Weekend Reading For Financial Planners (Sept 3-4)

Reg BI Enforcement To Zero In On Recommendations

(Melanie Waddell | ThinkAdvisor)

The Securities and Exchange Commission (SEC)’s Regulation Best Interest (Reg BI), issued in June 2019 and implemented in June 2020, requires brokers to act in their clients’ best interests when making an investment recommendation, by meeting four core obligations: disclosure, care, conflicts of interest, and compliance. Of course, regulations need to be enforced to be effective, and the SEC this year has taken a series of actions to clarify and enforce Reg BI, including issuing bulletins providing guidance on account recommendations and addressing conflicts of interest, as well as bringing its first enforcement action.

And now, the SEC has included enforcement of Reg BI’s requirement for brokers to act in a client’s best interest when making a recommendation in its draft Strategic Plan for fiscal years 2022-2026. Notably, in Reg BI, “recommendations” are deemed to include not just securities and investment strategies themselves, but how they are invested and implemented; consequently, recommendations as to the type of account (e.g., fee-based advisory vs. commission-based brokerage), whether to roll over or transfer assets from an employer retirement plan to an IRA (that will invest in securities), or to take a plan distribution (to open up an investment account with the proceeds) are also recommendations to which Reg BI would apply. At the same time, though, brokers are still only required to act in their clients’ best interests at the time the recommendation is made, and not with respect to the overall broker-dealer business model or its relationship to the client, a lower standard than the fiduciary-at-all-times requirement of RIAs. Which raises the question of just how far the SEC will really be able to drive change in the business practices of broker-dealers (or not?) with greater enforcement of Reg BI.

Other notable topics addressed in the draft strategic plan (which is open for public comment through September 29) include a desire to increase transparency in private investment markets and modify rules to ensure that core regulatory principles apply in all appropriate contexts. The SEC also expressed a desire to enhance its expertise in, and devote more resources to, product markets beyond equities, including cryptoassets, derivatives, and fixed income.

Altogether, inclusion in the draft strategic plan suggests that the SEC plans to prioritize enforcement of Reg BI’s measures regarding investment recommendations, which, combined with a growing number of private arbitration cases related to Reg BI, could not only improve discipline against broker-dealers and their representatives who violate the rules, but also provide further guidance on how the SEC views the not-quite-fiduciary regulation and its requirements. Nonetheless, because the rules only apply at the time of recommendation, further changes, such as title reform, are likely needed to help consumers really understand the difference between a broker who only has to act in their best interest at the time of the recommendation and an advisor one who must act in their best interests at all times!

Is A Great FINRA Purge Coming?

(Diana Britton | Wealth Management)

In September 2021, FINRA adopted Rule 4111, which targets broker-dealer firms with a “significant history of misconduct” and imposes new regulatory obligations on firms that hire disproportionate numbers of ‘problem brokers’. At its core, Rule 4111 establishes an annual process to identify certain broker-dealers as “Restricted Firms” (based on exceeding numeric thresholds across six conditions, including pending and adjudicated disclosure events for registered individuals or firms, as well as terminations and affiliations with registered persons from previously expelled firms). These firms will be required to deposit additional cash or securities into a segregated account to meet future FINRA fines, including potential unpaid arbitration awards.

In July, FINRA gave each firm access to its own Rule 4111 report, and those on the preliminary “restricted” list now are undergoing deeper scrutiny to determine whether some disclosures should not have been included in the regulator’s calculations, and also have a 30-day period to fire high-risk representatives to bring their risk number below the threshold. They also have the opportunity to consult with regulators before a decision is made.

Amid this ongoing process, broker-dealers appear to be taking the initiative to ‘clean house’ by firing brokers with a history of complaints and avoiding hiring those with complaints on their records. At the same time, this has raised concern among industry recruiters that brokers with even minor complaints (or who haven’t gone through the process of having dismissed issues expunged from their record) are having more difficulty finding positions, with the talent pool growing even larger with firms looking to fire representatives with complaints on their records. In addition, industry observers suggest that the rule could cause particular problems for smaller firms, which represented 40 of the 45 FINRA member firms that met the preliminary criteria for identification on the restricted firm list as of 2019. This could lead to small firms seeking to merge with larger firms to avoid the consequences of falling on the restricted list.

Ultimately, the key point is that FINRA’s rule appears to be having its desired effect of weeding out problem brokers from member firms, though it appears that some firms are taking a particularly draconian approach that is snaring some brokers with few or unfounded complaints. In addition, Rule 4111 could further the trend of a shrinking number of broker-dealers and registered representatives, as firms consolidate and brokers who have faced complaints and cannot find a new job leave the industry (with these figures perhaps also reflecting a preference shift among consumers toward advice-centric, rather than product-centric models, as the number of RIAs continue to grow?).

Study Suggests SEC Loophole Lets Funds Mislead Investors On Performance

(Dinah Wisenberg Brin | ThinkAdvisor)

Benchmarks are often used by advisors and consumers as part of their investment selection process. By comparing a fund’s performance with a benchmark index representing a similar investment style or strategy (e.g., large caps or value), an advisor can see whether the fund outperformed or underperformed its benchmark in a given period. A key part of this process is choosing a benchmark index that most accurately reflects the fund’s strategy to provide the most appropriate comparison. However, a new research study suggests that some funds regularly change their benchmarks to provide a more favorable (rather than more accurate) comparison.

According to a study by Kevin Mullally and Andrea Rossi, while the SEC requires funds to disclose at least one appropriate broad-based market index to which they compare their 1-, 5-, and 10-year returns, funds have the option to change the benchmark they use. And according to their research using fund prospectuses, between 2006 and 2018, 36.5% of funds made at least one change to their benchmark, with a median number of two changes for funds that made at least one change.

And while there are legitimate reasons for funds to change their benchmark (e.g., the fund changed its investment approach), several funds appear to be doing so to switch to benchmark indices with worse prior performance, making their fund returns appear more favorable in comparison. The study found that funds change to benchmarks with an average of 2.39% lower five-year returns than their existing benchmarks and 5.56% lower five-year returns than the index that best matches their strategy. Further, this appears to be to the detriment of investors, as funds that change benchmarks receive abnormal positive inflows for the five years after the switch while generating lower returns than peer funds, according to the study.

Altogether, the study demonstrates the importance for advisors of considering the appropriateness of the selected benchmark index when evaluating funds for their clients. Because, while many advisors recognize that past performance does not necessarily reflect future returns, assessing funds based on a skewed view of relative past performance can make selecting funds likely to have strong future returns even more challenging!

Morningstar To Merge Two Rating Systems

(Dinah Wisenberg Brin | ThinkAdvisor)

Morningstar investment ratings have been a frequently used tool for advisors and consumers assessing mutual funds and other investment vehicles since the inception of the company’s first mutual fund rating in 1985. Since that time, the company’s range of ratings has expanded, and now includes both backward- and forward-looking ratings, quantitative and qualitative analyses, as well as sustainability ratings, creating a more comprehensive – but arguably also more complicated and overlapping picture – than the original Star Ratings.

To help reduce some of the confusion, Morningstar is planning to combine its two forward-looking ratings, the Morningstar Analyst Rating (a qualitative measure conducted by humans) and the Morningstar Quantitative Rating (a quantitative measure using algorithmic techniques), into a single “Morningstar Medalist Rating” in the second quarter of 2023. The ratings will now shift to a common scale of Gold, Silver, Bronze, Neutral, and Negative. The company said that neither rating methodologies (which are based on “people, process, parent, and fees”) will change, and it does not expect the systems shift to affect the ratings it assigns to managed investments.

The combination of Morningstar’s forward-looking ratings comes at a time when its backward-looking Star Ratings (which are based on past risk-adjusted returns) have come under scrutiny. In its continuing response to a scathing analysis of its alleged ineffectiveness by The Wall Street Journal in 2017, the company last month released an audit report that suggested that while, particularly in the long run, the backward-looking Star Ratings (along with the forward-looking analyst and quantitative ratings) have done a good job of sorting funds based on future performance (with higher-rated funds being more likely to survive and outperform lower-rated funds going forward), the Star Ratings have struggled in the current bear market, with lower-rated funds ironically outperforming higher-rated funds.

Ultimately, the key point is that while Morningstar is moving to simplify its rating systems, it remains important for advisors to understand the methodology of the ratings (both the forward-looking Analyst and Quantitative Ratings, and the backward-looking Star Ratings) and their potential strengths and weaknesses. Though at the same time, given the challenges of picking funds that will outperform going forward (even for a well-resourced company like Morningstar!), it is perhaps not surprising to see the continued growth of advisors simply using passively-constructed ETFs instead, or choosing to outsource their investments altogether (e.g., via model marketplaces or Turnkey Asset-Management Platforms (TAMPs))!

As Investors Look To Alts, Private Placement Life Insurance Could Become More Attractive

(Rajiv Rebello | Colva Actuarial Services)

Private Placement Life Insurance (PPLI) has long been a tax-shelter vehicle for Ultra-High-Net-Worth (UHNW) clients, leveraging the tax-deferral build-up of cash value in a permanent life insurance policy but in a structure that accommodates more specific investment choices (for that particular UHNW client) and without the sometimes-expensive commission structure that can overlay 'traditional' permanent life insurance. This vehicle received a boost in late 2020 from the Consolidated Appropriations Act, which allowed insurance companies to use lower interest rate assumptions (based on a new variable rate tied to current market rates) in determining whether a life insurance policy will become a taxable Modified Endowment Contract (MEC), which has the end result of allowing substantially higher cash value contributions into permanent life insurance without triggering MEC status.

And now, recent market trends might give PPLIs a further boost. Because these policies are often used to hold tax-inefficient investments (as the gains are tax-deferred), a renewed interest among many investors in alternative investments (that are often tax-inefficient) in the current market environment (in which both ‘traditional’ stocks and bonds have performed poorly), could make these vehicles even more attractive. And while the proposed income, capital gains, and estate tax measures in President Biden’s “American Families Plan” proposal (that would have potentially made PPLI even more attractive) did not come to fruition, the prospect of these measures being considered in the future is also leading some UHNW clients to consider implementing PPLI now.

Despite their potential benefits, though, PPLIs aren’t a free lunch and are best used by clients in specific situations. PPLI is only available to clients who are qualified purchasers ($5M or more in investments) and who are willing to commit at least a total of $1M to $2M to the vehicle over 4 years (as those using PPLI will want to sufficiently fund the policy so that there is room for substantial investment gains to compound on a tax-preferenced basis above and beyond what may be eaten up by Cost-Of-Insurance [COI] charges, and to reduce the insurance amount-at-risk to bring down those COI charges in the future). Further, those using PPLI will typically want to have other sources of liquidity, as the breakeven point between PPLI and investing in taxable vehicles (based on the taxation and expenses associated with the PPLI) is typically 7 to 10 years.

Altogether, this means that PPLI is at best still only under consideration for a subset of UHNW clients facing significant income- or estate-tax liabilities and who have substantial liquidity and very long investment time horizons. Though from the business model perspective, advisors charging on an AUM basis can also potentially benefit from the PPLI vehicle themselves, as they can charge directly to manage the assets within a tax-deferred PPLI policy (similar to charging on a Traditional IRA), which effectively comes out of the portfolio on a pre-tax basis (rather than paying fees from traditional taxable accounts on an after-tax basis). Still, given the restrictions and expenses associated with PPLI, advisors and their clients will want to carefully consider whether the tax benefits of the vehicle outweigh the potential costs and complications (compared to more ‘traditional’ tax-deferral vehicles or other estate planning techniques that are still available)!

Crypto's Real Value Was Never $3 Trillion

(Vildana Hajric | Bloomberg)

When attempting to value a company or an industry, an advisor has many tools at their disposal, from profit and revenue data to the value of the company’s physical and intangible assets. But for cryptocurrencies, which do not generate revenue or own buildings or inventory that can be sold, measuring their actual worth is a challenging proposition.

One option for measuring the value of the cryptocurrency market is to look at its market capitalization, calculated simply by multiplying the number of tokens of each currency available by their most recent price. This figure for the total cryptocurrency market shot up as high as $3 trillion in late 2021 but has since shrunk to about $1 trillion amid the current broad decline in the prices of cryptocurrencies. But some industry observers note that the market cap of cryptocurrencies can be inflated by a number of factors, including leverage, wash trades (where actors sell coins to themselves), manipulation, dormant coins, and coins that never made it into circulation. With this in mind, an alternative approach is to look at the realized value, or the actual price of a coin in its most recent transaction. Using this approach, a $1 trillion valuation for the cryptocurrency market appears to be more accurate, as there is significantly less leverage in the system than in late 2021.

The key point is that for advisors assessing the cryptocurrency market (or those who are working with clients with cryptocurrency in their portfolios), the nominal price quoted for a given coin might not reflect the actual value market participants assign to it. And given that the ability to profit off of cryptocurrency investments is based on the ability to sell it to a buyer for a higher price than it was purchased, having a more accurate idea of the ‘actual’ value of a coin of interest is an important part of the investment process!

How Much Do Retirees Spend On Uncertain Health Costs?

(Karolos Arapakis | Center For Retirement Research At Boston College)

One of the key concerns among retirees is being able to afford health care costs, including potential long-term care costs, throughout the remainder of their lives. And given the uncertain nature of these costs for a given individual, retirees will often save excessive amounts to cover these expenses, leaving behind dollars that they might have used for other spending needs. Amid this background, a recent analysis suggests that thanks to insurance coverage, retirees might face fewer out-of-pocket health care costs than they think.

According to Arapakis’ research (using data from the Health and Retirement Study, the Medical Expenditure Panel Survey, and administrative Medicare and Medicaid data, a 65-year-old can expect to incur an average of $310,000 of health care costs during the remainder of their life. However, almost 80% of these costs are covered by insurance, leaving them to pay a mean total of $67,000 during their retirement (not including insurance premiums). Even an individual at the 90^th percentile of medical expenses would ‘only’ have to pay a total of $138,000 out of pocket (out of a total of $642,000 of costs incurred) from age 65 until their death.

This research suggests that advisors have several ways to support clients in planning for retirement health costs. First, putting expected out-of-pocket costs into perspective can give clients how much their ‘actual’ expenses might be (perhaps adjusting this total upward for any known or chronic conditions the clients might have). In addition, advisors can also help clients choose the best Medicare plan for their individual needs. But in the end, perhaps an advisor’s greatest added value in this area is helping clients recognize that health insurance premiums and out-of-pocket costs are not a one-time, lump-sum cost, but rather an ongoing expense that can be incorporated into the client’s financial plan!

A 21st Century Tontine Set To Debut

(Jane Wollman Rusoff | ThinkAdvisor)

One of the primary concerns among retirees (and advisors) today is longevity risk, or the risk that they will spend down their assets before their death. However, there are many ways to mitigate this risk, from delaying Social Security (and receiving larger monthly benefit payments for life) to purchasing a Single Premium Immediate Annuity (SPIA), which, in its most basic form, offers a ‘guaranteed’ monthly payment for the remainder of the annuitant’s life in return for an upfront premium payment. Another option, the tontine, has existed for hundreds of years but has waned in popularity during the past century.

But it appears that investors might be able to access the benefits of a tontine soon, as York University finance professor (and tontine researcher) Moshe Milevsky, has teamed up with a financial services firm (whose name is currently under embargo) to introduce a tontine product, with a twist on the traditional structure. A tontine agreement is a form of pooled investment fund to which the investors contribute a lump sum and, in exchange, receive ongoing payments (or “dividends”) as a return on their investment. Similar to an SPIA, the payments from a tontine are typically made “for life” and end only at death. However, with a tontine, the payments that cease at the death of one investor are redistributed to the other investor participants, increasing their subsequent payouts (until they, too, pass away).

Unlike traditional tontines, Milevsky’s product will be structured as a mutual fund, with a catch: investors can never exit the fund (though certain versions will allow for a limited amount of liquidity). And unlike SPIAs, monthly payments are not guaranteed; but in exchange for allowing for variation in payments, retirees who outlive other participants in the tontine could end up receiving more in payments than they would have with an SPIA.

So, while this ‘modern’ tontine prepares for its debut, advisors can compare this potential option with other ways to mitigate longevity risk for their clients. Nevertheless, for clients with long life expectancies who are willing to make an up-front, lump-sum investment, a tontine could be an attractive option to meet their retirement income needs!

Here's What A $2 Million Retirement Looks Like In America

(Veronica Dagher and Anne Tergesen | The Wall Street Journal)

During their working years, Americans are accustomed to hearing about the importance of saving for retirement. But after a lifetime of saving, retirement can come as a shock to some individuals, who have to make the mental transition from accumulating assets to decumulation. And at a more fundamental level, retirees have to consider how to spend their time and money.

One important part of planning for retirement is finding activities that provide the retirement with purpose and meaning (which might have previously come from their occupation). This could mean taking on a part-time job or consulting gig, volunteering regularly, or serving on corporate and non-profit boards. Not only can these opportunities provide a sense of purpose and day-to-day structure, but can also supplement retirement income (and reduce the amount they have to withdraw from their portfolio to cover spending in the current bear market!).

Another consideration for retirees is where to live. For those who bought a larger house to support their family while their kids were at home, moving to a less-expensive home can free up the equity in the original home and reduce ongoing housing expenses. In addition, retirees who currently live in a high-cost-of-living area might consider moving to a lower-cost area that offers the amenities they enjoy. Others might choose to move closer to their children to get the benefits of close family relationships (and perhaps offer free childcare for their grandchildren?).

So while advisors can help clients with the range of financial considerations that go into retirement planning (from assessing their preferred retirement income approach to analyzing their optimal Social Security claiming strategy), they can also add significant value by helping their clients consider what they want their day-to-day lives to look like in retirement. Because at the end of the day, the happiest retirees are often those who retire “to” something meaningful rather than “from” their previous career!

Big Beliefs

(Morgan Housel | Collaborative Fund)

When it comes to financial planning, an advisor might have hundreds of beliefs and opinions. From the best retirement savings vehicle to the optimal approach to life insurance, a wide range of ideas are likely floating around your head. But if you thought about it, you could probably distill these individual opinions into a few core beliefs.

In Housel’s case, he developed a series of ‘big’ beliefs that drive his analysis of business and investing. These include the idea that the inability to forecast the past has no impact on our desire to forecast the future (most people crave certainty even if they recognize the future is inherently uncertain!). In addition, he believes that no one’s success is proven until they’ve survived a calamity (as it can be hard to tell the difference between who is skilled and who is lucky until tough times arrive). Another one of his ‘big’ beliefs is that incentives are the strongest force in the world (even though nearly everyone underestimates how much of their own beliefs and actions are influenced by their incentives).

Particularly relevant to 2022 is his belief that sitting still feels reckless in a fast-moving world. For example, amid high inflation and volatile markets this year, it could be tempting for a client to want to change their long-term investing approach, while the best option might be to do nothing given that this money is not needed for years or even decades. He also cites Aldous Huxley’s quote, “Man has an almost infinite capacity for taking things for granted” as a core belief. For instance, humans have made amazing technological gains during the past century, but we are not necessarily happier, as what was considered an amazing innovation yesterday is often viewed as a baseline necessity today.

Of course, one person’s ‘big’ beliefs are unlikely to match another’s. But the key point is that while it can be easy to get stuck in the minutiae of financial planning (or another field), being able to identify the core principles of financial planning can help you break down and analyze specific client situations you encounter!

What's Your Delta?

(Nick Maggiulli | Of Dollars And Data)

It’s hard to resist the urge to compare one’s situation to others. Whether it is by income, job title, or – for advisory firms – AUM or client count, humans seem wired to compare themselves to others. At the same time, it’s important to recognize that not everyone started in the same position; some might have had the benefit of high-quality schools and a lucky draw in the genetic lottery, while others might have encountered much more challenging circumstances.

With this in mind, Maggiulli suggests that when you feel the temptation to compare yourself to others, instead compare yourself to where you would expect to be in the ‘average’ state of the world. For example, if you were to relive your life with the same genetics and general upbringing 10,000 times (Groundhog Day, anyone?), how does your life today compare to the ‘average’ result? If it is better (a positive ‘delta’), perhaps luck has played a role in your success, while if you are worse off (a negative ‘delta’), that might mean you’ve encountered some tough breaks.

The key point is that because everyone comes from different circumstances, comparing your current life to others can often lead to unnecessary frustration. Instead, considering how your own life has gone, given the hand you were dealt, can put your accomplishments into greater perspective. And for those who have found success, you could consider using your skills to help those who might not have had as many advantages or who experienced unlucky breaks!

41 Quick Tips For Health, Happiness, And Wealth

(Tony Isola |A Teachable Moment)

It’s likely that you’ve picked up a range of life lessons over time. Often, birthdays can serve as reminders to take stock of what you’ve learned and an opportunity to pass them on to others. This is the case for Isola, a financial advisor who compiled a list of his advice for achieving health, happiness, and wealth.

Among his tips for good health are some common recommendations, from eating plenty of fruits and vegetables to limiting sugar and alcohol consumption. Perhaps less well known, he suggests breathing through your nose rather than your mouth (as the latter practice is associated with numerous ailments), going to bed at roughly the same time each night and waking up at a similar time each morning, taking a 45-minute walk in nature daily, and avoiding sitting for longer than 30 consecutive minutes.

And instead of pursuing happiness (where temporary dopamine rushes feel great but don’t last), Isola instead recommends pursuing contentment and avoiding drama and toxicity along the way. He also suggests reading more books (but only finishing those that you enjoy!), worrying less about what others think about you, surrounding yourself with good people, and keeping an open mind to alternate viewpoints (while recognizing that you don’t have to have an opinion about everything!).

When it comes to money, Isola thinks that its purpose is to bring joy to others and fund contentment (rather than a way to purchase possessions that can lead to a never-ending trip on the hedonic treadmill). In addition, it is important to find an investing philosophy that you can stick to through thick and thin, which can help you ignore the constant barrage of (often scary) news.

Overall, Isola recommends finding ways to compound your wealth, health, and emotional well-being to build a life of contentment and purpose. And while you might not be able to relate to all of these tips, hopefully at least one will help you live a more meaningful life!

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We hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think we should highlight in a future column!

In the meantime, if you're interested in more news and information regarding advisor technology, we'd highly recommend checking out Craig Iskowitz's "Wealth Management Today" blog, as well as Gavin Spitzner's "Wealth Management Weekly" blog.