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Weekend Reading for Financial Planners (Feb 2-3)

Posted by Michael Kitces on Friday, February 1st, 7:30 pm, 2013 in Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" - this week's issues starts off with a fascinating article that studied brain images of investors working with CFPs or non-CFPs in volatile markets, and found that those following a CFP-credentialed advisor were more likely to stick with the advice and less likely to second guess than with a non-credentialed advisor. A second article looks further at some recent brain research and what it's beginning to tell us about not just how clients behave in general, but about how they interact with advisors and why they often don't implement an advisor's recommendations.

From there, we look at a few articles on the regulatory front, including one that suggests the SEC's recent crackdown on advisors misrepresenting AUM may be partially the regulator's own fault for having such a poor and ambiguous definition of what constitutes AUM in today's complex marketplace, a second looking at how fiduciary rulemaking is very likely to proceed this year from the DOL even if the SEC's own rulemaking progress has slowed, and a third striking piece by Don Trone suggesting that the real roadblock to moving forward on the fiduciary issue is that fiduciary advocates are spending too much time talking about principles the industry already agrees with and not enough time focusing on developing the fiduciary best practices and safe harbors that are really necessary for wider fiduciary adoption.

We also have a few technical articles this week, including guidance from Joe Tomlinson about how to craft better asset class return expectations for financial plans, a fascinating look from John Hussman at how the "great rotation" from bonds to stocks is a myth, a look at how "career asset management" is a new frontier for financial planners to deliver value to clients, and a deep look at the new "play or pay" tax rules for employers offering health insurance (or not) that will kick in starting next year.

We wrap up with three articles looking more broadly at the industry - the first suggests that financial advisor conferences are broken and need to be fixed (with a few suggestions about how to do so), and the last two provide a striking look at the research that's come out in recent years trying to quantify whether or how much value financial advisors really bring to the table for their clients - research that shows promising signs for the value of a financial planner, but research that is unfortunately confounded by the fact that apparently researchers often can't tell who's an advisor and who's a salesperson any more than consumers can! Enjoy the reading!

Weekend reading for February 2nd/3rd:

Brain Activity Suggests Planning Designation Helps Calm Investors - In what may be one of the neatest financial planning studies I've seen in years, professor Russell James of Texas Tech has studied how the brains of investors react during volatility in an experimental stock market game, and finds that based on brain imaging, clients who know their advisor has a CFP designation are less likely to mentally question or second guess the advisor's recommendations, compared to the results when working with a non-credentialed advisor. The driver appears to be the perceived expertise of the advisor - the point of the study was not that the financial results of the CFP certified advisors were better (since it was an artificially constructed investment environment anyway), but simply that investors were less likely to switch away from the credentialed advisors during periods of underperformance, apparently because the investors had more certainty in what the advisor was doing for them. Notably, the results found that the advisor's certification was primarily a driver for retention specifically during periods of underperformance; it had no measured impact during times of good performance. Ultimately, the study notes that the CFP certification was chosen as a benchmark simply because it is the most popular; in theory, advisors with other respected designations may perform similarly compared to non-credentialed advisors, assuming the designation is perceived as credible and a marker of expertise.

Double Think: Getting Past the Conflict in Your Clients’ Two Brains - In another article tying to brain imaging research, Olivia Mellan in Investment Advisor magazine looks at some of the insights from brain research to explore why it is that clients receive a well-thought-out financial plan specifically crafted for their personal needs and goals, yet just take the plan home and never implement it. Part of the challenge is that our brains themselves sometimes operate more like two independent brains, and sometimes the conflict between the two can result in client inaction. While recent popular psychology has framed this as an issue between a logical and analytical left side of the brain and a creative and artistic right side, a better framework from psychologist Daniel Kahneman in his recent book "Thinking Fast and Slow" suggests that in reality the problem is a fast, instinctive and emotional brain sometimes conflicting with a slower, more deliberative and logical brain. In fact, this conflict between the emotional and the logical can be seen in the fact that clients often just don't fully respond to rational arguments and discussions; or viewed another way, "money is never just about money" but attaches to other relationships with and around money; if those emotional dynamics aren't addressed, the rational brain isn't likely to implement the recommendations, especially since research suggests the emotional and largely unconscious portion of the brain is actually what drives most decisions, especially during times of excessive stress. Fortunately, though, research also suggests that the brain can literally rewire itself over time with learning, which means that while many of these challenges are present, they often can be overcome.

The SEC Needs To Clean Up Its Semantics Before Accusing RIAs Of Inflating AUM - This article from RIABiz weighs in on the recent SEC alerts that there may soon be a crackdown on advisors misrepresenting and overstating their assets under management (AUM). Noting that overstating AUM happens for a variety of reasons, from qualifying for SEC registration and getting out of the patchwork of state RIA registrations to simply giving off the perception of a larger firm, the article points out that it is perhaps hypocritical for the SEC to crack down on AUM representations when their own definition of AUM is a bit muddy in the first place. For instance, the AUM disclosure on Form ADV is based upon "regulatory assets under management" which is based on "continuous and regular supervisory or management services to securities portfolios." What exactly does that mean? AUM that is managed on a discretionary basis would clearly qualify, but what exactly constitutes a "supervisory" relationship? Is that a non-discretionary relationship? But can you really have continuous and regular supervision of a non-discretionary account? And what kinds of "securities portfolios" count? Classically, that would be stocks, bonds, and cash? Supervision of pooled or separate account managers can qualify given the SEC's definitions in its glossary, but does that just mean third-party managers, mutual funds, and ETFs, or would variable annuity sub-accounts count also? The bottom line from the article's perspective - a lot of confusion is created in trying to parse out discretionary AUM from non-discretionary AUM in various nuanced circumstances; perhaps the cleanest definition would be to relabel this as "AUMA" which would count both assets under management (discretionary) and under advisement (non-discretionary).

Emboldened Borzi Is Back - This article from Investment Advisor magazine notes that Phyllis Borzi, the assistant secretary for the Department of Labor's Employee Benefits Security Administration, is adamant that the DOL's proposed fiduciary rule will see the light of day this year. Borzi states that the reproposal of the fiduciary rule has been adjusted in response to legitimate issues and feedback that were raised in the comment process, and that the new rule will be "better, clearer, more targeted and more reasonably balanced." In addition, the reproposed rule is expected to include a "substantial economic analysis" and apply a strict ERISA fiduciary standard to nearly all those who provide adviceo to either plan sponsors or participants. The biggest looming question is whether the DOL will continue to try to extend its fiduciary rule to those who advice on IRA rollovers out of ERISA plans, as well as the assets within the plans, and what kinds of rules may be attached to the solicitation of IRA rollovers. In the meantime, the progress from the SEC on a fiduciary rule under Dodd-Frank is less clear, although the recent appointment of Mary Jo White as SEC commissioner (which occurred after this article went to printing) may lead to an SEC more willing to take on the fiduciary issue. The bottom line, though, is that 2013 appears to be the year when at least some major new fiduciary rulemaking will happen, at least from the DOL, if not the SEC as well.

Standard Issue - This article by Don Trone in Financial Advisor magazine notes that progress towards implementation of a uniform fiduciary standard under Dodd-Frank has been slowing lately, in large part because even broker-dealers who are conceptually willing to support the standard are uncertain how it can be effectively implemented within their business model. Accordingly, Trone notes that the pressure that fiduciary advocates have been applying with "their sharp pointy sticks" may actually be slowing the process themselves, as making the fiduciary issue about character and mudslinging just inflames the debate and impedes progress. Ultimately, Trone notes that fiduciary rulemaking can only move forward once three key elements are resolved: setting principles for a fiduciary standard; establishing practices under a fiduciary standard; and creating fiduciary safe-harbor procedures. Yet while there is relatively consistent consensus on fiduciary principles, Trone notes that dialogue has made little progress on establishing clear fiduciary practices. In fact, according to a recent fiduciary impact survey, even (RIA) firms that operate under a fiduciary standard are actually less clear about what constitutes best fiduciary practices than is often implied; in other words, many fiduciaries appear to focus merely on the intent of being a fiduciary but are not actually taking the necessary steps to ensure their services are actually fully implemented in a fiduciary manner with the appropriate checks, balances, and oversight. Furthermore, Trone notes that there has been no constructive discussion about how to establish fiduciary safe harbors, which provide clear and concrete guidelines to firms that are struggling to implement fiduciary that shows them at least one way to legitimately implement fiduciary practices that will be safe from liability. The bottom line - if a fiduciary standard is ever really going to be implemented, it's time to move past principles, motive, intent, and character discussions, and into the real realm of establishing fiduciary practices and safe harbors that can be applied in the real world.

Predicting Asset Class Returns: Recommendations For Financial Planners - This article by Joe Tomlinson on Advisor Perspectives looks at the assumptions being made in articles, research, and even financial planning software packages, regarding future asset class returns that are fundamental to crafting long-term financial recommendations for clients. The key crux of the issue relates to the differences between long-term historical averages, and where we stand now. For instance, the long-term average for intermediate-term government bonds according to Ibbotson is 5.4%, but is that really reasonable as an assumption when actual 10-year government bonds barely yield 2%? On a real basis, intermediate government bonds have averaged about 2.4% above inflation, yet intermediate TIPS are at a -0.73% yield on the 10-year! Similarly, if the (nominal) risk-free rate is only 2%, then even with a typical equity risk premium, does that mean stock returns should only be projected at something around 6.5% rather than the nearly 10% long term average? Ultimately, Tomlinson suggests that, to say the least, using long-term historical averages is unreliable, and that crafting proper return expectations going forward should be done by looking at the individual components of stock and bond returns and adjusting accordingly. And when you do so, make sure you acknowledge whether you're setting an arithmetic or geometric average return expectation, as the difference with volatile assets can be significant, and entering the wrong type of return into planning software can result in substantively incorrect conclusions for clients.

Capitulation Everywhere - In his weekly market commentary, John Hussman notes that market bears are capitulating and jumping onto the bull market bandwagon, driving the market even higher, despite the elevated risk conditions that remain. Recent media commentary has suggested that the latest rally is being driven by a "great rotation" from bonds and cash into stocks, but Hussman points out that the whole idea of stocks being "underowned" at points in time is actually a logical fallacy. Every share of stock that's out there is already owned by someone, as buying and selling merely causes shares to change hands; it doesn't change the relative ownership of stocks versus bonds for the markets in the aggregate. In fact, Hussman points out that the primary reason why so much money has been flowing into bonds recently is simply because there are more bonds outstanding, in total, than there have been historically; in other words, the problem isn't that investors are "overbuying" bonds but that, due to the rise in gross indebtedness, there simply are more bonds relative to stocks than in the past and therefore they consume a larger share of available investment dollars. This doesn't mean that the group of stock buyers and sellers can't be momentum chasers and bid up prices; but the fact remains that because some investor still has to hold the bonds, and the cash, and the stocks, it's not actually possible for "great rotations" to occur for markets in the aggregate. Nonetheless, Hussman notes that markets remain overvalued, overbought, overbullish, and are now experiencing rising yields; while past performance is not necessarily indicative of future results, the reality is that such factors have only lined up six other times in history, and those times - 1929, 1972, 1987, 2000, 2007, and 2011 - were followed by market pullbacks at best, and bear markets and crashes at worst.

Career Asset Management: Where Wealth Is Created - This article from the Journal of Financial Planning makes the case that financial planners need to view a client's career and earning potential as an asset, and that it's an area ripe for delivering value to clients (far more than trying to improve portfolio returns). Issues in managing careers as an asset include not only quantitative issues like how many years the client will work, and whether the client can take steps to get a (better) raise, but also more qualitative issues, such as the enjoyment of the work and how it fits in with family and work/life balance goals. In the process, the author points out that managing a career asset can impact other parts of the planning picture as well; for instance, some clients might need a career asset reserve, separate from the family's general emergency reserves, that can be used to handle issues like getting training or help for a new job if laid off, supporting lifelong learning in a current career path, or even funding a career sabbatical (where someone leaves the workforce for a period of time to rejuvenate and then returns). And notably, as discussed previously on this blog, the reality is that for younger clients, the career asset may be the largest asset to manage (and get paid for) on the client's personal balance sheet.

The Affordable Care Act’s ‘Play or Pay’ Tax: Determining Coverage Alternatives - This article from the Journal of Financial Planning provides a good look at the upcoming "Play or Pay" tax on employers that have to decide whether to continue offering health insurance for employees in 2014 (and likely pay some of the employees' premiums), or pay a penalty tax instead and let employees get their own health insurance. The new rules will only apply to "applicable large employers" that have at least 50 full-time equivalent employees, who either fail to offer health insurance, or offer "unaffordable" health insurance (by failing to pay a sufficient share of the premiums) that makes premiums greater than 9.5% of the employee's household income. If the requirements are not met for an applicable employer, the penalty in 2014 will be $166.67 per month per employee for not offering coverage or $250 per month per employee for providing unaffordable coverage. Notably, though, the cost of the penalties may still be less than what employers would have to pay as their share of health insurance costs to make the coverage "affordable", and any/all employees will be able to get guaranteed health insurance from state exchanges if the employer doesn't provide it. As a result, employers will need to begin to weigh whether it's cheaper to just pay the penalty - and perhaps even give employees a small raise - and simply direct employees to get their own health insurance, or whether such a change could impact employee recruitment, turnover, or morale. In the long run, though, the key change under the new rules is that employees will no longer be reliant on having an employer offer health insurance in order to get coverage... and if it's cheaper for employers to just pay a penalty, 2014 may mark the beginning of the end of employer-based health insurance and a transition to a world where all employers simply pay a "penalty tax" to support a system where employee and non-employees simply buy their own health insurance directly (guaranteed and without pre-existing conditions rules).

Everybody Get Together: Fixing Advisor Conferences - This article from Bob Veres in Financial Planning magazine looks at the role that national conferences play in the advisory world, and what can be done to improve them. The challenge is that conferences often serve several roles, from delivering Continuing Education (CE) credits, to keeping participants abreast of changes in the professional planning world, to networking with peers. And at the same time, to get value in these areas, the content needs to really be educational and actionable, not so focused on the "high level" that it can't be effectively implemented. To say the least, some conferences or sessions succeed in this regard more than others. Yet at the same time, Veres notes two other value propositions from conferences that are often ignored. The first is staff training; while many conferences provide CE credits to the advisors, why not have a conference that also delivers guidance in how to manage people, training in key software, or other content that would be relevant not to the advisor but to the advisor's staff. Not only would the content itself be valuable, but having the staff and advisor learning at one central event allows for more effective learning and implementation, as ideas about how to proceed can be hammered out before the conference is even over. In addition, Veres also notes that in practice, most conferences underutilize the expertise of the exhibitors; at a conference that has innovative software and key potential business partners, the exhibitors hand out lip balm and the advisors hurry past to get to the food and beverage areas! Instead, Veres suggests that exhibitors should be required to produce white papers, share real expertise in what they're seeing in the marketplace, and provide quality demos of how their customers really utilize their products or services effectively; at the same time, Veres also suggests that most conferences need a better screening process to ensure that the only companies in the exhibit hall are the ones serious about partnering with advisors and what they do, not merely the exhibitors who can write the biggest check.

Are Planners Worth The Fees They Charge? - On Advisor Perspectives, Wade Pfau provides a nice overview of the research that's been published in recent years about whether or how financial advisors add value to clients. Pfau notes that in recent years, most of the academic studies have been fairly negative on the value of advisors, but unfortunately, as noted previously on this blog, such studies tend to investigate brokers who would be better characterized as salespeople rather than true advisors. In fact, one recent high profile study that concluded "advisors" tend to be biased deliberately studied only brokers and actually excluded Registered Investment Advisors from their study, implicitly biasing the results themselves. A more recent study from Texas Tech attempted to look at the results of clients who work with more comprehensive advisors versus brokers and concluded that the comprehensive planners help clients achieve improved financial outcomes, although the available data was somewhat limited and difficult to analyze clearly, although it's not entirely clear how much was a result of the help from the planners and how much was simply because people who seek out planners may tend to be more planning-minded in the first place. Another recent study looked not at what advisors necessarily have done to add value, but at least what they can do, and found that applying advanced planning knowledge regarding techniques like proper portfolio design, good asset location, and other similar strategies can significantly enhance client wealth. The bottom line is that overall, the research still appears somewhat mixed, in part because it's difficult to design good studies and get good data to analyze, but nonetheless the results seem to favor comprehensive planners who can apply advanced knowledge for the benefit of their clients.

What's An Advisor's Value? - Continuing the theme of the prior article, Michael Finke also takes a look at the research on whether/how advisors provide value in the February issue of Research magazine. Unfortunately, Finke also notes the research results are mixed, again in large part because so many studies mischaracterize broker salespeople as advisors and then - not surprisingly - find the salespeople tend to act in their own interests and not as a true advisor. On the other hand, one study found that even broker-driven portfolios are often better diversified and may have superior risk-adjusted returns than what self-directed investors often create for themselves, and another study pointed out that even if consumers have lower returns from commissioned advisors, it may still be a plus for them in that the commissions are paying for the advisor to help comfort clients through difficult makes and keep them invested in the first place; in other words, the costs are simply a trade-off for the assistance in becoming an equity investor in the first place. The article also cites the recent Blanchett & Kaplan "Gamma" research from Morningstar that shows advisors applying proper advice can boost retirement income by as much as 30%. Yet ultimately, the real question is arguably whether advisors provide value beyond just what happens in the investment portfolio. In this regard, research so far is pretty light, but a recent study by Finke and his graduate student Terrance Martin suggests that people who plan and have an advisor actually do a better job saving for retirement, indicating that advisors can and do have an impact beyond just portfolio results. And of course, in some situations the value comes from other areas entirely, including income or estate tax savings, reduced costs from effective insurance design and implementation, or simply the peace of mind from establishing and following a good plan.

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!

  • Robert Wasilewski

    Hussman says, “Quite simply, the reason that pension funds and other investors hold more bonds relative to stocks than they have historically is that there are more bonds outstanding, relative to stocks, than there have been historically.” The brilliant late physicist Richard Feynman once pointed out that saying the reason you fall when you step on ice is because ice is slippery isn’t really an explanation – it is a description. It seems to me that Hussman is not explaining anything with the quote above.
    The Fed has pushed investors into bonds, thereby driving bond yields lower causing Corporate issuance to rise. At the same time, stocks were viewed as cheap by Corporations and buybacks have increased. This I believe explains the greater supply of bonds relative to stock.
    Furthermore, it seems to me that he confuses ex post and ex ante. Surely we can wake up tomorrow and say bonds are expensive and stocks are cheap. At the end of the day prices will adjust so that the quantities are is fact held.

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Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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