Nerd's Eye View blog

Using Retirement Accounts To Reduce Estimated Tax Penalties Via Tax Withholding From (Required Minimum) Distributions

November 4, 2020 07:23 am 17 Comments CATEGORY: Taxes

The United States tax system is set up on a “pay-as-you-go” basis, which means that taxpayers are required to pay taxes throughout the year as income is earned, whether it be through withholding income or making estimated tax payments. Individuals who don’t pay timely taxes throughout the year may be assessed Estimated Tax Penalties by the IRS, which are based on the amount of unpaid tax and the Federal short-term rate (in the first month of the quarter in which taxes were not paid) plus three percent. While understanding and helping clients comply with the requirements of tax payments can preclude Estimated Tax Penalties, advisors can also use simple arbitrage strategies to help clients maximize their savings when making estimated tax payments with tax-advantaged retirement account distributions.

While taxpayers who have income withheld to pay their tax liability generally aren’t required to make quarterly payments (as the IRS considers withholdings as if they were paid throughout the year, regardless of when they were actually paid), those who opt to make estimated tax payments must pay their estimated tax liability on a quarterly basis following a schedule of “General Due Dates for Estimated Tax Installment Payments” provided by the IRS. For taxpayers who choose to pay their taxes with estimated tax payments (versus through withholding taxes from paychecks or other qualifying accounts such as pensions or retirement plans), there are basically three options to calculate tax payments. Tax payments can be estimated based on the taxpayer’s prior year’s tax liability, where the estimated annual amount is equal to 100% of the prior year’s tax for income under $150,000, or 110% for income over $150,000, with the total estimated amount paid in equal quarterly installments. While this is generally the simpler way to calculate estimated payments (and more fool-proof in avoiding penalties, since the prior year’s tax will generally be known), individuals can also make estimated tax payments based on the current year’s tax liability instead. In this case, the amount due would be 90% of the current year’s liability paid in equal quarterly installments. The caveat to using the current year’s tax liability to calculate estimated tax payments is that, if the tax liability is underestimated, tax payments may be too low, and an Estimated Tax Penalty may result. The third way to make estimated tax payments is to use the Annualized Income Installment method, in which payments are based on the individual’s actual quarterly tax liability. While this method is cumbersome and time-consuming, it can be beneficial for taxpayers who earn income unevenly throughout the year.

Clients who pay their taxes by withholding income can benefit from the fact that quarterly payments are not necessarily required by the IRS. While paychecks are generally received on a regular basis throughout the year, resulting in withholding taxes in a true “pay-as-you-go” manner as intended by the IRS, retirement account distributions are often made only once per year, which effectively creates a “pay-as-you-go” loophole for taxpayers whose income consists of retirement account distributions! Because of this, advisors whose clients rely on retirement account distributions for income can help maximize savings by withholding taxes later in the year, thereby letting clients keep their money longer (and letting those funds grow in the meantime) without risk of incurring Estimated Tax Penalties.

For clients who may have inadvertently underpaid (or missed) estimated tax payments during the year, using an ‘erase-and-replace’ strategy can help them avoid an Estimated Tax Penalty by using a retirement account to withdraw the amount of underpaid estimated tax and withholding the entire amount from that distribution. The client can then ‘roll over’ non-retirement funds (that otherwise would have been used to make the estimated tax payment) within 60 days of the distribution to avoid any taxes due on the distribution itself, provided that no other rollovers have been made in the last year (so as not to violate the once-per-year-IRA-rollover ule).

Ultimately, the key point is that by leveraging the flexibility of tax withholding from retirement account distributions, advisors can develop strategies to help clients avoid tax penalties while keeping their money invested for longer and postponing tax withholdings until later in the year.

#FASuccess Ep 201: Building A Scalable Advisor Marketing Engine That Eliminates Reliance On Rainmakers Or Referrals, With John Wernz

November 3, 2020 07:05 am 1 Comment CATEGORY: Financial Advisor Success Podcast

Welcome back to the 201st episode of Financial Advisor Success Podcast!

My guest on today's podcast is John Wernz. John is the former chief marketing officer for Wealth Enhancement Group, an independent RIA based in Minneapolis that has nearly 20 billion of assets under management for nearly 20,000 affluent clients. What's unique about John, though, is the way he's scaled Wealth Enhancement Group's organic growth through marketing over the past decade, as the firm has grown from nearly 1 billion of AUM to nearly 20 billion, attracting more than 1.5 billion of net new client assets in the past year alone, not including acquisitions.

In this episode, we talk in-depth about how John built the organic marketing engine at Wealth Enhancement Group, why direct mail became a foundation for the firm's growth strategy, how Wealth Enhancement Group leverages third-party data sources to enrich its client personas to better target its marketing, why the firm uses a centralized sales team to field all prospecting queries before handing them off as leads for local advisors to close in service, and how John structures what is now a 30-person marketing team to execute across all of Wealth Enhancement Group's marketing channels.

We also talk about the economics and metrics of advisor marketing. How John evaluates the lifetime value of a client to the firm and why the company will happily spend more than $5,000 to get one new client. The core marketing metrics that Wealth Enhancement Group uses to track its success, including cost per lead, cost per appointment, cost per client, and why the firm doesn't target a certain percentage of revenue to spend on marketing and sales, and instead uses a media efficiency ratio to determine which marketing programs are worth sustaining or not.

And be certain to listen to the end where John shares how Wealth Enhancement Group's marketing success has led to a unique acquisition strategy to accompany it targeting firms in metropolitan areas that have enough depth to deploy their marketing strategies in that new market. How a growth-based acquisition strategy can result in cost synergies with a merger but avoid any layoffs in the acquired firm. And why John sees digital marketing from SEO to social media advertising, paid search to re-targeting, and more, as the next great frontier of scalable advisor marketing.

So whether you’re interested in learning how John’s firm uses direct mail marketing, how he calculates the firm’s media efficiency ratio, or how Wealth Enhancement Group uses acquisitions to open up new marketing channels, then we hope you enjoy this episode of the Financial Advisor Success podcast.

The Latest In Financial #AdvisorTech (November 2020)

November 2, 2020 07:08 am 0 Comments CATEGORY: Technology & Advisor FinTech

Welcome to the November 2020 issue of the Latest News in Financial #AdvisorTech – where we look at the big news, announcements, and underlying trends and developments that are emerging in the world of technology solutions for financial advisors!

This month's edition includes guest contributor Kyle Van Pelt, and kicks off with the big news that Morgan Stanley is acquiring asset manager Eaton Vance, in what was largely billed in the media as asset management consolidation of Eaton Vance’s mutual fund family… but in practice may be a $7B bet from Morgan Stanley on the future of Direct Indexing technology to displace ETFs and mutual funds, as in practice more than half of Eaton Vance’s assets were actually managed or overlay portfolios of its subsidiary Parametric (which is estimated to control a whopping 75%+ of the current Direct Indexing marketplace). Though in practice, Morgan Stanley will likely simply re-package Parametric into an ultra-HNW solution for its own 16,000+ brokers serving affluent clients… leaving the door still open for other Direct Indexing startups (or fast-encroaching incumbents) to gain market share with the mass of independent advisors.

From there, the latest highlights also feature a number of other interesting advisor technology announcements, including:

LPL acquires Blaze Portfolio for $17M to in-house its own model marketplace through rebalancing software
Lincoln Investment acquires Hanlon Advisory Software as the old IAS all-in-one ‘silver bullet seeks a new home
YCharts recapitalizes with LLR Partners to expand its footprint from investment research to investment communication (and potentially proposal generation?)
CapGainsValet launches its 2020 season of capital gains estimates for mutual funds with a new Delivery service to give advisory firms a weekly update on their firms’ individual holdings

Read the analysis about these announcements in this month's column, and a discussion of more trends in advisor technology, including MoneyGuide’s new built-in analytics to identify potential product sales opportunities for clients, Income Conductor’s novel discount on E&O insurance for independent advisors that use their retirement income planning software (with underwriters presuming that clients will be more likely to be satisfied with their outcomes?), ScratchWorks FinTech accelerator announces its season 3 winners with $5M of funding and opens for new applications for Season 4, and CRM systems signal that they may be becoming the new ‘hub’ for advisory firms as Holistiplan, fpPathfinder, fpAlpha, and Knudge all announce new integrations to Redtail and Wealthbox!

And be certain to read to the end, where we have provided an update to our popular new “Financial AdvisorTech Solutions Map” as well!

I hope you're continuing to find this column on financial advisor technology to be helpful! Please share your comments at the end and let me know what you think!

*And for #AdvisorTech companies who want to submit their tech announcements for consideration in future issues, please submit to [email protected]!

Weekend Reading for Financial Planners (Oct 31 – Nov 1)

October 30, 2020 02:53 pm 0 Comments CATEGORY: Weekend Reading

Enjoy the current installment of "Weekend Reading For Financial Planners" – this week's edition kicks off with the news that Congress is considering a new round of retirement legislation, dubbed the "Securing A Strong Retirement Act" or simply "SECURE Act 2.0" on the heels of last year's 2019 SECURE Act legislation, which could be passed in the lame duck Congressional session this December with a wide range of new benefits (from allowing QCDs from IRAs to be contributed to a charitable remainder trust, to increasing the RMD age yet again to age 75).

Also in the news this week is a rising discussion of new estate planning strategies that may become popular in the last 2 months of the year if there is a "blue wave" on election day (given looming discussions of proposed upper-income tax increases from the Biden campaign), and a recent Dalbar study finding that 83% of investors agreed that their account balance is higher today because of the help of their advisor during the crisis and 9-in-10 investors reported a slight or significant increase in confidence and trust in their advisor (and being more likely to retain their advisor) in the aftermath of the pandemic

From there, we have a few sales-related articles, including why it's so important for financial advisors to tell their own personal story of why they're an advisor in order to deepen a relationship with prospective clients, what to say and how to try to recover if you unwittingly put your foot in your mouth in the midst of a meeting with a new prospect, and why even advice-centric firms may still need to consider establishing sales quotas on business development to create a culture of accountability around growth (or risk being acquired and subsumed by other advisory firms growing faster because they have figured out how to do so).

We've also included a number of practice management articles, from a look at the ongoing rise of incorporating legal and/or accounting services into advisory firms (and some of the complexities that arise), the announcement that eMoney Advisor is piloting an outsourced paraplanner solution to help firms with the back-office work of actually creating their financial plans (so advisors can focus on client meetings), and some tips on how to delegate - what to keep doing and what should be delegated - to focus an advisor's time into its highest and best use.

We wrap up with three interesting articles, all around the theme of financial literacy: the first explores how, finally, financial education is starting to be incorporated more into college campuses as the ability to navigate the financial system is itself becoming an essential life skill in the modern era; the second explores how, despite the obvious appeal of financial literacy, the actual results of providing more broad-based financial education are mixed at best, and that 'just-in-time' focused education when needed most may be more relevant for individuals; and the last explores how to make financial literacy and personal finance more fun, by getting away from jargoned explanations of technical topics (e.g., what is life insurance and how does it work), and instead focusing on more entertaining and relevant ways to teach key financial concepts (e.g., why is life insurance appropriate for Homer Simpson but not Batman!?).

Enjoy the 'light' reading!

Growing Your Question Game: 21 Questions To Ask Clients And Prospects And How To Structure Them For Better Client Engagement

October 28, 2020 07:05 am 3 Comments CATEGORY: Client Trust & Communication

The very foundation of doing financial planning starts with gathering client information in order to produce financial plans that analyze a client’s situation and provide recommendations to help clients realize their goals. But the process of data gathering to do financial planning involves a lot more than simply gathering financial data. As while the first responsibility of the financial planning process under the CFP Board’s Standards of Conduct is to “understand the client’s personal and financial circumstances,” it is crucial for advisors to establish a solid rapport based on trust to facilitate open lines of communication in the first place. After all, identifying the issues that involve a client’s personal circumstances, along with the details of their financial goals and dreams, requires the client to have a high level of trust in their advisor to disclose their most intimate financial details and be able to comfortably talk about and explore their hopes, dreams, goals, and wishes. As a result, knowing how to ask the “right” questions that elicit trust and create rapport can be vital for financial advisors to gather the information they need – both financial and personal – to ultimately formulate the best financial planning recommendations for their clients!

In practice, there are several types of questions that advisors can strategically use to obtain information and at the same time strengthen client relationships. One type of question that encourages thoughtful reflection is the swing question, which poses situations with hypothetical phrases beginning with words such as “will”, “can”, “would”, or “could”. These are good question types to gently probe points of resistance (e.g., instead of asking “Why haven’t you called your estate planning attorney yet?”, ask “Can you tell me how it’s going with your estate planning attorney?”) or explore ideas that may be new to the client (e.g., “Could you explain your education funding ideas for your grandchildren?”). Swing questions are best used with clients with whom the advisor already has an established relationship, and can be good ways to deepen ties with the client.

Implied questions are another type of question and are generally statements structured as questions, beginning with phrases such as “I wonder…” or “You must be…”. Implied questions are a useful way to reiterate an important idea that the client has expressed, and show the advisor’s genuine interest in the topic. They also offer a good opportunity for the client to provide further details around personal situations that can impact how a financial plan should be tailored (e.g., “I wonder how you see your new employment opportunities affecting your retirement goals?”). Like swing questions, implied questions are most effective when the relationship has already been established, and can serve to enhance the rapport in those relationships.

Projective questions are open-ended questions that can be used to help clients visualize scenarios that the advisor may want the client to consider. They generally start with phrases like “What if…” or “What would…” and can help clients envision and understand new possibilities that may make sense for their financial plans. Scaling questions are another type of question and can be used to assess relative levels of a client’s interests and concerns. These are typically structured as “On a scale of x to y, where are you on that scale?” For instance, an advisor can ask their client something like, “I know you’ve expressed concerns about the recent market activity; on a scale of 1 to 10 where 1 is the calmest and 10 is the most anxious, where are you on that scale?” Both projective and scaling questions are good ways to solicit information that the advisor may be specifically interested in and can be used with any client, regardless of whether the relationship is well-established or still relatively new.

For any questions that the advisor chooses to use, it is important to be mindful of when to ask them, and when to give the client space to reflect on their answer and elaborate with details. Asking questions too rapidly without room for reflection will generally be very stressful and overwhelming for the client… feeling less like an advisor-client relationship and more like an interrogation! However, by pacing a series of questions to allow the client to digest what is being asked, and to contemplate their answer, the advisor can gather valuable information not just for financial planning purposes, but also for better understanding the client on a personal level and deepening the relationship.

Ultimately, the key point is that by choosing the right questions to ask, and pacing the questions to allow for reflection and thoughtful exploration, advisors can learn a lot about their clients to help them develop effective financial planning strategies and, in the process, enjoy deepening their relationships as well!

#FASuccess Ep 200: Scaling A Successful Business Beyond Yourself By Constantly Reinventing Your Role, With Michael Kitces

October 27, 2020 07:07 am 4 Comments CATEGORY: Financial Advisor Success Podcast

Welcome back to the 200th episode of Financial Advisor Success Podcast!

Our guest on today's podcast is me, interviewed by our guest host, Alan Moore. Leading up to this milestone 200th episode of the podcast, we put out a survey to the listenership via Kitces.com about whom to invite as a guest. Overwhelmingly, the feedback from all of you was a desire to hear more of my own story and how it's changed the nearly four years since I was first on the podcast, back in episode 20.

In this episode, we'll talk in-depth about my own career journey, starting out with how I landed in the financial services industry straight out of college, despite having studied psychology, theater, and medicine, and not finance or economics while I was an undergrad. Why I made the leap to launch the Kitces.com platform and split my time between writing and speaking and the advisory firm. And the reason I spend so much time advocating for smaller, independent firms, but recently made the decision myself, to switch to a much larger, so-called ‘mega RIA’.

We also talk about the unexpected ways that a career journey can unfold, including why I spent the first three years of my career trying to avoid a role that required any new business development, and then 10 years later, became a partner because of my success in bringing in new clients. Why spending years developing financial plans and delivering them to hundreds of clients made me not want to keep building my own client base for the next 30 years. Why, despite being highly risk averse, I've ended out launching nearly half a dozen different new businesses to serve the advisor community. And why, after nearly 10 years of operating Kitces.com, itself, is a lifestyle practice, we've made the decision to turn it around and grow from 3 to 13 team members in barely over 3 years.

And be certain to listen to the end where I share more of what happens behind the scenes, the low points I've had along the way of my journey, and the techy career I almost ended out with if I hadn't become a financial planner. How an admittedly non-traditional approach to financial planning for my own financial house has been a key to navigating my career journey. The advice no one gave me that I wish I'd had when I started to build and scale businesses, and the system that I've developed to manage my own time and hectic schedule so I can stay focused on having the biggest positive impact I can on the advisor community.

So whether you’re interested in learning about why Michael decided to pursue financial planning rather than psychology, medicine, or theater; how he uses “daily rocks” to manage his time and stay productive; or hear more about the hobbies of the man behind the blue shirt; then we hope you enjoy this episode of the Financial Advisor Success podcast.

The Best Conferences To Attend (Or Not) In 2021 And The Future Of Financial Advisor Conferences

October 26, 2020 07:04 am 3 Comments CATEGORY: Conferences

Reinvesting in one’s education is a staple of being a professional and is embodied in both the philosophy and the actual requirement of continuing education (CE). Of course, ideally, financial advisors will want to advance their knowledge not merely to fulfill a CE obligation but for the sake of the additional knowledge and expertise itself, which can pay dividends from better strategies for clients to practice management guidance that (even if not actually CE-eligible) helps them better execute their businesses and service their clients.

However, the world of financial advisor conferences – which so many advisors attend for those continuing education and advanced learning opportunities – were substantively disrupted in 2020 by the coronavirus pandemic, which shuttered virtually all in-person advisor events after the March outbreak through the end of the year, forcing some events to be canceled, others to be delayed into 2021, and most to be pivoted to an online/virtual format with… varying degrees of success.

Starting back in 2012, we began to publish an annual list of recommended conferences for financial advisors to attend – a byproduct of the fact that I’ve been speaking at 50 – 70 conferences per year for more than a decade myself, and as a result, have seen and attended virtually every major advisor event, and could provide a first-hand perspective on which events really delivered on their promise of advisor education, from membership associations to broker-dealers, insurance companies to RIA custodians, trade publications, private events, and more.

But as we come up on 2021, the reality is that no one knows exactly what the options for advisor conferences will even be in the coming year, given both the uncertainty about the timing of the coronavirus vaccine, a major shift in the economics of advisor conferences as vendors have pivoted heavily to running their own webinar events and appear to be scaling back on the future of conferences, and limited experience for any events about how well they really deliver, or not, in a virtual environment.

As a result, this year’s newest list of the “Top Financial Advisor Conferences” for 2021 takes an alternative approach, focusing instead on the ‘knowns’ we can control in the decision of what events to pursue, including Community Events for the advisor’s platform (e.g., the advisor’s broker-dealer, RIA custodian, or advisor network), Deep Learning events for advisors looking to better specialize, immersive Practice Management events for those looking to get more efficient in (or better execute on) their businesses, and the ever-widening range of both free and paid Continuing Education on various topics.

In addition, we’ll continue to maintain our new “Master Conference List” of all financial advisor conferences in 2021, with ongoing updates for which will be virtual versus in-person, as a guide for advisors to plan their own conference budgets and schedule in the coming year.

So I hope you’ll find this upcoming year’s 2021 financial advisor conferences list (and our new 2021 Master Conference List) to be helpful, in an environment that admittedly poses far more uncertainty in the landscape of advisor events than we’ve ever seen… while still recognizing that in the end, reinvesting into our own education as financial advisors is still a professional imperative.

Weekend Reading for Financial Planners (October 24-25)

October 23, 2020 03:00 pm 4 Comments CATEGORY: Weekend Reading

Enjoy the current installment of "Weekend Reading For Financial Planners" – this week's edition kicks off with a new consumer research survey from Cerulli, finding that consumer willingness to pay for financial advice is at an all-time high, as the pandemic has increased demand for financial advisors and shifting business models are providing consumers new ways to engage with a financial advisor on a fee-for-service basis (even if they don't have a portfolio to manage or a need for a particular financial services product).

Also in the news this week is an AssetMark study finding that while many financial advisors have been happy with their advisory relationship through the pandemic, many are not (and the biggest driver appears to be the extent to which the advisory firm has implemented virtual meeting tools to communicate with and stay connected to the client), and another Cerulli study finding that advisory firms that are heavier adopters of technology average almost twice the size of "light" technology users and are almost 60% more likely to have very affluent clients.

From there, we have a few marketing-related articles, including a discussion of how some advisory firms are adapting to remote business development, a series of 21 "virtual marketing" ideas (from virtual wine tasting events to virtual games nights with clients and prospects), and a discussion of the striking parallels between fishing and prospecting for advisors (including a focus on trying to reel in leads as soon as they bite, and recognizing that often the most important driver of the outcome is simply figuring out the right location to fish and focus your efforts in the first place!).

We've also included a number of practice management articles, including a look at how (and why it's so important) to hire for skills and not necessarily years of experience, the "Hawthorne effect" that often employees just want to know that management is watching and cares what's going on (more than any particular intervention they may try to boost productivity), and a powerful reminder that even in client-centric fiduciary advice businesses it's the team that should come first (and not clients).

We wrap up with three interesting articles, all around the theme of the ongoing evolution of financial planning itself: the first looks at how the nature of financial planning advice may be (permanently) changed by the pandemic; the second explores how the ongoing rise of financial services (including financial planning advice) in the employer workplace channel as an extension of how employers are already so financially connected to their employees (by the paycheck); and the last examines whether financial planning as a profession is doing enough to live up to its "implied promise" to always be there for clients and help them through the most challenging and often highly emotional times... which matters more than ever as we navigate through the pandemic.

Enjoy the 'light' reading!

Kitces & Carl Ep 45: (Re-)Structuring Client Review Meetings In Order To Focus On What Really Matters To Clients

October 22, 2020 07:01 am 0 Comments CATEGORY: Kitces & Carl Podcast

In the early days of financial advice, an advisor’s primary (and key) value proposition was giving clients access to capital markets via various investment products and vehicles that consumers simply couldn’t buy on their own. And as a result, the nature of the advisor/client relationship was such that they would ever only really need to interact when some sort of transaction needed to occur. However, as the internet made various investment products increasingly accessible to consumers directly – through online brokerage accounts – many advisors’ primary value-proposition became managing a more holistic diversified portfolio… necessitating regular (often quarterly) meetings to discuss the performance results of that portfolio. Yet as the financial advisor value proposition begins to shift once again, and the profession further broadens its scope to include all the other facets of a person’s whole financial picture, many advisor/client review meetings still revolve largely or entirely around investment performance reviews. Which (especially for advisors who are transitioning clients into ongoing planning relationships) raises the question: how exactly does the advisor change the conversation in review meetings with their clients to be less investment-centric (when it may be all their clients have ever known!)?

In our 45^th episode of Kitces & Carl, Michael Kitces and client communication expert Carl Richards explore what it takes to restructure the client review meeting, and discuss what advisors might talk about on a high level with their clients, how action items (which stem from their Goals) help them make progress towards their “desired future state”, and a way to systematically structure those meetings in such a way that allows the advisor to demonstrate exactly how they’re bringing more than just investment value to the relationship.

As a starting point, advisors can think of the periodic review as a sort of “State Of The Plan” meeting, which (barring any unforeseen events in their lives) typically is to know that they’re making progress towards their goals. Accordingly, on a broad level, talking points can include a review of the client’s Statement Of Financial Purpose (which could include things spending time with family, serving in their community, or traveling, to name just a few), Goals (which flow out of the Statement Of Financial Purpose), and then their progress towards those goals and if the use of their capital still aligns with where they are headed (which is where the real meat of the conversation resides).

Meanwhile, a strategy for structuring these meetings might include actually crafting a physical agenda, which should cover a basic check-in to make sure the proverbial plane is still flying in the right direction, any news and updates (either within the advisors firm or out in the world that might have a bearing on the discussion), some sort of planning item (which, depending on the time of year, might revolve around taxes or estate planning), and then (and only then) a portfolio review. Ideally, the agenda should be delivered a few days before the meeting itself, which will not only help build trust (first by telling the clients what will be discussed and setting expectations, and then by adhering to that agenda), but also gives them an opportunity to add anything that may have come up that the advisors isn’t aware of yet (further facilitating more non-investment-centric client conversations). .

Ultimately, clients really just want to learn three things when they meet with their advisor: are they okay, are they making progress, and are getting their money’s worth from the advisor relationship? And by using a consistent structure and cadence, with a standardized meeting agenda, not only can an advisor make those periodic review meetings more valuable to their clients beyond a discussion around portfolio performance (which can be sent separately anyway), but it also provides a framework that they advisor can use to mention all the great things they’re doing behind the scenes to continue to earn their clients’ business as well!

How ‘Free’ RIA Custodians Make It Difficult To Determine Which Is Actually The Most Expensive

October 21, 2020 07:02 am 1 Comment CATEGORY: Practice Management

In the early days of the Registered Investment Adviser (RIA), financial advisors who didn’t affiliate with a broker-dealer had no way to actually manage investment accounts on behalf of their clients… short of having clients open “retail” investment accounts with direct-to-consumer “retail” brokerage platforms, and grant their advisor a limited power of attorney to call in (pre-internet!) and place trades on their behalf, which was a win for the client (who had their portfolio managed), the advisor (who had a platform to manage their client portfolios), and the brokerage firm itself (that generated trading commissions every time an advisor traded on behalf of their clients). In the decades since, the nature of RIA platforms has evolved tremendously, from advisors phoning in trades to an entire ecosystem of RIA custodians providing trading, billing, and supporting technology for RIAs to use… but still all predicated on a model where the brokerage-firm-as-RIA-custodian profits from advisors at the expense of their clients.

In this guest post, Yang Xu – CEO of TradingFront which competes for RIA custody services in partnership with Interactive Brokers – explores how the RIA custodian business model continues to evolve, why the recent onset of zero-commission trading has merely shifted how (but usually not whether) clients are paying for trading, and how advisors can do their due diligence to understand the real investment costs that clients may face (and revenue sources that RIA custodians still generate) through the platforms that RIAs purportedly use for “free” (as in the end, “free” rarely ever is).

“Pay-to-play shelf-space agreements” are one way that RIA custodians offer No-Transaction-Fee (NTF) funds, which effectively embed trading costs within the mutual funds themselves (with little way for advisors or their clients to identify what the exact breakdown of what those 12b-1 and sub-TA costs may be). And with the shift to ETFs, that have their own unique rules regarding revenue-sharing to RIA custodians, new “data agreement” flat fees (potentially up to $650,000 per agreement from each asset manager to each advisor platform!) are now emerging as a way for RIA custodians to generate revenue in exchange for providing data that shows asset managers how their products are really being used.

Another major indirect cost of RIA custodial platforms is found in interest earned (or rather, not earned) on client cash holdings. Because when cash is maintained in a client account, it is often by default “swept” into a proprietary mutual fund of the RIA custodian, or even a bank deposit account of a subsidiary bank owned by the RIA custodian, yielding net interest income – the difference between what the cash position actually earns, and the lesser amount that is paid to the client – that is collected by the RIA custodian. Which for some RIA custodians is so large, that net interest from client cash actually forms the majority of the entire RIA custodian’s revenue and profits!

In recent years, another growing source of revenue for RIA custodians to generate from advisors and their clients is Payments For Order Flow (PFOFs), which custodians receive for selling the placement of client trade orders to high-frequency trading firms. And while directed trading to high-frequency trading firms can potentially improve trading efficiency (even with the drag of PFOFs), RIAs generally have very limited means to assess the actual quality of execution (which is actually becoming more difficult because rising PFOF and a rising volume of trades occurring off the traditional exchanges actually makes it systemically harder to benchmark good trade execution in the first place!).

Of course, the reality is that RIA custodians are businesses that can and should be able to generate revenue and profit from the services they provide. Still, though, the current model of RIA custodians generating such ‘indirect’ revenue from the clients of advisors, coupled with a dearth of any requirements to disclose financial statements and pricing (at least for non-publically-traded RIA custodians) make it difficult to research what RIA custodians are truly charging and whether it is a fair and competitive price to the available alternatives. Which, ironically, raises the question of whether advisors may soon even seek out RIA custodians that require RIAs to openly pay (fully disclosed) trading commissions and platform fees, if only to ensure full disclosure and a clear understanding of all expenses for the advisory firm and its clients (and an opportunity to price-shop for other RIA custodians that may offer advisors and their clients a better deal)?

The bottom line, though, is simply to understand that ‘free’ services rarely (if ever) exist when those services entail work, which certainly includes the business of brokerage and RIA custodial firms. And for financial advisors who aim to provide full disclosure of all expenses in the interests of their clients, and want to make good decisions on behalf of their clients regarding which platforms to affiliate with, it’s crucial to peel the layers of the onion and gain an understanding of the underlying costs that clients are incurring with their platform of choice… a due diligence process that applies to not only selecting investments for client portfolios but also where those portfolios are custodied and traded, too.