Weekend Reading for Financial Planners (Oct 20-21)

Posted by Michael Kitces on Friday, October 19th, 6:05 pm, 2012 in Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" - this week's edition starts off with an interesting analysis of fiduciary history and the CFP Board's current fiduciary rules for CFP certificants, suggesting that the CFP Board still has a little ways left to go to reach a truly all-encompassing fiduciary standard. From there, we look at an interview in the Journal of Financial Planning with Nobel Prize winner Daniel Kahneman, an exploration by financial planner and researcher Jon Guyton about how the safe withdrawal rate research is holding up for a year 2000 retiree, a study by David Blanchett on the use of variable annuity GMWB riders to support retirement income, a recent study by Harold Evensky (and co-author Shaun Pfeiffer) indicating that active managers may do better in bear markets than bull markets but not by enough to generate consistent alpha over a full market cycle, and a discussion by professor Michael Finke of Texas Tech that the recent Bill Gross article about the "dying cult of equities" may have some validity. There are also a few consumer investment pieces that may be of interest to planners, including a discussion of what "tactical" really means, and some things to watch out for with the recent trend towards managed ETF strategies, along with two strong technical articles, one about new tax planning issues and opportunities tied to the Patient Protection and Affordable Care Act, and the other about how to counsel clients through a short sale or other underwater-mortgage alternatives. We wrap up with an interesting research article suggesting that it's almost impossible for us to convey that we're "warm" and "competent" at the same time - instead, the constraints of our language force us to lean in one direction in how we're perceived, at the direct cost of the other. Enjoy the reading!

Weekend reading for October 20th/21st:

Will the CFP Board Move the Ball Forward, or Stall Progress Toward a True Profession? - This blog post by financial planner and fiduciary guru Ron Rhoades responds to some of the recent "clarification" that the CFP Board has issued regarding its fiduciary standard - in particular the determination of when fiduciary status does and does not apply. For context, Rhoades provides an interesting history of fiduciary in financial services, noting that back in the 1940s at the time of the Investment Adviser Act, brokers were already treated as fiduciaries the moment they provided advice regarding investments to a client - the key factor being where the client would have understood the situation to have implied a relationship of trust and confidence to which fiduciary status should attach. Similarly, Rhoades suggests that fiduciary status should attach to a CFP certificant merely on the basis that the individual has held out as a CFP professional, not merely because the planner has "done" financial planning, as is the CFP Board's current standard. This article is a bit of a long and in-depth read, but is some of the most sophisticated analysis of current fiduciary standards you'll see.

Daniel Kahneman on the Psychology of Your Clients … Oh, and Your Own Mental Hiccups - This article from the Journal of Financial Planning is their 10-Questions interview with Nobel Prize winner Daniel Kahneman. Although some of Kahneman's research has been recognized by financial planners in the past, the new focus on his is the publication of his book Thinking, Fast and Slow, a fascinating read that covers a tremendous range of the behavioral finance research that Kahneman started and upon which many have subsequently built. Some of the insights are striking - for instance, Kahneman warns not to learn "too much" from recent past experience (because we tend to overstate its certainty after the fact, leading to hindsight bias and subsequent overconfidence); more broadly, he also notes many other tendencies we have towards overconfidence, sometimes despite relatively flimsy evidence. Other intriguing ideas include: people who are more prone to regretting negative outcomes or generally experience stronger emotions should be more cautious about risk-taking behavior; the more specific a recommendation is, the more likely people are to be accountable to it and follow through; and to be cautious, because we planners as human beings can be just as prone to these issues as our clients!

Adventures in Advising the Millennial Retiree - This article by Jon Guyton in the Journal of Financial Planning looks not at the issues in advising a Generation Y "Millenial" into retirement, but instead the challenge of what has happened for current retirees that started at the turn of the millenium - i.e., back at/around the year 2000. A retiree who started in this manner in 2000 with a 65/35 portfolio and a 4.5% withdrawal rate would have seen the rate jump to 6.5% by the fourth year, and 7.8% by the 10th year. On the other hand, Guyton notes that for anyone following market valuation - who would have seen in 2000 that valuations were not merely high but at nosebleed 99th percentile levels - a year 2000 retiree might have started a bit more conservatively; if the rate was dialed down from 4.5% to only 4%, the withdrawal rate by the 10th year would have been a much more modest 6.4%, which is not unreasonable given that only a 20-year time horizon would remain at that point. Making dynamic portfolio shifts, such as underweighting equities by 10% during the highest valuation levels, would have moderated the result even further, down to 5.9%. Ultimately, Guyton advocates yet another layer, where spending levels themselves also undergo modest dynamic adjustments along the way, which smooths out the spending - and in his experience, eases client concerns - even further.

Optimal Portfolio Allocations with GMWB Annuities - This article by respected retirement researcher David Blanchett takes a fresh look at how annuities with Guaranteed Minimum Withdrawal Benefit (GMWB) riders fare as a part of a retirement portfolio. The article starts out by noting that on average, GMWB riders are likely to lose; in fact, that should be expected, as a guarantee that systematically pays out more than it takes in cannot possibly be sustainable! However, because the annuity also provides a guarantee, a proper comparison should adjust for the relative risk; thus, for instance, a portfolio with 50% in equities might be compared not to a GMWB annuity with 50% in equities, but such an annuity with 70% in equities (where the risk of higher annuities is offset by the risk reduction of the annuity guarantee). And in fact, the results show that the GMWB is of limited value if the equity exposure will be the same, but brings value to the table if the client will use the guarantees of the annuity as a trade-off to also own a significantly higher equity exposure, especially in scenarios where clients live unusually long (e.g., age 95+).  

No Alpha: Evensky’s New Research Delivers Fresh Blow to Actively Managed Funds - This article from AdvisorOne is a review of a recent paper entitled "Modern Fool's Good - Alpha in Recessions" in the Journal of Investing published by Harold Evensky and Shaun Pfeiffer. The study examined the claim that active managers earn their keep in part by successfully managing risk and mitigating bear markets. The results found that in reality, active managers do tend to outperform their fees during market downturns; however, the outperformance was typically limited, and the managers underperformed during bull markets by more than they outperformed in bear markets, leading to negative alpha over an entire market cycle. In addition, the study noted that there was a wide variance of results; while some active managers did very well, the bad ones did spectularly poorly - and the worst actually do even worse still in bear markets than bull markets - raising concerns that if anyone does seek active managers for this purpose, effective manager evaluation is crucial. In addition, even managers that do well in one cycle tend to have weak persistence in subsequent cycles. Nonetheless, Pfeiffer and Evensky acknowledge that there may still be identifiable characteristics yet to be found in research regarding the small subset of active managers that do generate positive alpha through market cycles with persistence.

Bill Gross Vs. The Equity Cult - This article by Texas Tech professor Michael Finke in Research Magazine discusses the recent controversial article "Cult Figures" by PIMCO's Bill Gross (covered previously in Weekend Reading) which suggested that the "cult of equities is dying" as future returns drop down from the levels they have been in the past. The historical 6.6% equity risk premium, Gross suggests, is unsustainable in an economy growing at only 2% - 3%, and Finke generally agrees, noting that this could only be true at the cost of worker's salary growth and sluggish bond holders. To test the theory, Finke, along with retirement researcher Wade Pfau, looked at how stock versus bond investors have fared over 30 year time horizons by looking at the "opportunity cost" for holding bonds instead of stocks. In fact, their results do suggest that the benefits of stock ownership has been declining from the heydey from the end of the Great Depression until the early 1960s, suggesting that returns may in fact be lower in the future. Finke also notes the research that suggests younger investors are shying away from equities, but points out that in reality this may be exactly what's necessary to push stock P/E ratio valuations down to the point where they once again provide a more favorable long-term return.

What Do You Mean By 'Tactical'? That's Actually a Good Question - This article from the Wall Street Journal notes the rising trend towards advisors using tactical approaches to investing; the majority of advisors report that they're seeing demand from clients for tactical strategies, and more than 75% of advisors believe tactical strategies can outperform an index over the long term. However, there is still not a great deal of consensus about what exactly tactical means (a topic discussed previously in this blog); some apply it as a method to make rotations within asset classes, and others rotate amongst them; some make small adjustments at the margin, while others make much more dramatic allocation changes. While this article is written to help consumers become aware of the tactical trend amongst advisors, some of the discussion may be equally relevant for advisors trying to evaluate tactical investment strategies or offerings to implement for their clients as well. 

When Cheap Funds Cost Too Much - This article by Jason Zweig of the Wall Street Journal looks at the rising trend of advisors using low-cost ETFs for more active and tactical investment strategies - which are causing what has typically been viewed as a very "cheap" investment vehicle to sometimes become part of a very high cost strategy, especially when the client ends out with 3 layers of fees: the ETF itself, the "ETF strategist" (e.g., a separate account manager) that manages the ETFs, and the advisor who selects the ETF strategist and manages the client relationship. As a result of this trend, it is estimated that nearly 20% of all ETFs are in managed account strategies; Morningstar estimates ETFs in managed accounts are up 48% from just last September to this June. The article notes that total costs aren't necessarily that far out of line with some other managed investment solutions out there, but may be far more than the low-cost perception typically associated with ETFs. And of course, the cost isn't necessarily a negative if it brings value to the table; however, Zweig notes with caution that few ETF strategists have a real track record, and most have simply backtested strategies that may or may not actually hold up in the future. The article wraps up with some questions for consumers to consider when working with an ETF strategist; they questions are probably also a good template for an advisor considering outsourced investment management as well.

Do Your Tax Strategies Accommodate the Affordable Care Act? - This article by Randy Gardner and Julie Welch in the Journal of Financial Planning provide a nice overview of the two new Medicare taxes coming in 2013 - the addition 0.9% Medicare surtax on earned income (and self employment income) above specified income thresholds, and the 3.8% Medicare contribution tax on unearned income (i.e., portfolio income) which also applies past prescribed income thresholds. Strategies are discussed to manage the latter tax in particular, including investing in non-taxable alternatives (from municipal bonds to Roth IRAs), managing income from year to year to stay below the AGI thresholds, or harvesting capital gains by completing sales before the end of the current year. The article also discusses the Small Employer Health Insurance Credit, which actually took effect in 2010 as a 35% credit but rises in 2013 to a 50% credit. The credit applies only to businesses with no more than 25 full-time employees, and the employees must have an average income of less than $50,000; so far, claims of the credit have been less than originally anticipated, although it's not clear if that's because of a lack of awareness in claiming the credit, or a difficulty in qualifying for it (or some of each).

Out Of The Depths: Is A Short Sale The Best Option For Your Client? - This article provides a nice walkthrough of the issues involved for clients considering a real estate short sale for an underwater property - when the home is sold at fair market value and whatever portion of the loan wasn't covered by the sale is forgiven, which the bank may prefer to going through the cost and hassle of a foreclosure. The process often begins once the property is underwater and the borrower stops making mortgage payments, although one expert points out that it may be possible to start the process by contacting the bank with a below-mortgage offer, even without having payments in arrears (and may be desirable to better preserve the client's credit score after the fact), although the bank may decline if the client clearly has significant other assets available to just continue paying off the mortgage. The latter scenario is particularly important if the client lives in a recourse state, where the bank has the right to sue the borrower to recover the shortfall from the client's other assets (although investigate thorough, as recourse treatment and details vary by state). Notably, the forgiven part of a mortgage can also trigger income tax consequences, although for tax years 2007 through 2012 the Mortgage Forgiveness Debt Relief Act has let many homeowners off the hook. Is a short sale isn't being accepted by the bank, there are other options to consider as well, including allowing foreclosure, or offering a deed in lieu of foreclosure, or seeking a loan modification (to change the rate and/or payments and/or principal).

Perceptions Of Friendliness And Competence Inversely Related - This article is a discussion of a recent Princeton research study, which found that when people want to convey themselves as being warm and friendly, they tend to make themselves appear less competent; conversely, those who wish to appear competent tend to make themselves appear more cold and aloof. The reason for this effect appears to be our use of language, and specifically that words which evoke warmth and trustworthiness tend to be substantively different than words which convey competence - as a result, people ultimately must lean one way or the other, and whichever way they lean tends in turn to evoke the stereotypes associated with that type. The implication for financial planners is that it make take conscious effort to mix and convey both types of words and images, or risk either appearing so warm that they are not competent or so competent that they are cold.

I hope you enjoy the reading! Let me know what you think, and if there are any articles you think I should highlight in a future column! And click here to sign up for a delivery of all blog posts from Nerd's Eye View - including Weekend Reading - directly to your email!


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Out and About

Wednesday, April 23rd, 2014

Understanding the New World of Health Insurance Evaluating Existing Annuities: What Every Adviser Needs to Know @ FPA New Jersey

Thursday, April 24th, 2014

Keynote @ Shareholders Service Group

Monday, April 28th, 2014

Safe Withdrawal Rates: Mechanics, Uses & Caveats @ St. Louis Estate Planning Council