekend Reading for Financial Planners (Sep 3-4)

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 3rd/4th:

Birth Of The Index Mutual Fund: Bogle's Folly Turns 40 (Jason Zweig, Wall Street Journal) - It was 40 years ago, on August 31st of 1976, that the index mutual fund was born with Vanguard Group's "First Index Investment Trust" (now the Vanguard 500 Index Fund); at launch, the fund only raised $11.3M, so far short of the original $150M target that the investment banks underwriting the fund they wanted to shut it down immediately. Yet 40 year later, the Vanguard 500 Index Fund holds over $250 billion in AUM, and index mutual funds and ETFs combined have nearly $5 trillion in assets. At the time, the issue was highly controversial (in the era of stockpicking "gunslingers"), and some critics called the index fund "un-American" (an issue raised again on the index fund's birthday as Sanford Bernstein analysts last week called passive investing "worse than Marxism [communism]"). Though at the same time, respected economists like Paul Samuelson were already observing that finding superior stock pickers was a futile endeavor... although it turned out to take decades for indexing to slowly but steadily eat away at the market share of active managers (now cumulatively estimated to have saved investors half a trillion in fees between reduced trading costs, lower fees, and the pricing pressure Vanguard has had on competitors). Notably, Vanguard wasn't the only player to have been experimenting with index funds at the time; in 1971, Wells Fargo launched an equal-weighted index fund (but quickly discovered that it was a hassle to manage the trading to maintain them the stocks at equal weights), and by June 1975 a rival firm (American National Bank in Chicago) was running about $300M in several index funds. Still, Vanguard ultimately proved to be the biggest and most successful player in the space, ultimately becoming the de facto center of the indexing and passive investing movement, though notably it still took almost 20 years for Vanguard to get its first $50 billion... and then in the past 20 years, added another $3 trillion on top.

IRS Eases Process To Fix IRA 60-Day Rollover Mistakes And Errors (Michael Kitces, Nerd's Eye View) - Last week, the IRS issued Revenue Procedure 2016-47, which will allow those who mistakenly fail to complete an IRA rollover within the required 60-day time period to complete the rollover anyway and "self certify" that the rollover should be accepted by the financial institution. In order to self-certify, the IRA owner must affirm that the reason for the late rollover was one of 11 specific reasons, from an error of the financial institution, to a lost check, a death in the family, a natural disaster, or a serious health event. Notably, the IRS still reserves the right to later audit and confirm whether the late rollover really was in fact for one of the specified reasons, but the financial institution will be permitted to trust the taxpayer's self-certification that the late rollover is for a valid reason; in fact, the IRS even provided a Model Letter that can be used for the self-certification process, and once the financial institution receives it, they can issue the rollover Form 5498 showing that it was a permissible rollover (though Form 5498 will be updated to add a new field specifically showing it was a "late rollover contribution" so the IRS knows who to potentially audit later!). Notwithstanding the rollover extension rules, though, the new guidance doesn't change the fact that individuals are still only allowed one 60-day rollover in any 12-month period. In addition, for independent financial advisors, it's important to note that the automatic exception for a rollover extension only applies to those directly connected to a financial institution; if the independent advisor is the one who caused the mistake, the client may still have to apply for a private letter ruling to get an extension to the 60-day rollover... which now has a $10,000 filing fee just to make the request (along with asking for a 60-day rollover extension for any other cause that wasn't on the list of 11 reasons that can be self-certified!)!

LTC Insurance Restrictions (Ben Mattlin, Financial Advisor) - Early on, most long-term care insurance policies were very broad in the potential claims they could pay, but as the actuarial data comes in, and insurers see what situations trigger the largest claims, they're beginning to make policies more restrictive in the fine print. For instance, while policies still cover dementia and Alzheimer's (in fact, those represent more than 50% of all LTC insurance claims by some estimates!), more recent policies may not fully pay the higher cost for special facilities that Alzheimer's patients sometimes require (and the elimination of Unlimited duration policies means extended dementia claims may eventually exhaust policy benefits). Other common policy exclusions today include for claims that arise from drug or alcohol abuse, self-inflicted injury or attempted suicide, or an act of war. But some LTC insurance carriers are going further, such as limiting claims for pre-existing conditions (or at least imposing a waiting period). In addition, many insurers have limited the amount that can be claimed as "caregiver's wages" for family members, instead requiring the use of third-party caregivers through an agency (which limits family members fraudulently claiming benefits for giving care, but unfortunately tends to be much more expensive for those with bona fide claims) or only offering a small portion of benefits (e.g., 30%) on a cash basis to be used freely. Other more restrictive changes to LTC insurance include tighter underwriting (with medical interviews now common, versus just filling out and sending in the application). And the situation is further complicated by the overall rise in LTC insurance costs - driven in part by today's low interest rate environment - which is leading people to trim back the amount of benefits they purchase, from the daily benefit amount and benefit periods, to choosing "just" 3% instead of 5% compound inflation riders. Still, some note that the LTC insurance industry now seems to be reaching a point of stability - albeit at a base of much higher premiums and more restrictive policies than in the past - and that if the new approach produces more favorable claims experience over time, LTC premiums could even begin to decline in the future.

How Insurers Are Losing When It Comes To Variable Annuities (Greg Iacurci, Investment News) - Variable annuity sales have been declining for the past several years, down from $158B in 2011 to just $133B last year, driven by both a recovery in markets that make their risk management features less salient, the growing popularity of indexed annuities as an alternative, and now the looming Department of Labor fiduciary rule. But as it turns out, perhaps the biggest headwind to variable annuity sales are the investment restrictions that were put in place after the financial crisis on products with income guarantees, which typically require investors to either use conservative asset allocations or "managed-volatility" funds as their investment choices. The forced bond allocations or hedging of these limited investment choices is causing investors to significantly lag in the bull market, especially when coupled with the higher variable annuity fees that have applied since the financial crisis. Unfortunately, from the perspective of annuity companies, they don't feel as though they have much choice - the investment requirements are specifically to help manage their own exposure to risk, a lesson learned after nearly disastrous outcomes during the 2008-2009 bear market. Yet from the investor's perspective, facing high fees on top of required-conservative allocations just makes variable annuities less appealing altogether; after all, the whole point of buying an annuity with guarantees is that it's possible to invest more aggressively, relying on the guarantee (rather than a bond allocation) to manage the investor's risk. Ultimately, this is just the fundamental market tension that occurs anytime one investor is buying a risk management guarantee that another is selling; still, the particular combination of conservative investment restrictions plus the cost of annuity guarantees are raising the question whether in today's environment, variable annuities that were supposed to provide an income floor with upside potential are just turning into a de facto conservative guaranteed income stream instead, and if annuity companies aren't really any more capable of guaranteeing against market volatility than what investors can do for themselves (which is to say, not much besides just investing more conservatively in the first place!).

Breaking The Mold: How Millennials Have Altered The Investor Life Cycle (Missy Pohlig, Practically Speaking) - The traditional view of an investor's lifecycle is that they go through three core stages: Growth (the aggressive-investing accumulation stage), Stability (getting more conservative as retirement approaches), and Distribution (as the withdrawal phase begins). Accordingly, financial services firms structure their investment offers based on which stage of the investor's lifecycle they may be appropriate for. But Pohlig notes that with 2/3rds of Millennials aged 23 to 35 having at least one source of long-term debt (e.g., student loans), and 1/3rd having multiple long-term debts, there now appears to be a fourth stage: the "Recovery" stage, where the young-investor Millennial tries to dig out of debt, just to get to the point of being able to save. And notably, this can apply to individuals that we otherwise might think of as traditional Growth investors - for instance, the young doctor who is making six figures, but doesn't care about "saving" because he/she is still trying to recover from a six-figure student loan balance from med school. While this phenomenon might seem 'self-evident' given the overhang of student loans in today's environment, Pohlig notes that reaching out to Millennials without first addressing their debt recovery needs will instantly make financial advisors (and asset managers) instantly irrelevant to the majority of the audience they're trying to reach, even/including the high-income ones that might have otherwise made 'good' accumulator clients. Of course, some might suggest that the easiest path is just to do nothing and wait for Millennials to work through the debt phase on their own, and then let them seek out a financial advisor... but arguably, this just means financial advisors are really focusing on investment management and getting access to the investor's money, rather than really helping the (young Millennial) investors with their actual financial planning needs!

Will Advisors Turn To Tech For DoL Compliance (Ryan Neal, Wealth Management) - The majority of financial advisors are now beginning to recognize that the DoL fiduciary rule will force them to change at least some policies and procedures and manage to new compliance obligations, and advisor tech vendors are viewing the fiduciary rule as a watershed moment to prove their value with technology tools that help advisors get more efficient as fiduciaries. However, in a survey of other 500 advisors, Wealth Management notes that barely a quarter of advisors see new technology tools as the solution, with the other 3/4ths of advisors reporting that their current systems are "very" or at least "somewhat" adequate to deal with their new fiduciary obligations. And the demand is even lower in the RIA channel, while independent broker-dealers appear to be the group most open to new technology adoption to address their DoL fiduciary challenges. In particular, advisors at broker-dealers indicate that risk tolerance and client profiling tools are one of the biggest gaps, as that helps to substantiate the fiduciary due diligence being done for new clients. The other opening is for "document management" solutions, though notably it's not clear if there's really a gap for managing documents, per se, or if the need is simply to have better tools to document each step of the wealth management process itself (as even without commission-based products, the DoL fiduciary rule still requires documentation of the advice process); in addition, as broker-dealers feel greater pressure to supervise their advisors in a fiduciary environment, there's also a growing demand from broker-dealer compliance departments to be able to document every step of the client-advisor interaction throughout the client lifecycle.

7 Myths Surrounding The DoL Rule (Christopher Robbins, Financial Advisor) - While almost five months have passed since the Department of Labor's fiduciary rule was released, a number of myths still abound. Key misconceptions include: 1) the final version of the DoL rule was weakened and will have little impact (in reality, the DoL simply eliminated specific lists of what was and wasn't required; the core imposition of a fiduciary duty to all advisors serving retirement investors remained intact); 2) the DoL rule only impacts traditional IRAs (in reality, it impacts any type of IRA, from Roth to traditional to rollover, along with 401(k) plans, though 403(b) plans and non-qualified taxable accounts are outside the DoL scope); 3) an RIA is already a fiduciary so the rule will have no impact (in reality, RIAs will still face a somewhat more restrictive environment, as the SEC's version of fiduciary relies heavily on disclosure, while the DoL fiduciary rule will outright ban certain conflicted practices); 4) all compensation conflicts can be resolved by disclosing them (in reality, the DoL rule will outright ban a number of variable compensation conflicts of interest, and puts significant pressure to eliminate more); 5) as long as the client signs the Best Interests Contract, the advisor can sell commission based products without being a fiduciary (in reality, signing the BIC commits the advisor to being a fiduciary, which means any commission-based products must meet a fiduciary level of scrutiny to affirm they were really in the client's best interests!); 6) the grandfathering provision allows advisors to keep getting commissions indefinitely as long as they stick to their existing clients (in reality, even new transactions with existing clients will trigger the new fiduciary obligation, once the rule takes effect); and 7) the new rules don't apply until 2018 (in reality, the fiduciary standard itself kicks in as of April of 2017, even though some additional documentation requirements won't apply until 2018).

Independent Researchers Seen Easing DoL Fiduciary Burden For Brokers (Christine Idzelis, Investment News) - In recent months, several major Wall Street firms have begun to announce relationships with third-party independent investment researchers, from UBS announcing a deal with Mercer to get access to 9,000 asset-manager research opinions, to Merrill Lynch expanding its relationship with Morningstar to get due diligence on mutual funds onto the Merrill platform by the end of 2017. While not being directly attributed to the DoL rule itself, commentators suggest that the rising role of third-party investment research firms may be a signal of what's to come in the broader broker-dealer community, particularly as brokerage firms face increased scrutiny in a fiduciary future over how funds are selected for clients. In other words, there appears to be a growing fear at brokerage firms that allowing brokers to choose whatever recommendations they wish may expose the company to liability; third-party investment research services provide both a way to vet the recommendation, and a more defensible process that can be systematically implemented across the brokerage firm. In turn, the additional scrutiny from independent researchers may lead some poor-performing or high-cost funds to get dropped from platforms altogether; Bank of America suggests that its fund lineup could narrow by about 1/3rd by the time the process is done.

Insurance That Advisers Will Need To Cover New Fiduciary Duties (Daniel Healy, Investment News) - As the DoL fiduciary rule introduces a new fiduciary obligation to many financial advisors that didn't face one previously (and expands the fiduciary scrutiny even on RIAs who already were fiduciaries), the question arises as to whether the typical insurance coverage that an advisory firm carries will actually protect the firm if it fails in its fiduciary duties. On the plus side, most advisors already have at least some form of Errors and Omissions (E&O) coverage, which should offer some protection. But with the DoL rule shifting how fiduciary is defined and its precise obligations, current insurance policy definitions of what constitutes a covered fiduciary breach may not match, particularly since advice will be given by advisors by the DoL's Best Interests Contract requirement is signed between the client and the advisory firm. Accordingly, it's necessary to scrutinize whether the policy covers both the firm and its advisors, whether they need to be employees or contractor to be covered, whether the cost of investigations is covered (along with claims themselves if they ultimately occur), and what level of negligence is or isn't necessary to substantiate a claim. And notably, some policies for individual advisors (particularly RIAs) specifically exclude paying out for ERISA liabilities, which may have been fine in the past if the advisor didn't work with 401(k) plans but now should be updated given the DoL's expanded reach to IRAs. In addition, advisors should be cognizant that many other types of policies that cover forms of fiduciary breaches (e.g., Directors and Officers coverage) specifically exclude ERISA-related fiduciary liabilities. The bottom line: make sure you review your E&O policy with the carrier before the DoL fiduciary rule kicks in next April, to be certain you're covered for the potential liability you face for the face you'll be giving!

A Concise History Of The Financial Planning Profession (Dave Yeske, Journal of Financial Planning) - The birth of the "modern" professional practice of financial planning is typically dated back to 1969, when on December 12th of that year Loren Dunton convened 13 financial services industry leaders at a hotel near Chicago O'Hare to discuss the creation of a new profession. Out of that meeting was born the Society for Financial Counseling (a membership organization that would eventually become the International Association for Financial Planning [IAFP]), which included an educational arm that would eventually be renamed the College for Financial Planning. Two years later, in 1971, the College created a five-course curriculum for the CFP designation, graduating its first class in 1973. That graduating class in turn formed the Institute for Certified Financial Planners (ICFP) as something of an alumni association. These three organizations - the IAFP, the ICFP, and the College - formed the core institutional framework for the emerging profession. Over the next two decades, the ICFP focused primarily on the interests of CFP professionals and promotion of the CFP marks to the public, media, regulators, and legislators, while the IAFP focused more broadly on anyone in the financial services industry who had an interest in financial planning or financial planners (and was "designation neutral"). In the meantime, the education of CFPs themselves shifted when in 1980, the College for Financial Planning sued Adelphi University for granting CFP marks to graduates of its financial planning certificate program, given that the College owned the service mark and trademark on CFP and Certified Financial Planner; ultimately, though, a fear that the case might lose lead the College's then-president Bill Anthes to propose creating an independent standard-setting body to control the marks, and seeded it with $2.5M, giving rise to the International Board of Standards and Practices for Certified Financial Planners (IBCFP), which later was renamed the Certified Financial Planner Board of Standards (today's CFP Board) and allowing for other programs to teach the CFP marks (which grew to 20 universities by 1987). The remaining College for Financial Planning entity was then wrapped up under a new umbrella entity, the National Endowment for Financial Education (NEFE), which in 1997 sold the College for Financial Planning to the Apollo Group and focused itself as a non-profit foundation to educate consumers about personal finance (and is still active today). Also in the 1990s, the IAFP (re-)activated a long dormant non-profit entity to help support the delivery of pro bono financial planning services to those in need, now known as the Foundation for Financial Planning. And ultimately the IAFP and ICFP themselves decided to merge in 2000, forming today's Financial Planning Association, which in turn decided to spin off its broker-dealer division to form the Financial Services Institute as the FPA prepared to sue the SEC over broker-dealers providing investment advice for a fee without registering as investment advisers. In the meantime, the CFP Board begin to promote the CFP standard worldwide, ultimately leading to the creation in 2004 of the Financial Planning Standards Board (FPSB) which owns the rights to the CFP marks outside the US (and now has more than 26 member organizations around the world, supporting over 161,000 individual CFPs). Also notable, given where this article itself was published... in late 1978, the ICFP founded a new Journal of the Institute of Certified Financial Planners (with the first issue published in 1979), which ultimately became today's Journal of Financial Planning.

Research On Delegating Shows How Uncomfortable We Are Making Choices For Others (Mary Steffel & Elanor Williams & Jaclyn Perrmann-Graham, Harvard Business Review) - A key issue for organizational efficiency, from large corporations to small advisory firms, is a manager's willingness to let go of control and delegate tasks. Though sometimes, tasks that are delegated become hot potatos, rapidly passed from one person to the next, such that no one takes responsibility. Accordingly, researchers have started to dig in and figure out why people delegate choices, when they're more likely to delegate, and what choices the delegee is more likely to accept (or not). The results reveal that people are much more likely to hand off decisions that impact others as well as themselves, especially when the choice is between unattractive outcomes. Yet the question still arises as to why those issues are delegated. The researchers found it's not because of how the decision impacts the decision-maker, or because the choice is difficult, or because decision-makers are lazy or don't trust their own abilities; instead, it turns out that one of the primary reasons we delegate choices to others is because we're afraid of being blamed if the choice goes poorly, especially if we don't want to feel responsibility for that outcome (so we're most likely to delegate decisions that would have negative consequences for others). Consequently, it turns out that we're also much less likely to delegate to subordinates, precisely because we know that the responsibility will still come back to us if the outcome turns out poorly. Of course, these fears also impacts us as the delegee - we're more likely to want to continue to pass the buck ourselves, if the decision that's been delegated to us could reflect poorly on us if the outcome isn't favorable. And notably, while the research was done in the context of organizations and their habits of management and delegation, the research has significant implications for financial planners, as you consider what kinds of decisions clients are likely to delegate to us (or not), and the kinds of decisions we in turn may want to delegate to third-party providers, to manage our own risk of blame for potentially adverse outcomes.

Why Luck Plays A Big Role In Making You Rich (Ben Steverman, Bloomberg) - The mere suggestion that people who got wealthy might need to thank luck as well as their own skills and abilities can be a highly controversial topic. Nonetheless, in a new book entitled "Success and Luck: Good Fortune and the Myth of Meritocracy", economist Robert Frank raises the question of whether we at least need to give some additional consideration to the significant role that luck plays. Not that those who are highly successful, like Bill Gates or Warren Buffet, didn't have significant talent and weren't very hardworking; still, though, good luck circumstances can be a non-trivial tailwind. For instance, in professional hockey leagues, 40% of players are born in the first 3 months of the year, a disproportionate representation that is driven by the fact that January 1st is the birth date cutoff for youth hockey teams, such that those born early in the year are the oldest (and therefore the biggest and strongest) and are most likely to stick with the sport and move up the ranks; similarly, 1/3rd fewer CEOs are born in June and July than would be expected by chance, which again appears to be related to the fact that they'd tend to be the youngest in their classes when they start school. And ironically, Frank notes that as marketplaces become more competitive (and more likely to be winner-take-all markets, which Frank has studied for decades), and the differences between the participants narrow, which in turn causes the role of luck to be even bigger (as the hidden edge that causes one person or business to end out outperforming another initially, and having the opportunity to then sustain their edge). Notably, though, because luck is often a catalyst in an otherwise competitive marketplace, that doesn't mean it can be relied upon; those who haven't invested in the education, infrastructure, etc., to capitalize on luck, won't be able to leverage it if/when it happens anyway. Which means ultimately, the controllable part of success is still about getting educated and working hard to get ahead, as luck may be a key factor in the end, but the fact remains that "luck favors the prepared".

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!

In the meantime, you may want to check out this video below, by famed philosopher Alan Watts, which provides an interesting perspective on how life isn't just like travel - where it's about the journey and the destination at which you arrive - but is more like music, where the whole point is not to get anywhere, but simply to enjoy the composition itself. Which has profound implications for financial planning, which in today's world is all about treating life goals as a journey to a destination...