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The Impending Fiduciary Armageddon Of (Most) Mutual Fund Share Classes

February 23, 2017 08:38 am 5 Comments CATEGORY: Investments

Even for financial advisors, the proliferation in recent years of different variable annuity and mutual fund share classes can be overwhelming. Some companies may have as many as 15+ share classes for a single investment strategy, all with unique advisor compensation, surrender charges, and fees. Yet by definition, not all of these share classes can possibly be the best for any particular investor. And in too many cases, it's simply a matter of the advisor choosing how they wish to get paid.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we discuss why there are only a few share classes necessary under a fiduciary rule, and why that means there's an impending fiduciary armageddon for (most) mutual fund and variable annuity share classes coming soon!

Because the reality is that the differences amongst most share classes ultimately boils down to the different ways that mutual fund companies pay distribution costs - i.e., commissions - across various sales channels. Those who preferred upfront commissions would sell A or B shares, while those who preferred levelized commissions would sell C shares, and those who got paid an advisory fee would charge their 1% AUM fee separately and use institutional or advisory share classes instead. Retirement plans and 529 plans cut their own deals as well, for their own share class alternatives. And the client got whichever share class happened to be sold by the broker or plan they were working with, and paid the associated cost, including embedded commissions, 12b-1 fees, and sub-TA fees, that may or may not apply.

But in a fiduciary world, the advisor is always expected to use the lowest cost share class for the client. Notably, the fiduciary rule doesn't actually require that advisors use the lowest cost fund, period; it's a myth that the fiduciary rule requires index funds to the exclusion of actively managed funds. However, if the advisor is going to recommend an actively managed fund... it better be the cheapest version of the fund available, because using anything different would represent a conflict of interest for the advisor enriching themselves at the expense of the client with an unecessarily-more-expensive product.

Yet taken to its logical conclusion, this means that most variable annuity and mutual fund share classes will be rendered entirely irrelevant under DoL fiduciary! At best, there may only be 2 share classes available - the uniform-commission T share for those who are paid some moderate upfront commission, and an institutional or advisory share class for everyone else (who separately charge their own advisory fee on top). And the other dozen or more share classes just vanish!

Of course, the transition may not happen immediately. Not only is there the potential that DoL fiduciary will at least be delayed, but given that it only applies to retirement investors, other share classes may still get used in non-retirement accounts for a while longer. But the key point is that under a fiduciary rule, there is only a legitimate need for one or two share classes at most. As a result, whether it's the Department of Labor fiduciary rule, or one that the SEC follows with in a few years, what we'll soon see is an armageddon that destroys most mutual fund and variable annuity share classes, as we complete the shift from being brokers who sell whatever products we can get paid to sell, into advisors who actually sell advice and implement the best solutions we can at the lowest cost they're available for!

The Impact Of Decreasing Retirement Spending On Safe Withdrawal Rates

February 22, 2017 07:00 am 17 Comments CATEGORY: Retirement Planning

The conventional method for evaluating safe withdrawal rates assumes that retirees maintain a stable standard of living through retirement in real (inflation-adjusted) dollars. While there’s nothing unsound about this assumption – at least so long as it reflects a particular retiree’s goals – it is worth considering how accurate this assumption is relative to actually observed retirement spending behavior of the “typical” retiree.

Because, as it turns out from a growing base of research, constant real spending is not particularly realistic for most retirees. Instead, various studies are finding that real spending actually declines throughout retirement, by as much as 1% to 2% per year. And compounded throughout retirement, this discrepancy between standard industry assumptions and actual retiree behavior may be underestimating the safe withdrawal rate.

In this guest post, Derek Tharp – our new Research Associate at Kitces.com, and a Ph.D. candidate in the financial planning program at Kansas State University – analyzes safe withdrawal rates assuming decreasing spending in retirement, finding that the discrepancy between standard industry assumptions and actual retiree behavior may be underestimating the safe withdrawal rate by 0.32% to 0.75% – turning the so-called “4% rule” into something closer to a “4.5% rule” (with subsequently reduced real spending) instead.

While some may argue that “overstating” spending assumptions is good for the sake of being conservative in making retirement projections (certainly it is worse to run out of money that it is to have some extra!), assuming constant real spending is not the only (nor necessarily the best!) way to incorporate a margin of safety. Further, an appropriate safety margin will vary by retiree, depending on their risk tolerance and spending flexibility. If advisors truly wish to give advice that is customized to an individual’s goals and values (as most say they do!), then the safety margins utilized should reflect an individual retiree’s situation, too.

Obviously, the best way to capture an individual’s unique circumstances is simply to create a customized financial plan — which isn’t a radical idea for most advisors — but it is still important to understand what is actually customizable within a plan and what remaining assumptions may be biasing the results. And for advisors who prefer to apply and adapt the safe withdrawal rate to individual retiree circumstances, it’s still crucial to build on the right baseline assumptions – recognizing that the 4% rule may be predicated on retirement spending that simply doesn’t reflect reality!

#FASuccess Ep 008: David Grau On Maximizing The Valuation Of A Financial Advisor’s Book, Practice, Or Business

February 21, 2017 07:00 am 3 Comments CATEGORY: Financial Advisor Success Podcast

Welcome back for the eighth episode of the Financial Advisor Success podcast!

This week’s guest is David Grau Sr. David is not a financial advisor himself, but over the past 20 years his business, FP Transitions, has facilitated the sale of nearly 1,500 advisory firms, and valued almost 9,000 of them. Which means David brings an incredibly unique perspective to the evolution of buying and selling independent advisory firms, having had a front-row seat over the past two decades.

In this podcast episode, David shares the four different types of advisor ownership structures – books, practices, businesses, and firms – what characterizes each, how they’re typically valued, and what kinds of acquirers are interested in one type versus another. We also explore how to grow ownership from one stage to the next, and the classic pitfalls along the way – for instance, why the industry-standard revenue-based compensation is actually prohibitive of transforming a practice into a true business.

You’ll also hear about how advisory firm deals are typically structured today (and how it’s changed from 10 and 20 years ago), valuation trends with the looming seller wave of Baby Boomer advisors, the best way to find the right prospective buyer if you’re looking to sell now (or soon), and how the growing availability of bank financing is changing the way advisory firms are bought, sold, and valued.

And be certain to listen to the end, where David talks about why most advisors should be very wary of relying on their broker-dealer or custodian platforms to facilitate a sale, and how to spot the “predatory buyers” that are often lurking within those platforms.

So whether you’re a financial advisor getting ready to sell your advisory firm, just thinking about how to maximize the value for the future, or are a newer advisor who wants perspective on the dynamics of buying into an advisory firm, I hope you enjoy this latest episode of the Financial Advisor Success podcast!

FP Transitions And The Kelley Blue Book Valuation Of An Advisory Firm

February 20, 2017 07:00 am 7 Comments CATEGORY: Practice Management

An independent financial advisory firm can have significant value, even if the business doesn’t have any physical or intellectual property to yield profits. Because the reality is that with annually recurring revenue and 95%+ client retention rates, there really is income-producing value in an advisory firm, even if it’s mostly based on the “goodwill” of clients to stick around year after year.

However, valuing a business whose primary assets is intangible goodwill can be challenging, especially given that the overwhelming majority of independent advisory firms are small/solo practices that generate little net profit beyond the healthy income paid to the advisor-owner to operate the business. As a result, the traditional Discounted Cash Flow (DCF) approach to valuing most businesses tends to break down (and undervalue) a “small” advisory firm (e.g., those with <$1M of revenue).

For such hard-to-value assets, an alternative approach to valuation is simply to look at the prices being set by buyers and sellers in the actual marketplace, and to simply value the business relative to its marketplace comparables. In fact, sometimes digging further into the piecemeal value of the business isn’t even relevant, just as no one values a car by disassembling it to value and then add up all the component parts; instead, for nearly 100 years, they’ve just looked up the going market value in the Kelley Blue Book instead.

In the context of advisory firms, the leading “Kelley Blue Book” solution for valuation is FP Transitions and its “Comprehensive Valuation Report” (CVR), which uses their comparables database of more than 1,500 advisory firms bought and sold in the past 20 years to estimate the value, after making reasonable adjustments for transition risk, cash flow quality, market demand, and the payment terms of the transaction itself.

Unfortunately, the FP Transitions CVR valuation estimate isn’t quite as cheap and accessible as buying the Kelley Blue Book – due to the harder-to-value aspects like transition risk and cash flow quality that must still be considered – but nonetheless, at $1,200, it makes getting a reasonable valuation accessible for the vast majority of independent advisory firms. In fact, a growing number of firms get regular valuation updates every year or two, just to understand how the value of their firm is changing, and whether/how they should make changes to further enhance the value.

Ultimately, the largest advisory firms that have greater complexity may still want to rely on custom valuations using the DCF approach, and a growing number of online valuation tools for advisory firms are starting to crop up to compete as well. Nonetheless, it’s hard to argue with going right to the source, and getting a valuation from FP Transitions using their actual (albeit proprietary) database of over 1,500 completed advisory firm transactions.

Weekend Reading for Financial Planners (Feb 18-19)

February 17, 2017 02:54 pm 2 Comments CATEGORY: Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" – this week's edition kicks off with a 2-part series from Bob Veres, exploring all the various technology solutions that have emerged in recent months specifically to help advisors comply with various aspects of the DoL fiduciary rule, from workflows for transitioning clients to level fee fiduciary engagements to benchmarking tools to evaluate the "reasonableness" of the advisor's fee and to conduct due diligence on the client's existing 401(k) plan (and the performance and costs of all its investment options).

From there, we have several financial advisor marketing articles, including: how to "repurpose" content to leverage your time doing blogging and social media as a financial advisor; how to rethink client appreciation events as "client connection events" to drive more engagement and referrals; when it's time to consider revisiting your advisory firm's brand; and why at least some types of private client lawyers can be especially good as center-of-influence referrers of high-net-worth clientele.

There are also a couple of practice management articles this week, from alternative strategies to finding advisory firms to acquire (beyond just waiting for advisors to retire), why regulators are actually pushing back on the industry's transition from AUM to retainer fees, and the various ways that "generic" business advice really does not fit the typical advisory firm.

We wrap up with three interesting articles about personal success and productivity: the first is a look at how you can divide your activities of the day/week/month/year into those that give you energy, and those that take away, recognizing that one of the biggest ways to boost your productivity is to adjust the balance in a way that increases your net energy (and yes, I can attest this really works!); the second provides tips on how you can break through if you're finding that your advisory business has plateaued; and the last is a look at how if you really want to make positive changes for yourself, it's better to think not in terms of setting goals but creating new systems and habits for yourself that allow your goals to be achieved.

Enjoy the "light" reading!

Why Series 7 Brokers Legally CAN’T Be Client Fiduciaries Without DoL Fiduciary

February 16, 2017 08:46 am 32 Comments CATEGORY: Regulation & Compliance

Periscope Office Hours Cover Image Feb 14 2017 Why You CAN’T Be A Full Fiduciary To Your Client With A Series 7 License

With the flurry of activity and attention surrounding the Department of Labor's fiduciary rule and whether it will be delayed or not, there has been a dramatic increase in media coverage around what it means to be a fiduciary, and a push for consumers to seek out RIAs over those who work at broker-dealers. Despite the fact that most advisors, at both RIAs and broker-dealers, are trying to do the right thing for their clients.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we discuss why being a fiduciary matters, and why Series 7 licensees technically CAN'T be full fiduciaries to their clients without the DoL fiduciary rule.

The key issue is that the Series 7 exam is technically the "General Securities Representative Examination". This name is important, because it indicates that ultimately, the licensee is acting as a representative of the broker-dealer. In other words, a Series 7 license allows an individual to represent the broker-dealer in the sale of securities products to clients. This is why Series 7 licensees are referred to as "Registered Representatives" of a particular broker-dealer.

And as a representative of the broker-dealer, the broker technically has an obligation to serve the broker-dealer, not the client. This is why a broker-dealer can terminate a broker for outside business activity, or for soliciting a client to move with them to a new broker-dealer. In fact, technically the client isn't even a client of the broker's; it's a client of the broker-dealer's, and the broker is just the sales representative. That's why it's illegal for the broker to take any client information when changing broker-dealers!

Of course, in today's environment, the overwhelming majority of those working at a broker-dealer are dual-registered as a sales rep under the broker-dealer and working under a corporate RIA. Nonetheless, anytime the broker sells a product and earns a commission (i.e., using the Series 7 license), the broker is not a fiduciary, but a sales representative! Notably, these advisors are fiduciaries when they give under the RIA and are paid an advisory fee. But they are still effectively wearing two hats, and cannot be full fiduciaries while the Series 7 hat is on!

And the reason all this matters is because, if someone wants to take money from their clients by selling high-commission products to anyone they can, the suitability standard that applies to brokers is a relatively low caveat-emptor bar. But a fiduciary standard doesn't legally permit such behavior. That's why it matters - it's not about the already-good advisors who are doing the right thing, but about raising the bar to reduce the risk of bad brokers who try to do the worst they (legally) can. Which is why the focus on fiduciaries vs non-fiduciaries has morphed into a discussion of RIAs vs broker-dealers. Because the "easiest" way for the media to recommend avoiding a bad non-fiduciary (broker) is simply to recommend avoiding all of them.

The bottom line, though, is to recognize that Series 7 licensees are legally sales representatives. And if you don't like being treated as a salesperson, (re-)consider how your business is structured! Although ironically, if the DoL fiduciary rule does not get delayed, it may all soon be a moot point - as everyone working with retirement investors will be subject to the same fiduciary duty, regardless of their current business model! Ultimately, though, until brokers either voluntarily move to a new business model or are held to new DoL fiduciary standards, the reality will remain that you can't be a full fiduciary with a Series 7 license!