Weekend Reading for Financial Planners (Sep 1-2)

Posted by Michael Kitces on Friday, August 31st, 6:30 pm, 2012 in Weekend Reading

Enjoy the current installment of "weekend reading for financial planners" - this week's edition starts off with a fascinating interview with Ron Rhoades where he shares his thoughts about the history of fiduciary and regulation of financial advisors, with some surprising insights, and also look at the recent back-and-forth between incoming FPA CEO Lauren Schadle and American College CEO Larry Barton about the CFP marks and whether there should be one designation for financial planning. From there, we look at a few good articles from Advisor Perspectives, including a list from Bob Veres of the top ten faulty assumptions in financial planning, and a good article by Joe Tomlinson looking at how safe annuity companies are. There are a few retirement articles as well this week, including a look at the "critical path" approach to setting a threshold for when clients can and cannot afford to take risk, a new framework for evaluating various retirement income strategies and alternatives, and an article looking at how disability can threaten retirement success yet may be neglected by advisors (especially for their female clients). There's also an article that presents a good discussion about risk (and the difference between risk and uncertainty), and the latest from John Mauldin showing some surprising employment trends (older workers are actually taking job market share from younger workers!). We wrap up with two very interesting articles - one looking at the dynamics between patients and doctors in providing recommendations that has some striking parallels for what we do as financial planners, and the other exploring some surprising research that demonstrates we actually value the potential for future success more highly than a demonstrated track record of prior success (which may help to clarify why many clients are always so attracted to the next great thing, even when the current thing is working just fine). Enjoy the reading!

Weekend reading for September 1st/2nd:

Ron Rhoades Sounds Off On The RIA Industry - This article from RIABiz is an interview with Ron Rhoades, who recently resigned as the incoming chair of NAPFA due to a compliance violation. Although the interview article is quite long, it's well worth the read, as Rhoades shares his extensive knowledge of advisor regulation, and reflects on both the current regulatory environment and how it compares to nearly 70 years ago when much of the current regulatory organizations and rules were first established. Amongst the wide range of topics covered, Rhoades shares his well-researched views that all advisors should be subject to the fiduciary standard simply by holding themselves out as advisors, that the two-hat standard is impossible, and that 12(b)-1 fees are anti-competitive to the point of meriting an anti-trust investigation. 

FPA Stand By New Leader In Dustup Over Designations - Last week, when it was announced that Lauren Schadle would take over as the new CEO of the FPA, she noted that the organization is "putting together action plans that speak to the FPA's being the professional resource and advocate for CFP professionals ... we believe that one profession and one designation is the best way to build the financial planning profession." In response, Larry Barton, the CEO of the American College (which grants the CLU and ChFC designations, in addition to CFP), declared Schadle's comments were "ill-informed and detrimental to consumers, especially those in the middle and lower income brackets" suggesting that "No one designation can embrace the full gamut of consumer needs." In what may be a refreshing new direction for the FPA, Board President Paul Auslander reaffirmed in Schadle's defense that the FPA is coalescing around a "one profession, one designation" position. 

The Profession's Faulty Assumptions: A Top Ten List - This article by Bob Veres in Advisor Perspectives shares Veres' top 10 list of poor assumptions that planners use when crafting recommendations for clients. For instance, advisors may be overestimating how low tax rates can actually be for clients in retirement when distributions are managed in a tax-aware manner... causing an excess of Roth conversions when the client's future tax rates may actually have been much lower. Other issues that make the list: using marginal tax rates when planners really mean to use (and should be using) effective tax rates; adjusting asset allocation for embedded tax liabilities; ineffective determination of asset allocation by either excessively constraining the asset allocation or using poor historical assumptions; underestimating longevity for clients (who tend to be wealthier than the average person and consequently may have above-average longevity to go with their access to above-average health care services); underestimating the decline of retirement expenses in later years; underestimating health care costs in retirement; not properly measuring downside volatility risks; and overestimating US equity returns by building on historical data that includes when the US was an emerging market, even though now it is a developed one.

How Safe Are Annuities? - This article by Joe Tomlinson for Advisor Perspectives explores not the risk of annuities, per se, but of annuity companies and their (in)solvency. Tomlinson notes the existence of state guaranty associations, which back annuity holders in the event of company insolvency, but subject to caps such as $250,000 (of present value, but sometimes higher or lower). In practice, most annuity companies that "fail" are often sold to healthy insurers, and state guaranty funds just provide a backstop; nonetheless, there have been at least a couple annuity company failures over the past several decades where annuity owners with funds in excess of the state guaranty cap did not get back everything. Higher failure rates do occur in times of stress, with more failures in the early 1990s (during the high-yield debt debacles) and the recent 2008 financial crisis, although notably the biggest headline company, AIG, never really faced any risks in its insurance and annuity division (which was segregated from the part of the company that had problems). Tomlinson also points out that although consumers (and some advisors) tend to group insurers and banks together as "financials" the reality is that insurance companies are far better capitalized (i.e., less leveraged), and Tomlinson suggests the actuarial, balance-sheet-focused culture of insurance companies also helps. In the current environment, the greatest risk appears to be persistent low interest rates, but the good news is that because the problem plays out slowly, insurers have time and capacity to build reserves and adjust. 

Drawing A Hard Line - This article from Financial Advisor magazine discusses the concept of the critical path - the minimum amount of capital that the client needs to achieve their goals, which is plotted over time and forms the minimum threshold for risk-taking. If assets are below the line, the goals need to be changed (to bring the line down) or savings need to increase (to bring assets up to the line), and riskless investments would be used; if assets are above the line, clients can afford some risk-taking behavior (i.e., riskier investments). Since the critical path represents the threshold for riskless versus risky assets, the author cites research suggesting the critical path be benchmarked to a portfolio of laddered TIPS, and/or a combination of TIPS and a contingent deferred annuity (also known as a longevity annuity). While this approach is quite different than the conventional thinking on planning around retirement, it does present an interesting framework to consider, not only with respect to retirement portfolio design, but also for framing what is and is not feasible for a client's prospective retirement goals.

A Framework For Finding An Appropriate Retirement Income Strategy - Continuing the retirement theme, this article from the Journal of Financial Planning tackles the challenge of trying to develop a more comprehensive framework for evaluating retirement income alternatives, especially those that incorporate multiple retirement income products and strategies. The article suggests that instead of simply looking at the amount of income generated and measuring the probability of success (a "traditional" Monte Carlo framework), that the planner should also evaluate the average legacy at the end of the time horizon, and evaluate how long income lasts in a bad market scenario, along with the amount of "fixed source coverage" (cash flows that are fixed, such as pensions and Social Security, immediate annuities, or bond ladders held to maturity). The article provides several examples of how the framework might be applied. The upside of the approach is that it certainly does provide a richer picture of comparing retirement income alternatives; the downside is that it may not be clear to a consumer how to weigh the different factors (e.g., what's more important, having the best probability of success, the longest years of income in a bad market, or the highest fixed source coverage, if each one is best in each of three different alternatives?). Some may also object to the particulars of the metrics - for instance, what's the point of measuring Fixed Source Coverage if it mixes together nominal and inflation-adjusted income streams, and combines fixed-term and lifetime payments (e.g., inflation-adjusted Social Security payments versus a 20-year bond ladder). Nonetheless, the article provides an interesting contribution to the retirement income discussion in its emphasis, as noted previously on this blog as well, that just looking at probabilities of success amongst alternatives does not give the whole picture about the relative risks and benefits of competing choices

Women And Disability Risks - This article from the Journal of Financial Planning reviews the expensive risk of disability (the present value of $50,000/year of wages for 40 years at 3% inflation is a whopping $1,155,738), and the study's survey research reveals the sad fact that most people underestimate the risk (in reality, approximately 22% of all adults report some type of disability; about 2/3rds of those are severe disabilities, driven primarily by arthritis and spine/back problems). Notwithstanding the misperception of risk, consumers report the primary reason they don't purchase the coverage is the perception that it is (too) expensive, followed by the fact that advisors often do not bring up the issue, and a general lack of knowledge about disability coverage. The top reasons for actually purchasing the coverage included "to ensure you can stay in your home" (#1) and "peace of mind" (#2), followed by "maintaining standard of living" (#3). The results were especially noticeable for women, who tended to express more concern on these issues, which is problematic because women are more likely to become disabled; however, the research suggested that women are also more receptive to planning, and are more receptive to transferring risk through the use of insurance.

Reckoning With Risk - In his latest blog post, Bob Seawright tackles the issue of risk and some ways to think through it. The discussion begins with a distinction between risk and uncertainty - with the former, the outcome is unknown but the distribution of prospective outcomes IS known, while with uncertainty we know neither. Thus, for example, roulette and blackjack are risky, but war is uncertain. With that as a framework, Seawright notes the importance of playing with the odds in your favor, that the size of your investment "bets" should relate to the likelihood of winning, but that it's important to have a lot of different investment "bets" because markets can stay irrational for a long time. At the same time, it's important to ensure different bets really are different (i.e., that the correlation really is low) - with 2008 a prime example where many investors though they had diversification but actually had a series of bets all tied to the same risk-on/risk-off environment. It's also important to beware "the wild things" - the potential for extreme risky events - and to have a clear goal so you know when to cash out (i.e., "once you have won, stop playing"). Although there may be nothing "new" here about risk, it's a good reminder of tips and ways to think about investment risk.

Boomers Are Breaking The Deal - In his weekly article, John Mauldin shares some new research trends he's exploring around employment. For instance, in the late 1800s, the US went through an incredible employment shift as technology made farming more profitable but more competitive, and labor shifted to urban areas, and over the span of 50 years the largest group of workers had shifted from farmers to domestic workers (i.e., household help for the rising middle and upper class). In today's environment, a similar split is emerging, focused around education. Those with college degrees gained 187,000 jobs through the recession and 2 million more in the recovery, while those with high school diplomas lost a whopping 5.6 million jobs in the recession and are down yet another 230,000 through the recovery. And notably, follow-up research suggests that a whopping 98% of the job gains for degree holders actually went to those with not just bachelor's degrees, but graduate degrees. The job situation is being exacerbated by the fact that baby boomers are not retiring from the workforce as originally anticipated; in fact, since the start of the recession, employment of those age 55 and over is up by over 4 million, while total jobs for all workers is still down 4 million from the pre-recession peak, which means older workers are actually taking market share from those younger. The implication - a college degree alone is not enough anymore, it's about having advanced education, skills, and training, which goes a long way to explain why the older generation is actually faring better than their younger counterparts. 

Sunday Dialogue: Conversations Between Doctor and Patient - This article from the NY Times presents an interesting letter to the editor from a cancer patient who, when presented with treatment options from the doctor, made a bad decision that was very problematic until eventually repeated attempts by others persuaded her to change her mind. The letter suggests that perhaps the doctor should have been more willing to at least argue with her as the patient before acquiescing to the decision, noting that often the best decisions come from some hard conversations. Conversely, though, sometimes patients are unwilling to argue and have a constructive conversation, instead deferring to the doctor's opinion which may not always be right. What follows in the article are some responses from readers to the letter sharing their own perspectives, and debating whether "medical paternalism" is a relic of the past, or something still necessary given the disparity of knowledge between the doctor and the patient. While the focus of the article is in the medical context, there are some very striking parallels to the challenges that we as financial planners also face when trying to provide guidance and share our expertise with clients regarding financial matters.

The Surprising Secret To Selling Yourself - This article from the Harvard Business Review blog attacks the traditional view of how we sell ourselves - focus on our track record of success - and explains how recent research demonstrates that, surprisingly, we actually prefer the potential for greatness over someone who has already achieved it. Although we evaluate the latter as being superior, when it comes time to make a decision, we tend to choose the former, if the expectations are credible. The purported reason is that future stars are uncertain, and the uncertainty forces our brain to consider the matter more carefully - and in turn, the extra processing time (unconsciously) leads to a more positive view of the candidate. In the financial planning context, this behavior may be reflected in the tendency of many clients to constantly be looking for the next great thing, especially with regards to investments - even if the current strategy is working well with a track record to prove it, we seem to place an irrationally high value in something different and new with the potential for more.

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!

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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Out and About

Wednesday, September 2nd, 2015

*Understanding Longevity Annuities and their Potential Role in Retirement *Trends & Developments in Long-Term Care Insurance *Understanding the New World of Health Insurance @ FPA Illinois

Wednesday, September 9th, 2015

*Future of Financial Planning in the Digital Age *Modern Portfolio Theory 2.0 @ FPA San Diego

Thursday, September 17th, 2015

*Future of Financial Planning in the Digital Age *Social Media for Financial Planners *Understanding Longevity Annuities and their Potential Role in Retirement Income @ FPA Colorado