Enjoy the current installment of "weekend reading for financial planners" – this week’s issues starts off with the big regulatory news that Mary Jo White has been nominated to replace interim SEC chairwoman Elisse Walter; White is an industry "outsider" with a background as a U.S. attorney who has prosecuted terrorists and organized crime bosses, raising the question of whether there’s about to be a shift in the aggressiveness of the SEC towards Wall Street and in favor of the fiduciary movement. After looking at a second article on the trend towards fiduciary as well, we have a series of more technical articles, including one that suggests potential estate tax reforms may change how ILITs are designed, another that provides a useful checklist of reminders for advisors and their clients when someone passes away, and an interesting look at how education regarding stock options can help employees overcome the mental shortcuts they take that often misjudge the value of their option compensation.
We also have a series of retirement-planning-related articles this week, including: research about how clients can start with significantly higher safe withdrawal rates if they’re willing to give up inflationary adjustments in later years (which often happens anyway as clients age); a new research study suggesting that the base safe withdrawal rate may need to be reduced below 4% given today’s dangerous combination of high market valuation and low yields; and how it may be worth delaying immediate annuities given today’s low return environment until clients are well into their 70s or even their 80s. There’s also a striking article looking at how annuities may change in the coming decade, going back to their industry roots from centuries ago where annuities didn’t guarantee a lifetime of cash payments, but of lifetime services like food, clothing, and shelter. There are also two behavioral-finance-oriented articles: the first looks at how to manage not the behavioral biases of our clients but our own biases; and the second shows how keeping too much liquidity for clients is a problem not just because it’s a return drag but also because clients may actually be happier if their long-term investments are illiquid to reduce temptation to spend!
We wrap up with a nice reminder that working as a professional can lead to a lot of sitting – which can be very unhealthy over extended periods of time. The proposed solution: try "walking meetings" where you actually conduct the meeting while taking a walk, instead of just sitting. The author notes that it’s not only a healthier way to meet, but can even lead to more productive meetings as well! Enjoy the reading!
Weekend reading for January 26th/27th:
Mary Jo White Gets Obama Nod For SEC Chair – In the biggest news of the week, President Obama nominated Mary Jo White to become the new chair of the SEC; if confirmed by the Senate, she will replace interim chairwoman Elisse Walter. What’s notable about the nomination is that White is a relative outsider to the industry – her past includes time as a U.S. attorney for the Southern District of New York, where she prosecuted terrorists and organized-crime bosses, not Wall Street – and this shift to an "outsider" is especially notable compared to Walter, whose prior experience included time as an executive with FINRA. With White’s nomination, the direction of SEC action regarding greater oversight for RIAs and the implementation of a uniform fiduciary standard is now uncertain, but for consumer advocates this uncertainty is actually a positive, as many had feared Elisse Walter’s leadership would have been a fait accompli for ensuring the status quo. In point of fact, White’s rise to the leadership position at the SEC will mark the first time the agency has not been led by a career regulator or politician – a change from the status quo that perhaps implies the mandate of her appointment is to change some of the status quo on Wall Street as well. To say the least, White’s appointment almost certainly ensures that regulatory change for advisors will be a hot topic to watch for the coming year.
Changes In The Financial Services Industry And The Rise Of The Fiduciary – On his Scholarly Financial Planner blog, Ron Rhoades takes an interesting look at the history of the financial services industry and how it is changing towards "the age of the trusted advisor" in an ongoing evolution. Rhoades notes how in the early years, financial services focused on the commissions for brokering stock trades, which saw the beginning of its end when stock commissions were deregulated in 1975; in response, the industry shifted to a focus on manufacturing and distributing mutual funds and other pooled investment vehicles. Yet an increasingly sophisticated consumer, on top of a rather difficult decade for investing, is beginning to question much of the active management foundation upon which the mutual fund industry rests, leading to a shift towards index funds and lower-cost investing that is once again undermining much profit-making activity in financial services. So how does the industry reinvent itself as investments themselves become more commoditized? With a more substantive focus on advice itself, as the profit of products continues to be eroded, but the complexity of the financial world means most consumers still need help navigating the landscape and making effective decisions.
Planners Beware: ILITs Are Under Attack – This article provides an interesting look at how Irrevocable Life Insurance Trusts (ILITs) may soon either disappear or become significantly changed as a result of potential legislation intended to ‘crack down’ on estate planning. The key issue was a proposal last year that would require all grantor trusts – where in the income tax consequences of the trust belong to the grantor, rather than the trust itself – to be automatically included in the grantor’s estate. In other words, it would simply mean "if you owe the income taxes on it, you have to pay estate taxes on it, too." As noted on this blog when the proposal first came out, the new treatment would eliminate the effectiveness of Intentionally Defective Grantor Trust (IDGT) strategies, but the article points out it would impact ILITs, too; a trust can become a grantor trust by owning life insurance on the grantor, which means an ILIT under the new rules could be included in the estate of the insured, entirely defeating the whole purpose of the ILIT in the first place (which is to get the life insurance out of the grantor’s estate!). The potential workaround would be to give the beneficiaries expanded powers under the trust, which could shift the income tax consequences to them – away from the grantor, and thereby keeping the life insurance out of the grantor’s estate. Even with a workaround, though, if the proposal is implemented, ILITs may become more complex to draft and administer in the future; on the other hand, given today’s higher estate tax exemption amounts, ILITs may already be declining in popularity for all but the most wealthy!
Death Of A Client: Checklists For Advisors And Executors – This article from Morningstar Advisor provides some nice checklists for advisors to apply either for themselves or for clients who are executors in the event that someone has passed away. The starting list is simply a good set of reminders for what advisors should ensure clients have in place before anyone dies (including legal documents that identify key parties, proper beneficiary designations, and appropriate professionals), but also what to do when the advisor finds out a client has died, what guidance to provide heirs, key steps that executors must take, how to work through and resolve both probate and non-probate assets. There’s nothing new and novel in this article, but it’s a nice series of reminders and may be a helpful resource to bookmark for future reference.
How To Help Employees Better Value Stock Options As Compensation – This article from the Journal of Financial Planning looks at how to better value employer stock options, in light of recent research showing that employees themselves typically misjudge (and typically underestimate) the value, most commonly by just looking at the current in-the-money value of the options and not truly accounting for their time value appreciation potential, or by simply assigning it a value of zero because it hasn’t vested yet (even if it is likely to do so); sometimes employees overestimate value by just looking at the total stock price and not recognizing they merely hold options, not the actual stock. These inaccurate estimates of option value are important, as it can impact both the client’s overall financial planning decisions, and also lead to a poor understanding of how (well) the employee is being compensated overall. The research here finds that educating employees about their options, including the Black-Scholes formula and the factors that go into it, results in more accurate understandings of the value of the option, even in light of the actual complexity of Black-Scholes. In turn, the research notes that for financial planners in particular – who may spend more time and be able to better educate and make relevant the key factors for options – there is significant value in educating clients to better understand the value of their options. In other words, this article isn’t about the technical aspects of valuing stock options, per se, but about the importance of helping clients to understand and internalize that accurate valuation themselves, so they make appropriate financial and employment decisions.
Achieving A Higher Safe Withdrawal Rate With The Target Percentage Adjustment – This article by David Zolt in the Journal of Financial Planning looks at how to expand the use of safe withdrawal rates by applying more dynamic adjustments along the way. In this research, clients only take their annual inflation adjustments if the portfolio is on track or ahead of where it was projected to be; otherwise, the clients must keep their spending even on a nominal basis, resulting in a small (but presumably quite manageable) decrease in their standard of living until they get on track again. But adopting such incremental adjustments along the way, the research finds that sustainable withdrawal rates increase to 5% to 5.5%; although there is some risk of a decline in purchasing power in the later years due to foregone inflation adjustments, it’s notable that much of this impact is offset over lifetime by the greater spending power in the early years. Ultimately, it’s up to clients individually about whether they’re willing and interested in taking on the risk of reduced purchasing power in later years in exchange for greater spending power in early years, but several studies in recent years have shown that clients already tend to engage in reduced spending in their later years; as a result, the research here arguably just helps to quantify a phenomenon of modest real spending declines that clients tend to engage in naturally as they age, but acknowledges that the tendency to do so should be associated with higher withdrawal rates in the first place.
Finke Study Warns: 4% Retirement Rule Is Dead, Long Live Annuities – This article from AdvisorOne discusses a recent draft study released by financial planning and retirement researchers Michael Finke, Wade Pfau, and David Blanchett, which expands on the existing safe withdrawal rate research by modeling on a prospective basis the combined impact of today’s elevated market valuation on top of today’s low interest rates (given negative real yields on TIPS). The results suggest that this risky combination in today’s market environment may mean the 4% withdrawal rate should actually be more like 3%, and that blindly following a 4% withdrawal rate path has a whopping 57% risk of failure. Granted, this assumes rates stay low, while most advisors expect them to normalize at some point, but the research notes that if rates normalize within 5 years, the risk of failure is still 18%; if it takes 10 years, the risk of failure is 32%. Notably, Finke also points out that just using a bucket approach to segment investments doesn’t help the problem either, since retirees are still ultimately reliant on investment returns that are still diminished in today’s environment. As for what to do about this, Finke suggests either moderating spending to lower levels to account for today’s lower return environment, or (re-)consider annuitization as a solution (notwithstanding the fact that annuitization is also less effective in low-return environments). (Editor’s Note: For a full copy of the study itself, you can read it here on SSRN.)
Examining The Benefits Of Immediate Fixed Annuities In Today’s Low-Rate Climate – This article by David Blanchett in the Journal of Financial Planning looks at immediate fixed annuities (also discussed more commonly as single premium [fixed] immediate annuities), and the commonly expressed concern about whether it’s a poor decision to utilize a SPIA that would lock in today’s low interest rates. Blanchett notes that the concern about interest rates is reasonable, as a look at the history of immediate annuitization rates clearly shows a strong 0.94 correlation to long-term Treasury yields (a trend that has held up despite changes in mortality tables over the decades as life expectancy increases). After providing a thorough discussion of how the internal rate of annuities rises over time for annuitants, and is more stable for couples than for individuals, the key aspects of the analysis come at the end, where Blanchett evaluates how SPIAs fit into a portfolio at today’s rate or higher future rates. Notably, the results suggest that optimal allocations to SPIAs for couples may not begin until the couple approaches their 80s at today’s rates, or even with a modest uptick in rates, although SPIA rates that are 100bps higher would drive the optimal age lower. Single individuals (male or female) may find it effective to annuitize some of the portfolio slightly earlier, but generally still not before age 70 unless rates rise significantly. Ultimately, Blanchett’s conclusion is that it may in fact be wise for retirees to delay the implementation of SPIAs until the future, either to allow rates to rise, or simply to reach an older start age where the payoffs as a longevity hedge are greater.
Annuities 2020: Will The Future Of VAs Look Like Their Past? – This article by Moshe Milevsky from Research Magazine looks at the ongoing evolution of the annuity industry, as more and more companies slowly constrain or entirely eliminate their various Guaranteed Living Withdrawal Benefits (GLWBs), to the point that the products simply may no longer be compelling to most consumers even with the best of annuity marketing and wholesalers. So what’s next for the industry? Milevsky puts forth an intriguing notion: that annuities may begin to pay out in terms of lifetime guaranteed retirement services, instead of just paying in cash. For instance, the first recorded annuity thousands of years ago paid out not lifetime cash, but a lifetime of guaranteed dinners, and in the middle ages people bought a lifetime guarantee of food, clothing, and shelter (from monasteries and abbeys), since they already had wealth; famous poet and author Geoffrey Chaucer actually had a lifetime annuity from King Edward III in the form of a gallon of wine per day, for life! It was only in the 16th century that annuities bought with cash would actually pay in cash, rather than paying in units of consumption. Milevsky suggests that as annuity companies try to find their next opportunity, that there may be an opportunity in offering "forever services" – where the purchased annuity covers something like a water, gas, or electric bill for life, or units of days in a nursing home, or lifetime units of important prescription drugs like Lipitor. While Milevsky notes there are a lot of regulatory and other challenges for this change to come to fruition in the immediate future, it nonetheless raises an interesting question: would you buy a retirement-service annuity from a utility company or pharmaceutical company for key services you need, eliminating exposure to any inflation in the cost of these services in the process (albeit while becoming exposed to the credit risk of the business)?
Top Ten Ways To Deal With Behavioral Biases – On his "Above The Market" blog, Bob Seawright provides some helpful thoughts about how to deal with our own behavioral biases, noting that while we often think of biases as something that other people – colleagues or clients – suffer from, we think ourselves objective and immune. In fact, there’s even a label for the behavioral bias of not thinking you’re subject to behavioral biases; it’s called the bias blind spot. Of course, just recognizing the problems of self-bias is only one the first part of the issue; the real meat is how to manage or deal with it. Seawright offers his top ten tips, including: focus on the data (try to minimize your subjectivity); actively seek out contrary data and conclusions (or you’ll easily succumb to a self-confirmation bias where you only read what already confirms what you think you know); build in accountability mechanisms so you can’t ignore or explain away your own mistakes when they do happen; focus on process; test and re-test your views about your advice or the recommendations you provide; avoid the noise (which includes just tuning out known sources of noise); take a tip from attorneys and practice arguing the other side of the issue to ensure you’re really looking at it from all sides; track your mistakes as carefully as your successes (or you’ll tend to just remember your successes and ignore/forget your mistakes, dooming you to repeat them); take your time (recognize that shortcuts are sometimes useful but often not); and try to stay humble (confidence is important for success, but humility helps you keep perspective).
The Dangers of Too Much Liquidity– This article by Michael Finke of Texas Tech in Research Magazine looks at our tendency to want liquidity – often more than necessary or more than we need – and the harm that it creates by keeping assets invested for lower returns. Yet at the same time, Finke also explores recent research that shows how in reality, we’re often prone to spend it when we have it, and as a result many people deliberately choose illiquidity specifically to reduce temptation. In point of fact, some research shows that having liquidity and being forced to resist temptation actually makes us less happy, and that therefore taking steps like making ourselves illiquid – which Finke labels "commitment devices" that force us to keep the commitments we make – can actually increase happiness by eliminating our need to unpleasantly fight our own temptations! Notably, our tendencies for mental accounting – where we label accounts to associate them with certain goals, even if the money ultimately is fungible – also seems to be a mechanism that helps us create these kinds of commitment devices, and that strategies which reinforce this (like keeping long-term money in an entirely separate account from short-term spending money) helps us to implement accordingly. Ultimately, Finke suggests its no coincidence that most Americans build wealth in illiquid ways, from businesses to retirement accounts to real estate. It’s not just the return premium for illiquidity, but the fact that the illiquidity helps us to ensure the investment stays an investment.
Sitting Is the Smoking of Our Generation – This article from the Harvard Business Review provides a nice reminder to anyone in a professional services job, including financial planners: a sedentary lifestyle is a serious health hazard. In a world where on average we sleep only 7.7 hours a day, but sit 9.3 hours – whether that’s in the car, a restaurant, at a conference room table, or in front of a computer – it’s important to stand up and take regular breaks. While stand-up meetings have become more popular in recent years partially for this reason, the author suggests that it can be even better to try "walking meetings" (with staff, or perhaps even with some clients?) to ensure you get some real movement. The author notes that after adopting a habit of walking meetings, several side benefits have shown up as well: conversations seem more productive (and just easier to hear!) walking side-by-side than sitting across from someone in a coffee shop or conference room; the combined stimulation of walking and talking reduces the temptation for the additional stimulation of a mobile device; and sometimes the best way to really get outside-the-box thinking is to get outside the box of the traditional meeting room. So if you’re struggling to keep up physical activity in the face of a professional world that’s so focused on sitting, try the walking meeting yourself.
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!