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Deducting Financial Planning And Retainer Fees, And The (Tax) Problem With Bundled AUM Fees

Under the Internal Revenue Code, expenses for investment management are tax deductible. Accordingly, taxpayers are permitted to deduct the typical assets-under-management (AUM) fee of an investment manager. However, financial planning fees not specifically attributable to investment management (or tax planning) are non-deductible, treated instead as a personal expense.

With the rise of wealth management, though, it is increasingly common for consumers to pay a single “bundled” AUM fee, that covers not only (deductible) investment management services, but also (non-deductible) financial planning as well. Which means technically, those clients should probably only be deducting a portion of the AUM fee, not the entire amount – at least, where the AUM fee covers a “material” amount of financial planning services. And the issue is especially concerning when it comes to retirement accounts like IRAs, where paying a personal financial planning fee with retirement assets could trigger a (taxable) deemed distribution, or at worst disqualify the entire IRA as a prohibited transaction!

Ultimately, the easiest solution to the problem – at least from a tax perspective – is simply to unbundle the financial planning and investment management fees. And in fact, unbundling is now required under new IRS regulations when it comes to the investment management vs administration and other fees for estates and trusts. Yet for some firms, unbundling fees can present other business challenges about communicating the value of their services.

Fortunately, the issue may not receive scrutiny anytime soon, given that many advisory firms with bundled fees are still charging the same as investment-only firms (implying the financial planning fees may not be "material" from a tax perspective). Nonetheless, as long as the tax treatment is different for financial planning versus investment management fees, advisors should at least be cautious about how those fees are characterized by clients, especially when extracted directly from an IRA!

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Wednesday, May 20th, 2015 Posted by Michael Kitces in Taxes | 5 Comments

With the ongoing rise of advisor FinTech, one of the “hot” new categories starting to emerge are “Advisor Matching” services – websites where consumers can enter some personal information, and get suggested “matches” of potential advisors who can help them with their financial issues. Ideally, consumers get a potential advisor who can solve their problems, and advisors save time by being matched to prospective clients who are a good fit for their services.

However, thus far the ideal rarely matches the reality. The fundamental problem with building a “Match.com for Advisors” service is that it’s almost impossible to effectively screen and filter a list of potential advisors when most advisors are generalists who work with a far-too-wide swatch of consumers in the first place. If advisors don’t differentiate themselves, an advisor matching service can’t differentiate amongst them, either! And ironically, the advisors who do differentiate themselves with a niche or specialization will likely have better sources of clients than a generalist advisor matching service anyway!

Compounding the challenge of creating a viable advisor matching service is the simple reality that it’s expensive to market and build the trusted brand – whether as an advisor, or a “trusted” website to find one – necessary to generate a sufficient volume of highly qualified prospective clients. Which means in the end, even though advisors will pay astonishingly well for new clients – which means a “Match.com for Advisors” solution will be highly lucrative, if the puzzle can be solved – the low trust in financial services and incredibly high costs of client acquisition may be just as destructive for advisor matching services as they are for the advisors being helped.

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Monday, May 18th, 2015 Posted by Michael Kitces in Technology & Advisor FinTech | 8 Comments

Enjoy the current installment of "weekend reading for financial planners" - this week's edition kicks off with the news that major ETF providers have been establishing and expanding their lines of credit to prepare for a possible liquidity squeeze that could emerge in a market crisis, where a sell-off could force ETF redemptions that would be difficult to fund if/when the underlying securities are illiquid (e.g., with many types of bond and other fixed-income ETFs, as well as emerging markets). The news accentuates the warnings from some pundits, who have cautioned against the risks of owning "liquid" ETFs that are wrapped around otherwise illiquid securities.

From there, we have a few practice management articles this week, particularly focused around succession and continuity planning for advisory firms, including: a look at the key provisions to watch for in establishing a continuity agreement with another advisory firm that would take over in the event of death or disability; a discussion of the key succession planning issues firms should consider if the SEC adopts a succession/continuity planning requirement similar to the recent NASAA Model Rule on Succession Planning for state-registered investment advisers; how advisory firm owners can regain that "new business" feeling if they've otherwise lost their energy and focus in the practice; and whether there may be a quiet "demographics tsunami" still lurking as the average age of advisory firm owners approaches age 62 and more and more consider potential retirement.

We also have a couple more technical articles this week, from a look at some research suggesting that baby boomers may not actually be so far behind in retirement after all (once you consider their ability to spend less and save more as kids finally leave the home), to a discussion of the benefits of variable retirement spending strategies that "smooth" the spending in volatile years. There's also an article on how Medicare Part B and Part D premiums will be increased in 2018 for certain higher income individuals, and a discussion of a new type of long-term care insurance policy from John Hancock that will use "flex credits" to create a kind of LTC coverage that is "participating" similar to dividend-paying whole life insurance.

We wrap up with three interesting articles: the first examines the history of 401(k) plans and how they have evolved from a supplemental retirement plan to one of the key foundational pillars of retirement, which raises the question of whether the current structure of 401(k) plans is still "right" as such a widespread solution; the second article looks at how the SEC has become increasingly gridlocked over the past decade as the five SEC commissioners have become increasingly partisan; and the last is a story about "10 Young Advisors To Watch", highlighting the inspiring stories of 10 up-and-coming advisors who show how much talent there is in today's emerging next generation financial planner.

And be certain to check out Bill Winterberg's "Bits & Bytes" video on the latest in advisor tech news at the end, including a recent Investor Alert from the SEC about the risks of "Automated Investment Tools" (i.e., robo-advisors), the latest efforts of Envestnet to build its "Advisor Now" platform, and a review of the buzz from this week's Finovate Spring 2015 conference!

Enjoy the reading!

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Friday, May 15th, 2015 Posted by Michael Kitces in Weekend Reading | 15 Comments

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The Incredible Shrinking Alpha – What Was Once Alpha Is Now (Five-)Factor Beta?

In the world of investing, the Holy Grail is finding an investment manager who can reliably, persistently deliver alpha – a feat that seems to be of increasing rarity, as active managers in the aggregate continue to see outflows due to ongoing underperformance.

Yet in their new book “The Incredible Shrinking Alpha”, Larry Swedroe and Andrew Berkin make the case that the woes of the active management industry are not merely an artifact of the post-financial-crisis investment environment, but are a result of the ongoing evolution of the investment management industry.

As research continues to identify unique risk factors that are rewarded with excess returns, what was once believed to be alpha is increasingly turning out to be an active manager who simply invested to benefit from a not-yet-identified-as-such risk factor. Yet as the number of known risk factors increases – along with the availability of new solutions to passively invest in them at a low cost – it is more and more difficult to find active managers really adding something beyond an appropriately-factor-adjusted benchmark. And the situation is only further complicated by an increasing volume of professional managers competing against each other for a limited pool of available alpha where it is harder than ever to outperform against similarly-highly-skilled peers.

Of course, the caveat is that just as the investment research has evolved from one factor to three and now five, more factors may be found in the future that still create alpha opportunities in today’s marketplace. And given that not all factors are favored at once, tactically allocating amongst the risk factors may also present an opportunity for an active manager to add value. Nonetheless, Swedroe and Berkin do make a compelling case that the odds an active manager can even find any alpha, and wrest it from increasingly competitive set of peers, is not great, as getting a hold of a reasonable share of the shrinking pool of alpha is truly harder than it has ever been.

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Wednesday, May 13th, 2015 Posted by Michael Kitces in Investments | 19 Comments

In the world of investment advisors, competition has long been driven at least in part by investment performance results. Yet the challenge is that performance reporting can also be prone to abuse, due to the lack of consistent standards - amongst individual financial advisors in particular - about how those results are measured and reported in the first place. In fact, in recent years a number of advisory firms are trying to improve their performance reporting process to meet the Global Investment Performance Standards (GIPS) requirements specifically as a means to differentiate themselves.

Accordingly, in this guest post, GIPS compliance consultant Amy Jones and marketing expert Thusith Mahanama share some of the details that advisors should be aware of in considering whether to pursue the path of GIPS-compliant performance reporting for their own advisory firm. And notably - as the authors point out - the decision about whether to pursue GIPS-compliant reporting is a firm-wide decision, as one of the first key requirements of GIPS reporting is that it must be done on a firm-wide basis, to eliminate the potential that advisors try to cherry-pick the best performing accounts to include in their composite results.

So if you're an advisory firm that manages portfolios on a model basis, and have already been considering whether to adopt GIPS as a means to differentiate yourself, hopefully this primer on the requirements for GIPS compliance will be helpful for you. Alternatively, if you're an advisory firm that's had strong results for clients but is currently struggling to differentiate yourself from the marketing of other advisory firms, you may find the idea of GIPS-compliant reporting appealing as a means to differentiate why your performance reporting results really should be viewed as more 'credible' than the competition!

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Tuesday, May 12th, 2015 Posted by Michael Kitces in Investments | 6 Comments

The so-called “Custody Rule” under the Investment Advisers Act of 1940 was designed to ensure additional oversight of an RIA that has actual possession of client assets, including both additional reporting to clients, and the requirement of a “surprise” annual audit of the firm. Given the costs involved to comply, most RIAs will go out of their way to avoid having custody so that the rules aren’t triggered.

Yet a recent SEC “Risk Alert”, rule warns that as many as 1/3rd of RIAs are failing to comply properly with the custody rule, most commonly because the RIA fails to realize it has custody in the first place! As the SEC notes, just using a third-party custodian like Schwab or Fidelity alone is not a safe harbor; there are many ways an RIA can indirectly trigger custody, from being a trustee on a client’s account, to providing bill-pay services, and even “just” having a client’s username and password for their 401(k) can be enough to trigger the rule sometimes!

Accordingly, as RIAs continue to expand their services to differentiate in today’s increasingly competitive environment, it is more crucial than ever for firms to be aware of where the line is when it comes to the custody rule. In some cases, firms may decide that having custody – and handling the additional compliance requirements – is worthwhile for the service that will be provided to clients. But if the goal is to not have custody, firms need to be more cautious than ever about how their services are executed – and some may need to step back from a line they’ve already crossed, when it comes to common situations like having client login details to rebalance their accounts!

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Monday, May 11th, 2015 Posted by Michael Kitces in Practice Management | 13 Comments

Enjoy the current installment of "weekend reading for financial planners" - this week's edition kicks off with the big industry announcement that Envestnet is building financial planning software company FinanceLogix, as it continues to build towards a "one-stop shop" holistic technology platform for advisors. Also in the news this week was the announcement that the Vanguard Personal Advisor Services solution is now fully open to the public, with a new lower minimum of just $50,000... and notably, has already crossed the threshold of more than $17B of AUM even while it was still in its "beta" phase.

From there, we have a few technical planning articles this week, from a look at the new Section 529 ABLE Accounts for disabled beneficiaries, to a discussion of whether today's potentially low returns in both stocks and bonds may "wreck" retirement, to a recent study from AQR finding that perhaps Active Share is not such a good predictor of fund outperformance after all.

We also have a couple of practice management articles, including: an article by Angie Herbers suggesting that most advisory firm problems aren't actually "business" problems but instead are personal challenges of the owners that they must overcome as the firm grows and evolves; a look at how to properly structure an advisor study group "retreat" to get the most out of your time away from the office; a review of some of the key issues that new advisors should be thinking about (that they aren't always told up front); and a look at how financial advice is not a business where "if you build it, they will come", which is why advisors need to learn to better target a particular type of clientele and really market to them accordingly.

We wrap up with three interesting articles: the first is an article by Shlomo Benartzi in the Harvard Business Review suggesting that employer retirement plans are not paying enough attention to the little issues around how retirement planning choices are presented to today's workers, and that even the smallest differences in how online tools are designed can have significant impacts on retiree savings and investment decisions; the second is a discussion by Bob Veres suggesting that as advisory firms grow, the single most important issue is becoming the firm's ability to cultivate and develop its future leaders, such that the primary role of an advisory firm CEO should actually be focusing on the personal development of its top people; and the last is a look at how 40 years ago, Wall Street predicted doom and gloom with "May Day" and the elimination of fixed commissions, yet instead found that allowing competition and forcing firms to act more in the interests of their customers actually fueled a tremendous investing boom... which raises the question of whether the brokerage industry's current objections to recent proposals for a fiduciary standard represents another moment where the predictions of doom and gloom are off base and that forcing the industry to act more in the interests of their customers could actually lower the cost of and expand the availability of financial advice.

And be certain to check out Bill Winterberg's "Bits & Bytes" video on the latest in advisor tech news at the end, including a review of IBM's recent "World of Watson", the Envestnet acquisition of financial planning software FinanceLogix, and the rollout of Vanguard's Personal Advisor Services to the mainstream public.

Enjoy the reading!

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Friday, May 8th, 2015 Posted by Michael Kitces in Weekend Reading | 11 Comments

As the Envestnet Advisor Summit gets underway today, CEO Jud Bergman kicked off the event with the big news that financial planning software and PFM provider FinanceLogix is being acquired in a deal reported at $32.5M of cash and stock, plus significant additional options to the upside. The news comes on the heels of Envestnet's acquisition of robo-advisor-for-advisors Upside Advisor just a few months ago.

Relative to other recent deals like Fidelity's acquisition of eMoney Advisor and the Northwestern Mutual purchase of LearnVest - both rumored to be bought for more than $250M each - the FinanceLogix deal is noticeably smaller, but given that the company may have only had 1/5th the market share of eMoney Advisor, seems reasonably in line and suggests that the acquisition interest in integrated financial planning and PFM software solutions remains strong. In fact, with the FinanceLogix purchase, there are virtually no remaining fully integrated planning-plus-PFM solutions available today... so expect to see the major players begin to acquire standalone PFM solutions and 'manually' integrate them instead as the buying frenzy continues.

From the perspective of FinanceLogix, the Envestnet acquisition will give them significant resources to continue to build and iterate the software - which will remain available to existing and new standalone users, even as it is more fully integrated into the Envestnet Advisor Suite. And from the Envestnet perspective, the acquisition suggests that Envestnet is aiming to build the "Holy Grail" of advisor technology platforms, a fully integrated technology stack including CRM, portfolio accounting, and now financial planning software, integrated with a "robo"-style client-facing portal that includes PFM capabilities... and revealing that perhaps Envestnet is not positioning to someday become a competing custodian, but instead simply wants to take the high ground of advisor value-add and deliver the ultimate integrated technology platform of the future for advisors - one that can be used regardless of their underlying (and increasingly commoditized) custodian or broker-dealer relationship.

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Wednesday, May 6th, 2015 Posted by Michael Kitces in Industry News | 13 Comments

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Does Tax Loss Harvesting “Almost” Substantially Identical Mutual Funds And ETFs Trigger A Wash Sale Problem?

Harvesting capital losses to generate a current tax savings is popular. So popular, in fact, that not long after the US income tax was first created a century ago, the strategy was rapidly adopted as a tax savings technique and became a perceived tax abuse. In turn, this lead to the establishment of one of the first pieces of legislation to close an “abusive” tax loophole, and we now know Congress’ solution as the “wash sale” rules.

Yet the challenge of the wash sale rules is that the requirement not to own a “substantially identical” stock or bond within the 61-day wash sale period was rather straightforward to apply in its day, but has become outdated given the rise of pooled investment vehicles like mutual funds, and especially with the explosion of index ETFs. Now, taxpayers face oddly disparate treatment, where it’s not permitted to harvest the loss on a stock that’s down and replace with the same stock, but it’s “fine” to harvest the loss on a mutual fund that’s down and replace it with another mutual fund that owns overlapping securities.

Ultimately, the spirit of the wash sale rules was that investors should be required to endure some “tracking error” risk with the replacement security owned during the wash sale period… which means swapping ETFs with a 0.99+ correlation to harvest a loss without any risk of a performance difference almost certainly violates Congressional intent. And while it remains to be seen whether the IRS will become more aggressive in pursuing the issue, and/or whether Congress will attack this abusive “tax loophole” once again, the fact that there has been no action to limit the abuses yet does not protect taxpayers who are in clear violation of the spirit and intent of the rules in the first place. So investors should at least be cautious to consider how far they push the limits with tax loss harvesting of mutual funds and ETFs.

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Wednesday, May 6th, 2015 Posted by Michael Kitces in Taxes | 9 Comments

With markets up and clients (generally) happy, advisory firms are enjoying record productivity, with the average advisor now responsible for nearly $500,000 of revenue by one benchmarking study’s measure. And the larger the advisory firm – and the more it scales its advice offering – the greater the advisor productivity seems to be.

Yet a deeper look at the numbers reveals that in reality, the largest advisory firms actually have the least productive advisors, at least when measured by the number of clients they serve. Similarly, while profit margins for advisory firms overall are healthy, they are remarkably similar regardless of whether a firm has $1M, $5M, or $10M of revenue. In other words, financial advice does not actually appear to be scaling across the landscape of advisory firms!

Instead, the key differentiator for the largest firms appears to be their ability to attract the biggest, wealthiest clients, and accelerate their growth rates despite spending the smallest percentage of revenues on marketing. Which means ultimately, while the productivity of financial advisors themselves doesn’t appear to scale much as a firm grows larger, the ability of the largest firms to attract the most affluent clients and scale their marketing may be the biggest advantage of that large firms have over their smaller competitors!

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Monday, May 4th, 2015 Posted by Michael Kitces in Practice Management | 18 Comments

Michael E. Kitces

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Out and About

Tuesday, May 26th, 2015

*The Impact of Valuation-Based Asset Allocation on Retirement Income *Understanding Longevity Annuities and their Potential Role in Retirement Income @ FPA NorCal

Thursday, June 4th, 2015

*Cutting Edge Tax Planning Developments & Opportunities in Long-Term Care Insurance *Trends & Developments in Long-Term Care Insurance @ FPA Central Virginia/Richmond

Wednesday, June 10th, 2015

*Setting a Proper Asset Allocation Glidepath in Retirement @ AICPA

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