Nerd's Eye View blog

Limits To Converting Rental Property Into A Primary Residence To Plan For IRC Section 121 Capital Gains Exclusion

June 4, 2014 07:01 am 104 Comments CATEGORY: Taxes

The exclusion of up to $500,000 of capital gains on the sale of a primary residence under IRC Section 121 is one of the most generous tax preferences available under the tax code, due in no small part to the fact that most people only have occasion to sell their home and harvest such gains a few times in a lifetime.

However, for those who also invest in rental real estate, the capital gains exclusion on the sale of a primary residence creates an appealing tax planning opportunity – to convert rental real estate into a primary residence, in an effort to take advantage of the capital gains exclusion to shelter all of the cumulative gains associated with the real estate. And since the Section 121 exclusion can be used as often as once every 2 years, the planning opportunity is quite significant for those with large rental real estate holdings (or simply those who serially purchase new primary residences!).

To prevent abuse of this planning scenario, Congress has enacted several changes to IRC Section 121 over the past 15 years, preventing depreciation recapture from being eligible for favorable treatment, requiring a longer holding period for rental property acquired in a 1031 exchange, and more recently forcing gains to be allocated between periods of “qualifying” and “nonqualifying” use. Nonetheless, some opportunities remain for real estate investors who do have the flexibility to change their primary residence in an effort to shelter capital gains on long-standing real estate properties.

What Are The Key Performance Indicators (KPIs) For Your Financial Planning Firm?

June 2, 2014 07:02 am 9 Comments CATEGORY: Practice Management

As an advisory business gets started, the focal point is typically on just getting the first few paying clients in the door – the key aspect being paying clients. Simply put, it’s all about just trying to generate some revenue, and the key indicator for measuring the advisory firm is pretty straightforward: how much revenue is there.

However, as the advisory practice begins to grow, the picture gets more complex. Soon there are a range of different clients, paying varying fees for what may be a varying services. The cost to operate the business begins to rise as well, with investments into anything/everything from technology to staff. Suddenly, just look at how much money is coming in the door is no longer enough; just because there’s revenue doesn’t mean there’s profits, and there are too many clients to just keep it all straight in your head.

Accordingly, as a financial advisory practice grows, it becomes increasingly important measure and track more information about the business, so it can be managed as a business. As the saying goes, “if you can’t measure it, you can’t manage it.” Building a financial dashboard of “Key Performance Indicators”, KPIs, for financial advisors, that track key metrics of the business, its growth, and its clientele, can give you the information you need to make better practice management decisions. It's not necessarily about harnessing the "big data" insights of an entire industry, but simply the "small data" opportunities of better understanding your own business!

Weekend Reading for Financial Planners (May 31 – Jun 1)

May 30, 2014 01:30 pm 1 Comment CATEGORY: Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" - this week's edition kicks off with the big regulatory news from the Department of Labor, that its re-proposal of a fiduciary rule is being delayed once again, and is now expected next January of 2015. At this point, it's still unclear whether the delay is just to build support and finalize a cost-benefit study to get the rule implemented, or if the delay will result in fiduciary opponents building more momentum to try to undermine or change the rule.

From there, we have several practice management articles this week, including: a look at the success that "robo-advisor" platforms are having with young tech millionaires who have money but little desire to deal with 'antiquated' non-tech-savvy advisors; a second article about the growth of online investment platforms amongst older clientele as well (an estimated 40% of investors over age 60 are now 'self-directed' using robo-advisors or online brokerage platforms); a discussion from practice management consultant Angie Herbers about whether advisors should even try to manage people, or whether it's better for the advisor to just stay small and happy; how to categorize clients through your CRM to begin to refine and differentiate your services at varying tiers; and an intriguing article from Julie Littlechild suggesting that the real differentiator of the most successful advisors is not merely their vision of serving clients well and acting in their interests but their ability to operationalize those big ideals into actual tactics to be implemented in the business.

We also have a few technical articles this week, from a look at how the long-term care insurance industry is trying to restructure its regulatory rules to allow for more regular but much smaller premium adjustments, to a review of a new white paper by Cliff Asness and his team at AQR looking at the "myths and facts" of momentum investing, and also a good discussion of the pitfalls of portability of the estate tax exemption that advisors should consider before going with this 'simple' new estate planning technique.

We wrap up with three interesting articles: the first is a review of a fascinating book called "The Great Depression: A Diary" that details the diary entries of an investor who lived through the Great Depression, and consistently observed that at the time many/most investors realized it was the investment opportunity of a lifetime but simply had no cash available to invest at that point (and making the fundamental point that large cash positions are not a "negative real return" drag but funding for future opportunities that may be more than significant enough to overcome the drag of cash returns); the second is a look at the recent white paper issued by the Australian Financial Planning Association as it begins to lobby for new laws and regulations that would make financial planner/advisor a protected term that can only be used by advisors who meet specific education, experience, and other requirements; and the last is a nice discussion of how advisors can use RSS readers as a better means to keep up with industry news and developments in a simple and easy manner.

And be certain to check out Bill Winterberg's "Bits & Bytes" video on the latest in advisor tech news at the end! Enjoy the reading!

Indexing 2.0: How Declining Transaction Costs And Robo-Indexing Could Disintermediate Index Mutual Funds And ETFs

May 28, 2014 07:01 am 15 Comments CATEGORY: Investments

Historically, one of the benefits of purchasing index mutual funds and ETFs has been the simple transaction cost savings of being able to buy into a diversified portfolio of securities in a single step (pooled) transaction, rather than absorb the transaction costs of buying a small quantity of each individual investment one at a time (not to mention the sheer trading complexity of trying to do so). Yet since fixed trading commissions were deregulated in 1975, transaction costs have faced an ongoing inexorable decline, as competition from discount brokerage firms, then online discount brokers, and more, drive the cost of implementing a trade closer and closer to zero (or at least, to the point of being truly negligible).

Yet at the point that transaction costs really do become negligible, an interesting question arises: why bother to buy index funds or ETFs at all, instead of simply using technology and near-zero trading costs to buy, own, and manage a portfolio of all the underlying individual investments directly. At face value, the investment characteristics may be the same either way, but for tax purposes there is a key distinction: owning each individual investment at such a granular level allows investors to be far more selective about proactively harvesting capital losses (or even gains in certain situations) or taking more tax-sensitive liquidations in retirement (and of course harvesting itself is easier in an environment where there are no trading costs to engage in such strategies in the first place)!

The end result is a kind of "Indexing 2.0" solution, where investors still hold the investments of an index fund, but without actually using a pooled index mutual fund or ETF itself, opting instead to own the underlying individual investment directly and take advantage of the associated tax benefits. And the concept isn't entirely new; in fact, Wealthfront offers a version of this exact service to replace the S&P 500 with the underlying investments against which proactive capital loss harvesting can be done on a daily basis. While this "Wealthfront 500" service still has a $500,000 minimum, it seems only a matter of time before ever-declining transaction costs make this feasible at a lower and lower price point... until eventually, there may still be value to indexing itself, but there will be little reason for index mutual funds and ETFs at all?

3 Lessons About Profitability, Fees, And Pricing That Financial Planners Can Learn From Airlines

May 26, 2014 07:01 am 7 Comments CATEGORY: Practice Management

As a frequent speaker at industry conferences, I fly more than 100,000 miles every year, which means I spend a lot of time interacting with airlines as a customer and buy a whole bunch of plane tickets… and have a lot of opportunity to experience the way airlines price their tickets, charge for their services, and try to attract my business (or retain my loyalty). And a look at the best practices in “what works” for the airline industry leads to some striking parallels – and contrasts – for financial planners.

For instance, while in the financial planning world, there is often a focus on trying to ensure that every client is equally profitable and avoid a situation where more profitable clients "subsidize" less profitable ones, yet airlines recognize that strictly trying to equalize profitability can have harmful unintended consequences (the cost to travel is highly sensitive to weight, but does anyone really think it’s a good business idea to charge heavy people more for airline tickets than thin passenger!?). Simply put, extreme efforts to equalize profitability across clients can actually be perceived unfavorably by them!

Similarly, airlines have also long since recognized that value is not based on what you pay for; value is intrinsic to the service/feature/benefit provided. Accordingly, charging separately for a service is not something you do to enhance its perceived value, it’s something you do to discourage people from using it (e.g., baggage fees)! In fact, the best use for some of the most highly valued services is not to charge for them at all, but to give them away for free as perks to attract and retain otherwise-high-value customers/clientele!

Ultimately, airlines have still struggled to bring down their costs to be economically viable businesses, given the significant costs involved. But that challenge has also forced them to recognize how important it is to establish clear and consistent tiers of service, and price them accordingly… not require phone calls, data gathering forms, and a meeting or two, just to find out what the service will cost in the first place, as financial planners are notorious for doing! In the end, customized pricing may be appealing for a business, but it can make the process so hard for consumers to buy a service, that transparent and simple pricing/service tiers win out in the end!

Weekend Reading for Financial Planners (May 24-25)

May 23, 2014 03:23 pm 1 Comment CATEGORY: Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" - this week's edition kicks off with a small act of contrition from the CFP Board, which acknowledged this week that it "could have done a better job" in looking at compensation disclosures on its website, and announced that the organization will now begin to do its own "spot checks" on its website compensation disclosures along with making it easier for brokerage firms to ensure that none of their employees indicate that they are "fee-only" in violation of the current rules.

From there, we have several practice management and technology articles this week, including some ideas for new client (or prospective client) events to try out, tips on how to pick a CRM system (either as a change or for the first time), a review at a new all-in-one advisor platform called Advyzon (being built by one of the former architects of Morningstar Office and Workstation), a look at how RIAs now surpass wirehouses in their share of ETFs and long-term mutual funds (if you're an RIA, expect a lot more contacts from product providers trying to reach you in the near future as the industry wholesalers shift!), and a discussion of how to fix (or create for the first time) an incentive compensation system for your employees.

We also have a few more technical articles this week, with a discussion of why SPIA payouts still seem to be given their money's worth despite today's low rates (in large part perhaps because the long end of the yield curve has already priced in future rate increases?), a great analysis from AQR's Cliff Asness of why markets are not rigged (despite the allegations in Michael Lewis' "Flash Boys") and how HFT firms are really just a more cost efficient version of what market makers have always done, and a nice overview of the key points from the new "hot" book on income equality, Thomas Piketty's "Capital in the 21st Century".

We wrap up with three interesting articles: the first is from Jason Zweig of the Wall Street Journal and looks at the rise of the "Robo-Regulator" - FINRA's new CARDS approach to applying big data insights to try to find questionable activity in brokerage accounts; the second is a discussion from industry commentator Bob Veres about how independent firms and fiduciary advocates may be losing the fight against the lobbying dollars of Wall Street and what the next step should be (hint - band together with other organizations fighting the "Bigger Fight" as well); and the last is from Gail Graham of United Capital about how small advisory firms may soon need to get a whole lot more serious about marketing, because some large ones are already beginning to step up. Enjoy the reading!

Could The MyRA Be The Beginning Of The End Of The 401(k)?

May 21, 2014 07:01 am 28 Comments CATEGORY: Retirement Planning

The employer pension plan has been a part of the employee benefits landscape for nearly 140 years. Yet the reality is that after a tremendous rise in the decades after World War II, the availability of the defined benefit plan has been in decline for over 30 years, as the defined contribution plan has risen to take its place.

Yet unlike a pension plan that was paid in addition to an employee’s salary, the defined contribution plan often amounts to little more than an employee saving his/her own money in the first place, perhaps plus a moderate match that is losing its purpose as a behavior incentive when more and more plans include automatic enrollment and automatic escalation of contributions in future years.

All of which raises the fundamental question: if employers simply paid a greater salary (with a raise equivalent to what the match would have been) and let employees choose whether to save, is there really any need for a 401(k) plan at all? And with the MyRA coming soon – which once in place, could be easily modified in the future to include automatic enrollment, and higher contribution limits similar to what 401(k)s allow today – could we be witnessing the beginning of the end of the 401(k) plan altogether?

Managing Your Advisory Practice By How Much You’re Paid For Your Time

May 19, 2014 07:01 am 8 Comments CATEGORY: Practice Management

Running a financial planning practice means really getting to know your clients, as you explore their goals and aspirations and craft a plan to help them get there. Yet as an advisory firm grows, while it may be possible to know all the clients, it becomes increasingly difficult to know all the clients, and how they impact the advisory practice itself. In other words, you may be spending so much time focused on the trees (clients), you begin to lose perspective on the forest (practice) itself.

Accordingly, prudent business management suggests that from time to time, it’s necessary to take a step back, and look at the broad base of clients across the practice. How much revenue does each client generate? How much time does it really take to service them? If you convert the dollars paid and time spent into an hourly rate, do you know which clients pay you the equivalent of $150/hour, or $250/hour, or $500/hour? You may know who your biggest and smaller clients are, but which ones are the most profitable and generate the greatest revenue for each hour of time you spend working for them?

Ultimately, what one does with this information is up to the advisor. Some may view it as an opportunity to improve and refine their practice, refocusing on the ‘best’ clients and culling the worst, or to lift up their minimums to ensure they’re generating a certain amount of revenue for their time, or to hire staff members to delegate less profitable tasks (or segment clients altogether!). Others may choose to do nothing – at least for now – beyond observing the health of their practice. But in the end, time is your most limited and valuable personal resource as an advisor, so it’s crucial to measure and manage how it is being spent!

Weekend Reading for Financial Planners (May 17-18)

May 16, 2014 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 a great overview of the current landscape of CFP Board registered programs and the ongoing efforts to raise the profile of financial planning in colleges, from shifting programs into business schools, to boosting funding and alumni/corporate giving, to simply building more awareness of financial planning on campuses. Given the industry demographics, the opportunity for young people entering financial planning today is tremendous, but only if they know about it in the first place! There's also an article looking at how a number of large firms are entirely retooling their advisor training programs to make the entry path for young financial advisors more appealing, and a brief look at some how firms are bringing in junior advisors to work with clients.

From there, we have a long list of practice management articles this week, including: the rise of "bogus" award/recognition programs for advisors and an increasing volume of "advertorial" solicitations (where advisors can pay to be featured in a major publication's "top advisors" list or have a profile article written about them); tips for solo advisors who are looking to sell their practices (from two solo advisors who recently did sell their firms); a discussion of some of the latest advisor outsourcing trends around investment and back-office support; a look at the decision to become a hybrid RIA and when it's better to use a broker-dealer's corporate RIA rather than create an independent one; and a sample template for building your business plan as a new financial advisor (or perhaps an existing one planning on launching a new advisory firm).

We wrap up with four interesting articles: the first looks at the rise of social media in wirehouses and large broker-dealers, who have been 'laggards' with social media in the past, but are now accelerating adoption with some highly capable (and compliant) enterprise social media tools; the second is an RIABiz profile of Motif Investing, which has now raised an astonishing $86M of venture capital, despite having only about $86M in managed assets, raising the question of what the tremendous opportunity really is that the VCs see in Motif's future; the third examines some recent criticism of the famous Dalbar research regarding the investor behavior gap, suggesting that while there are still investors who harm themselves, the Dalbar methodology of calculating returns may be drastically overstating the issue in the aggregate; and the last is an interesting recent interview with Sebastian Thrun, founder of the first MOOC, who has now acknowledged that a purely free technology-driven open education just doesn't work very well because students don't follow through, and that charging a little more to add a human service layer component may ultimately be the superior model... which has very interesting implications for the current traditional-vs-robo-advisor environment as well!

And be certain to check out Bill Winterberg's "Bits & Bytes" video on the latest in advisor tech news at the end! Enjoy the reading!

How Rising Interest Rates Will Impact Far More Than Just The (Bond) Portfolio

May 14, 2014 07:01 am 3 Comments CATEGORY: General Planning

There has been a growing fear in recent years that we may soon, “finally” face a rising interest rate environment again for the first time in over 30 years. While the catalyst to trigger such a rate increase is uncertain – first it was anticipated with rising inflation due to the Fed’s QE policies, and now it’s expected as a result of the tapering that slowly ends them – it’s hard to argue against the view that from a long-term perspective, rates are likely to be higher at some point in the future.

While the ramifications are quite straightforward – and not very good! – for bond prices, and at least raise concerns for other asset classes like stocks and real estate, it’s notable that there are also many ‘secondary’ impacts of rising rates that are equally notable for financial planning purposes. In fact, for many clients, the most profound impacts of rising rates may be the planning issues most clients are not even thinking about right now!

For instance, while higher rates are negative for retail bond investors, it can be very good news for insurance companies, who invest the overwhelming majority of their assets into bonds that match their liabilities. With higher rates, insurance companies need less in premiums to secure the requisite cash flows for their future claims, potentially providing much needed relief to the premium pricing pressure on everything from long-term care insurance to secondary guarantee universal life policies. On the other hand, higher interest rates are also higher discount rates for other strategies, which can reduce the value of everything from a pension lump sum, to the benefit of delaying Social Security, to the borrowing limits on a reverse mortgage. On the other hand, the sustainability of safe withdrawal rates may be improved!

Perhaps the most significant shift with higher rates, though, will simply be the fact that once again, “cash” will actually pay something. For companies that offer money market funds – including the major RIA custodians – this represents a potentially significant financial boon, as rates rise to the point where companies don’t have to subsidize and can actually profit from their money market offerings. Yet given how much easier it is to now manage “cash” electronically, from a mobile device, and move money across accounts or even financial institutions to seek out a better yield, the coming rise in interest rates may open up a whole new world of “digital cash management” as well!