Kitces.com - Advancing Knowledge in Financial Planning

Weekend Reading for Financial Planners (Jun 7-8)

June 6, 2014 01:51 pm 4 Comments CATEGORY: Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" - this week's edition starts out with a cautionary warning from both FINRA and the SEC that this year will be one of heightened scrutiny on cybersecurity issues, and that advisors large and small will be held accountable for the quality of their protections of firm and client data... and that there may even be a few firms that will be "made an example of" with enforcement and fines for especially lax security. On the other hand, a separate article also notes that more generally, FINRA is acknowledging that its regulatory requirements may be getting too burdensome for small firms, and that some kind of relief may soon be coming as the regulator shifts to a more surveillance-based (rather than examination-based) approach.

From there, we have several practice management articles this week, including advice from Mark Tibergien on the importance of trying to control what you can control in attracting and retaining employees (while also recognizing what may be beyond the firm owner's control), some insight from Angie Herbers on the importance of having not only a long-term 'voluntary' succession plan but also a plan in place for how to handle a more sudden unexpected succession event if there is an unexpected death or incapacitation of the firm owner, and a look at the challenges that advisors face when they consider breaking away from a wirehouse and going independent (from the time and stress costs, to the "leap of faith" that if the advisor leaves to go out on their own, that clients will follow).

We also have several investment-related articles this week, from a roundtable looking at strategies to manage against the risk of rising interest rates (and whether it's even necessary to do so), to a second article that looks at whether annuities might be an effective bond substitute to manage a fear of rising rates, to a discussion of whether REITs still have a place in the modern portfolio given their significant volatility over the past decade. There's also an interesting article looking at strategies to manage our behavioral biases, which are a challenge for clients but can be as relevant (and challenging) for advisors in their own investment process too.

We wrap up with three interesting articles: the first is some guidance for advisors who have started a new practice and are struggling to work through "the gap" between where their business is during its initial stages and where they want and aspire it to be (which requires no small amount of patience and perseverance!); the second is an interview with financial advisor Ron Carson about the issues he sees in the industry, from the importance of fee transparency to the concerning lack of succession and continuity planning that advisors have failed to put in place to protect their clients; and the last is some professional and career advice from advisor and blogger Barry Ritholtz about his own unusual path in finance, affirming the importance of continuous hard work and a recognition that "once in a lifetime" opportunities come more often than we may realize, but only help if we're ready to take advantage of them when the time comes. Enjoy the reading!

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!