Enjoy the current installment of "weekend reading for financial planners" – this week's edition kicks off with the news that while it appears the Department of Labor is not going to defend itself against the recent 5th Circuit Court of Appeals loss that would vacate its fiduciary rule, a coalition of three state attorney generals (from California, New York, and Oregon) are petitioning the court to be allowed to defend the fiduciary rule in the DoL's stead, and mega advocacy organization AARP has also filed a similar petition to take up the case, requesting an en banc review of all 17 appeals judges (beyond just the 3 who made the original ruling). Also in the news this week is turmoil in Australia over its fiduciary rule that took effect several years ago, as it turns out that just banning commissions and having a best interests obligation may not be enough to protect consumers, without actually breaking up vertically integrated product manufacturers and distributions that, even without commissions being paid, are still finding ways to incentivize their advisors to give overly conflicted advice (and providing a potential roadmap for the next stage of the fiduciary debate in the 2020s!?).
From there, we have several practice management articles this week, from a look at why the top producers are the least happy in broker-dealers (when normally businesses would try their hardest to make their top producers the most satisfied!), to a discussion of the key issues to consider in finding a new broker-dealer that might make you happier in the long run, why it's a bad idea to focus on trying to be the "best" at what you do (and instead focus on the standards, process, or habits that will get you to being the best), and why even great financial advisors often hit a wall in their businesses (because eventually, it's not actually about being a great/better financial advisor, but learning to be a great/better business owner and CEO of an advisory business!).
We also have several tax-related articles, including: a discussion of the confusion that has emerged since the Tax Cuts and Jobs Act eliminated the entertainment deduction for businesses but kept the meals deduction (leading to questions of when a meal is "entertainment" and when it's just a meal); an analysis trying to quantify the economic value of using retirement accounts (finding that it's mostly about the ongoing tax deferral of interest, dividends, and capital gains, and not about the tax deduction you get up front for contributing!); and the last looks at how estate planning is changing since the adoption of the Revised Uniform Fiduciary Access to Digital Assets Act (or RUFUDAA for short) to facilitate digital estate planning.
We wrap up with three interesting articles, all around the theme of behavioral finance and decision-making: the first looks at how natural selection appears to favor getting larger (in both nature, and in business), yet ultimately larger species (and businesses) tend to get so large they accelerate their own demise and extinction, which means that while the key when you're small is to get bigger (for safety and economies of scale), the key when you're big is to be paranoid about avoiding the potential extinction event you may not otherwise be able to adapt to quickly enough; the second explores our human tendency to explain "lucky" events with narratives, to the point that we seem to discount the value of efficient algorithms in part because they're so efficient there's no compelling narrative to explain them; and the last looks at fascinating research that finds the decisions we make actually change our own preferences, causing us to repeat similar decisions in the future (even if we don't remember the original one), which helps to explain why small bad choices can often compound into big ones, but similarly suggests that making small positive choices can compound into highly favorable long-term outcomes!
Enjoy the "light" reading!
Weekend reading for April 28th – 29th:
Can AARP Save The DoL Fiduciary Rule? (Sean Allocca, Financial Planning) - This week, AARP (the mega advocacy organization for retirees) filed a motion with the 5th Circuit Court of Appeals asking for a full court review of the 3-judge decision to vacate the Department of Labor's fiduciary rule. The request for an "en banc" review of all 17 judges in the 5th Circuit Appeals Court would have been one of the potential next-step options for the Department of Labor to defend its own rule, but with no apparent movement from the DoL as the April 30th deadline approaches to request a review (suggesting that the DoL may intend to abandon the case and allow the rule to be vacated), AARP has intervened and requested the court that it be allowed to take up a continued defense of the case on behalf of its 38 million members that it claims will be harmed without a more stringent standard for financial advice. In addition, the Attorney General's offices in New York, California, and Oregon also filed similar petitions to be allowed to continue a defense of the review in front of the full Appeals Court, noting that since the 5th Circuit's decision differs from the 10th Circuit Court of Appeals (which upheld the DoL's fiduciary rule), there is a strong case to be made that the court differences need to be resolved. However, the question remains as to whether the Appeals Court will even allow the states or AARP to take up the defense of the case, both because it's normally the government's decision about which cases to defend (or not) and it's not clear that AARP or the states would have legal standing to defend the matter, and because conceding to AARP in this situation would set a legal precedent for other advocacy groups to try to intervene in the court defense of other future regulation (a precedent that the judges may not be willing to set). And of course, lobbyists for the financial product manufacturing and distribution industry, including SIFMA and FSI, have indicated that they intend to fight and opposed any motion to intervene and try to save the fiduciary rule. Either way, we'll know within a week whether the AARP or state attorney generals' petitions will be accepted or not, as the deadline to open the review is April 30th.
Royal Commission Will Drive More Change For Australian Financial Planners (Adele Ferguson, Financial Review) - 4 years ago, the Australian securities regulator (ASIC) implemented its version of a fiduciary best interests standard for financial advisors, known as their "Future Of Financial Advice" (FOFA) reforms, with several major requirements to mitigate and eliminate compensation conflicts of interest, including a full ban on investment commissions for financial advisors. Yet in Australia, where the overwhelming majority of financial advisors work for one of four big banks (roughly the equivalent of the US wirehouses), it appears that banning commissions alone has still not be sufficient to eliminate the conflicted advisor recommendations. In fact, a recent study by ASIC earlier this year found that advisors across the big four banks still flouting the best interests of their customers a whopping 75% of the time... and in 10% of cases, the advice left the customers "significantly" worse off; the report also found that although the average bank's approved product list included only 21% proprietary funds, "somehow" 68% of customer assets ended up in those in-house products. To some extent, this may be because the actual educational and competency standards for financial advisors in Australia are low in the first place, and ASIC is in the process of rolling out a new higher competency standard for Australian advisors (including a set of bachelor's degree, experience, exam, and Ethics requirements akin to CFP Board's requirements) that are anticipated to potentially drive nearly 1/3rd of Australian advisors to leave or retire in the next 6 years. Yet at the same time, the rising question in Australia now is whether the regulators will break up the vertically integrated models of the big banks, as "scores" of financial planners leave the big banks and set up their own independent advice businesses anyway (the Australian version of a breakaway broker trend), but a Royal Commission explores whether it may be necessary to require that the big banks' whole advice divisions be separated entirely from the product manufacturing and distribution arms (the US equivalent of forcing advisors to be RIAs and banning hybrid broker-dealer relationships, or requiring that doctors be independent from drug manufacturers). Which paints an interesting picture of what the next stage of fiduciary and best interests standard debates could look like here in the US in the 2020s.
Why Top Producers Aren't Happy (Donna Bristow, Investment News) - In the recent J.D. Power Ratings on financial advisor satisfaction (with their own broker-dealers), a surprising new trend has emerged: the top producers at broker-dealers (those with >$1M in GDC) are the least satisfied with their companies (and their ratings are declining), while "smaller" advisors (those with <$250k in production) are more satisfied (and their ratings are rising). Logically, one would expect the opposite – that broker-dealers would work hardest to keep their top producers satisfied, and simply "do what they can" to try to retain the rest. Bristow suggests, though, that the problem may be less of one where broker-dealers aren't trying to serve their top producers, but simply that the top performers are the most entrepreneurial and independent-minded... and therefore the most likely to feel constrained in the broker-dealer environment, leading to lower job satisfaction. For instance, while large producers tend to concentrate in larger broker-dealers with more resources, the largest broker-dealers may have such sprawling infrastructures, that include layers of inflexible legacy platforms, that their solutions end out being even more of a bureaucratic maze for (top) advisors than smaller broker-dealers that may provide less support to smaller brokers but at least can deliver better on what they do promise. The rising burdens of compliance may also be complicating the matter, as increasing scrutiny on advice and how it's delivered (e.g., the oversight requirements from the DoL's fiduciary rule) are also putting more pressure on top producers who may feel their independence is slipping away as the broker-dealer caters its compliance to the "lowest common denominator" rep (notwithstanding how it constrains and frustrates their top advisors). And even efforts of broker-dealers to "digitize" and offer "robo" services may not be well received by their top producers, who don't necessarily want to change their business models when what they're doing is already working well for them. So what's the alternative? Bristow suggests that broker-dealers need to focus more on winding down their legacy systems (so workflows can be consolidated), facilitate easier access to data (i.e., more advisor dashboards and tools that actually facilitate the advisor's business), and focus technology on how to augment the client engagement rather than trying to displace advisors from the process.
Picking A New Broker-Dealer? Here's How To Do It Right This Time (Nina O'Neal, Financial Planning) - As the world of financial advisors shifts to become more and more about advisory accounts and fees and less about product sales, and it's increasingly common to be dual-registered under a broker-dealer and with a (corporate or outside) RIA, the shift is leading to a growing pressure on broker-dealers to reinvent themselves for what is a less-broker-dealer-centric future... and those falling behind are causing their advisors to increasingly cite their broker-dealer as a pain point (instead of a platform that facilitates their success). Yet switching broker-dealers can be a huge business interruption as well, and potentially financially straining (as revenue is halted until the transition to the new broker-dealer is completed). Which means in today's environment, it's especially important for advisors changing broker-dealers to determine whether the one they're going to next will be one they can likely stay at given the industry shifts that are underway. So what factors should be considered? O'Neals suggests several key areas to evaluate when it comes to figuring out whether the broker-dealer will likely be a good long-term fit: Leadership and Ownership History (as with a 13% decline in broker-dealers since 2011 alone, it's important to find one with stable leadership and ownership that won't just be sold out in a few years); Company Culture (which you should evaluate by doing a home office visit, visiting each department, and see how you feel about interacting not just with the home office employees themselves, but the culture they live and work in, that will be responsible for supporting your business going forward); Succession Planning capabilities (and whether the broker-dealer can help ensure there is value for your business if something happens to you). Of course, the basic "numbers" like payout rates and technology costs matter as well, but for advisors looking to make the right long-term decision, O'Neal emphasizes that it's the long-term factors around leadership, ownership, and culture that really matter most.
You Can't Choose Awesome (Stephen Wershing, Client Driven Practice) - In the popular show "How I Met Your Mother", the character Barney Stinson once famously quipped "when I get sad, I stop being sad and be awesome instead", implying that being awesome was simply something that Barney had control over to choose at any time. Yet Wershing points out that in practice, it's almost impossible to just choose to be awesome... notwithstanding the fact that advisors routinely try to make statements about their businesses like wanting to have "a commitment to excellence" (i.e., they are trying to choose to be awesome), even though they can't even clearly articulate what "excellence" means exactly, how they'll achieve it, or how they'll measure it to know that they're doing it well. Even more to the point, though, being excellent, or giving clients peace of mind, or simply being "awesome", is best viewed as the outcome of a choice, not a choice itself. The real choice is deciding how you will try to achieve excellence (or awesomeness); for instance, will you choose Standards (e.g., focusing on specific activities and outcomes that you will track and measure in every client relationship, such as an exact process for what constitutes an "excellent" communication effort to schedule a client meeting), or Process (i.e., establishing a specific series of steps to consistently follow when delivering advice to clients, that can be repeated and more importantly iteratively improved upon), or Habits (e.g., writing thank-you notes to clients, or follow-up letters, or emptying your inbox every day, or setting aside time for reading and learning, any of which can drive superior levels of competency for or communication with clients). The bottom line, though, is simply to understand that you can't choose to be great/excellent/awesome; instead, choose to engage in the practices that lead the CFP Board's Code of Ethics doesn't advocate for excellent... it requires Integrity, Competency, and Diligence to those outcomes (which as Wershing notes, is why, that lead to more excellent outcomes!).
Why Being A Great Financial Adviser Is Not Enough (Stephanie Bogan, Investment News) - Financial advisor entrepreneurs typically excel at the "technical" side of the business (i.e., financial planning, investment management, etc.), because those are the skills that enable the advisor to engage clients, deliver value, and actually grow an advisory business. Yet as Bogan notes, the advisory business may eventually reach a point where the skills it takes to continue to excel are no longer about being a good technician in the business, but getting better at running the business itself. And unfortunately – at least in this context – advisors are much more likely in practice to be great at the financial advising part than be great at the actual "business owner" part... which can result in operational challenges in the business, stagnating revenue/income growth, reactive (but not proactive) client service, and staffing challenges. What does it take to overcome these challenges and make the shift? Bogan suggests it starts with mindset, and the need for the advisor to shift from seeing themselves as a "financial advisor" to seeing themselves as the "CEO of an advisory business" instead (regardless of how large the firm actually is). Which starts by focusing in 3 key areas: Mapping (practice trying to articulate a clear vision of your ideal firm and experience, and then work on creating a map for the path between where you are, and where you want to be); Mindset (as Einstein famously said, "No problem can be solved with the same consciousness that created it", which means you can't change the trajectory of your business without changing your mindset about the business and your role in it); and Methods (figuring out what steps to take to actually implement what you want to achieve, as a good idea poorly implemented is no better than no idea at all!). The bottom line, though, is simply to understand that there really is a difference – in mindset, that is ultimately expressed in actions – between trying to be a great financial advisor, and a great CEO of a financial advisory business. Which one do you want to be?
New Tax Law Creates Confusion About Entertainment Deductions (Roger Russell, Financial Planning) - In the past, businesses were allowed to deduct 50% of their business meals and business entertainment expenses, but under the Tax Cuts and Jobs Act, the deduction for entertainment was repealed... and while the deduction for business meals remains, now confusion is emerging about what, exactly, falls in the entertainment versus meals categories, and whether the very act of taking a client out for a meal could be construed as an "entertainment" event that would no longer be deductible. Notably, the the Committee Reports for the TCJA legislation indicated that they didn't intend to change the prior-law treatment for business meals... but the actual law that was passed is not as clear, and arguably could be based on what the "intent" of the meal was (as a business discussion over a meal, or a meal as a part of entertaining customers). Clearly, typical entertainment-only expenses – e.g., tickets to a sports event – are not deductible anymore, while purely internal expenses for entertainment (e.g., holiday parties, team-building outings, etc.) remain deductible. But the intersection of meals-for-eating and meals-for-entertainment remains murky, with the IRS anticipated to (hopefully!) issue further regulatory guidance later this year.
Quantifying The Value Of Retirement Accounts (Aaron Brask, Alpha Architect) - Retirement accounts like IRAs and 401(k)s enjoy special tax preferences under the Internal Revenue Code, yet Brask notes that in practice consumers don't often articulate accurately what the real value of a retirement account actually is, and there's been little research for advisors in quantifying its tax-deferral and other benefits. As the reality is that the benefits of tax-deferral really break into two separate categories: 1) the ability to get a tax deduction on contribution and pay taxes at the time of withdrawal (which amounts to deferring the taxes on the original earnings amount that was contributed until they're subsequently withdrawn); and 2) deferring taxation on investment income itself (e.g., dividends, interest, and capital gains either due to investment changes or rebalancing) to allow it to compound more fully (with taxes on growth only paid at the end). The distinction is important, because the first tax "benefit" – deferring taxes on contribution until they're withdrawn – isn't necessarily a benefit at all, as the reality is that whether you pay the taxes later (i.e., by contributing to an IRA) or pay them now (i.e., by contributing to a Roth IRA instead), as long as the individual's tax bracket doesn't change, the value is identical regardless of which type of retirement account, and the only value that's created is when the tax rates change during the intervening time period (e.g., where the traditional IRA wins if tax rates decline because the upfront tax deduction is worth more at a higher rate than the tax impact of the subsequent distribution at a lower tax rate, and vice versa for the Roth if tax rates rise). By contrast, the second tax-deferral benefit – avoiding ongoing taxation of interest, dividends, and capital gains – is a real tax benefit that accrues value along the way, as keeping all the dollars fully invested (and not taxed annually for interest, dividends, and capital gains) reduces the "tax drag" that would otherwise apply, for which Brask finds the benefit of a retirement account averages out to 1.5% - 1.7%/year of additional cumulative growth (thanks to not experiencing tax drag along the way, even after accounting for liquidation taxes at the end). Which, notably, means that if stocks remain in an IRA long enough – especially if they're higher turnover, and/or have higher dividend rates – the additional compounding wealth of avoiding tax drag can make it worthwhile for asset location purposes even though the IRA converts qualified dividends and long-term capital gains to ordinary income tax rates!
Estate Planning For Digital Assets: Understanding the Revised Uniform Fiduciary Access to Digital Assets Act (I. Richard Ploss, Journal of Financial Planning) - In the modern digital world, estate planning is especially challenging when it comes to digital "property"... from social media profiles to pictures saved in an online vault to websites and email accounts, historically there has been little consistency (or clear property rights) in what happens to such digital assets after death. To formalize the rules, and provide for some consistency, the Uniform Law Commission developed the (Revised) Uniform Fiduciary Access to Digital Assets Act (or "RUFADAA" for short), which has now been adopted in 38 states (as while the Uniform Law Commission can make a 'model' rule, it's still up to each state to make it into a law in their state). The core of RUFADAA is to define what a Digital Asset is in the first place ("an electronic record of which an individual has a right or interest"), which includes both information stored on a computer or other digital devices, content uploaded to websites, and any other "rights in digital property" (which captures everything from email communication to social media accounts to photos and videos online, websites, music subscriptions and movie services, and even cryptocurrencies). With digital assets properly defined, RUFADAA then provides that attorneys-in-fact (under a power of attorney), personal representatives (of an estate), or trustees (under a trust) can be granted rights to have access to and control digital assets (as they can other types of assets), as well as prescribing methods (for fiduciaries) and protections (for custodians of digital assets and information) about how those digital assets can be accessed, shared, or transferred without violating any privacy or property right laws. Notably, though, users (including deceased users) may still be limited to whatever the Terms of Service (ToS) were that the individual signed (or clicked "Accept" for) when signing up for the account, as unless the estate planning documents (i.e., power of attorney, Will, or trust) explicitly grant the fiduciary the power to access a digital asset, the ToS provisions will prevail (which often limit the ability of a third-party to access such digital assets). And given these dynamics, that means it's also important for clients to keep a clear "inventory" of their digital assets and accounts – just as they might with physical assets and property – to ensure that the executor or trustee can even find all the relevant digital assets if/when the time comes that they need to do so... in addition to the fact that clients may now need to update their estate planning documents to grant attorney-in-facts, trustees, and/or executors access to their digital assets under the new RUFADAA provisions.
Casualties Of Your Own Success (Morgan Housel, Collaborative Fund) - Edward Drinker Cope was a 19th century paleontologist, who discovered after studying the lineages of thousands of species that there is a clear bias for animals to evolve towards ever-larger sizes over time (now known as "Cope's Rule"). Accordingly, horses went from the size of small dogs to their modern height, snakes from being just an inch long to modern boards, and of course humans from small primates to our current upright form. Yet the counterintuitive question also arises – why aren't all species absolutely enormous at this point, given the preference for size? The answer: while evolution tends to create larger species, the larger species are also more likely to be made extinct, as their large size eventually makes them less able to adapt (e.g., small animals can survive big falls but big animals will die from small falls, and animals at the top of the food chain may find it easier to be predators and survive attacks from prey but their greater food needs make them more prone to die off in an unexpected famine). And Housel suggests the same phenomenon applies to investments and businesses as well; for instance, at its peak in 2007, Citigroup had more employees than Miami had residences, operated in 160 countries, and served 200 million customers... which ultimately made it so large that management couldn't be aware of the fact that one small segment of the business had put the entire company at risk (as the liquidity puts their trading division put on ended out costing the company $25B in just 90 days), a classic example of a company that survived because it was large (as Citigroup had incredible economies of scale), until its size was the (indirect) cause of its extinction. Similarly, Facebook is now struggling with an exposure to Cambridge Analytica (which at the time the events happened was already "too small" for senior management to be aware of in such a big company), big investment funds with early success often grow so large that they can't deploy their own capital as effectively, and even Warren Buffett has noted that the deals he gets today aren't as good as the ones he could buy when dealing with smaller amounts of money in the past. Notably, the ultimate point of this is not that it's a good idea to avoid getting big – as size does bring safety, economies of scale, etc. – but simply to understand that everything moves in cycles, and that growth doesn't just always mean more growth, it can eventually lead to greater risks that precipitate the change to the next cycle. Conversely, this also helps to explain why many of the biggest and most successful businesses help to remain at the top – because even as they're at the pinnacle of their success, they're "paranoid" about going out of business... which may be the only way when you're large to ensure you're still ready enough to adapt to the potential extinction event that may come along!
The Skill Of Managing Luck (Daniel Egan) - As human beings, we're not very good at managing luck, as our brains appear to be hard-wired to attack a "narrative" and create a story (accurate or not) to connect causes and effects, even if there was no connection. And the desire for a compelling narrative is so strong, it leads us to go out of our way to avoid miniscule risks (e.g., sharks, snakes, plane crashes) ironically because their rareness makes the stories about them stick out in our minds (causing us to overweight the actual risks), while we too-easily accept common risks (e.g., car crashes, smoking, bad diet) because they're so common there's no memorable narrative to accompany them. In this context, Egan suggests that one of the virtues of using decision-making algorithms – which he broadly defines as "any systematic process based on a data-calibrated model" – is that it doesn't easily succumb to these narrative-based fallacies. Yet ironically, we may be so drawn to narratives that, notwithstanding the improved accuracy of algorithms, we still tend to prefer a (more error-prone) human forecaster to an algorithm. In part, this seems to be because we at least recognize that human forecasters are more error prone, but that simply makes us more willing to accept occasional human errors... whereas with algorithms, we expect perfection. (Thus why an algorithm that is 85% accurate is still 'dangerously' wrong 15% of the time, but a human who is 60% accurate is doing great because it's better than 50/50 chance!) But it may also simply be because there's no compelling narrative to tie to a fact-based analysis that determined there was a small probability of path A being superior to path B (even as it's factually true). So in a world where algorithms can and often do provide superior results, even as we don't find them compelling, what can be done to get more comfortable with algorithms? Egan provides a few suggestions, including to encourage tweaking (both because it's important to refine algorithms over time, but also because knowing that the algorithm can and does get adjusted from time to time apparently makes us more confident in the algorithm), and focus on providing algorithm output that doesn't just give the "answer", but explains the why and how it arrived at that conclusion (which better fits our hunger for a narrative explanation of results).
Be Careful What You Choose (Nick Maggiulli, Of Dollars And Data) - In a famous psychology experiment, researchers asked participants to rank six paintings from most to least favorite (numbers 1 to 6 respectively), and then let them take home either their 3rd or 4th choice, and later asked them to re-rank the paintings... and found that the paintings participants took home went up in ranking (to 2nd) while the ones they left behind moved down (to 5th). Which isn't entirely surprising, as people commonly try to justify their selections to themselves, even/including after the decision is already made, to make them feel better about the choice they made. Yet the real genius of the experiment is that they performed the test again on a second set of participants, who had anterograde amnesia (which meant they couldn't retain short-term memories more than about 30 minutes), and found that the amnesiacs did the exact same thing, showing a greater preference later for the picture they selected (while downranking the one they didn't select), even though they couldn't even remember their original decision because they had amnesia! Instead, what happened was that the decision itself appeared to rewire their own mental pathways to actually have a greater preference based on what they had already expressed they liked (even though they didn't remember it). The phenomenon became known as the "free choice paradigm", and is important, because it means that the choices we make have reinforcing cycles that will literally make us feel more bonded to that choice (not just to validate our prior choice, but because it actually leads our brains to prefer that and similar choices in the future!). Which also helps to explain the so-called "endowment effect" – that once we have/own something, we ascribe a higher value to it and are less willing to part with it (causing all sorts of financial distortions as we overvalue what we have based on its value to us instead of what someone else will pay for it, from personal/household goods, to the investments in our portfolios). So what's the solution? Simply put: "the only way to counteract the effects of the free choice paradigm is to use an outside source to evaluate your situation" instead. Which is important, because it fundamentally validates the role that a third-party financial advisor can play, helping the client to detach themselves from the preferences implicitly created by their prior choices that may render them unable to objectively evaluate their own situation. At the same time, the free choice paradigm also emphasizes why it's important to be wary of even making "small" choices in an unhealthy direction... because small choices repeated can continually change your preferences until they spiral out of control (which may help to explain how drugs, gambling, and other vices progress into addictions as well!). Although it also explains why getting "small wins" when trying to make a positive behavior change can be so effective at helping us follow-through to achieve an even bigger long-term goal!
I hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think I should highlight in a future column!
In the meantime, if you're interested in more news and information regarding advisor technology, I'd highly recommend checking out Bill Winterberg's "FPPad" blog on technology for advisors as well.
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