Enjoy the current installment of “weekend reading for financial planners” – this week’s edition starts out with some new research from the CFP Board about why it is that so many students who go through financial planning programs don’t sit for the CFP exam… and find that the sheer cost of both the exam itself (at $595) and the typical exam review class along with it, may be a key impediment, especially given that so many young planners still have limited income and may be digging out from their student loans; students who ended out at firms that paid for the test on their behalf were significantly more likely to follow through on the exam and become CFP certificants.
From there, we have a few practice management articles this week, including: an overview of the latest results from the FA Insight practice management study showing that advisory firms are enjoying record productivity and profit margins but may be too complacent about future growth challenges; a good overview of the challenges to consider for advisors who are thinking about “breaking away” from a broker-dealer (considering everything from needing access to capital, to complying with the Broker Protocol); and a good overview about how to get started in building a social media following once you’ve set up your initial accounts.
We also have several investment research articles this week, from a look at the value of continuous tax loss harvesting (which may be far less valuable than commonly believed, over just executing loss harvesting transactions once a year when rebalancing), to a discussion from Vanguard about whether indexing is getting “too big”, and a look from Morningstar’s fund flows finding that actively managed funds are only seeing inflows in a few specialized areas (international funds, allocation and target-date funds, and alternatives) with 2/3rds of all net flows going to index funds.
There’s a trio of retirement-related articles too, including the upcoming launch of a big Federal government program to encourage phased retirement (which could become a template for the private sector as well), some tips for advising clients on Medicare decisions, and a good discussion by retirement researcher Wade Pfau about the circumstances in which the “4% rule” may be too high, or too low.
We wrap up with three interesting articles: the first raises the question of what it means to fulfill an investment adviser’s fiduciary duty when there is no human advisor relationship and the portfolio is implemented by a “robo-advisor”; the second looks at the various threats that have been a danger to advisors over the decades (including most recently, the robo-advisors) and concludes that the natural outcome of these threats is not the ‘death’ of advisors but their forced evolution to continue higher up the value chain; and the last is an in-depth article looking at the severe racial diversity problem in the world of financial planning, and some of the efforts that are slowly getting underway to try to tackle the issue.
Enjoy the reading!
Weekend reading for August 16th/17th:
Why More Graduates Aren’t Sitting For The CFP Mark (Liz Skinner, Investment News) – According to a recent survey of 506 graduates from bachelor’s and master’s programs in financial planning, a whopping 69% have still not moved forward to taken the two-day comprehensive exam in the 5 years since they completed their degree, and the CFP Board is trying to figure out why. To better understand why, the CFP Board has had researchers sit down and do in-depth interviews with 16 graduates from five different programs and find out what they’ve been doing since graduating six years ago, and to explore their decisions about whether or not to take the exam. For those who haven’t gone through with the exam, the sheer cost – at $595 for exam registration, plus likely additional costs for a review class – was cited as a major deterring factor, especially for young planners who may still be paying off student loans and not yet seeing much compensation as an advisor; in fact, the study noted that those who pursued the exam were more likely to be at firms that had paid for the test on their behalf, or otherwise “encouraged” them to get the marks. Other prospective planners reported that their early internships actually turned them off from the profession, not liking what they saw in the firms where they interned.
The Virtues of Growing by Design: 2014 FA Insight Study (Dan Inveen & Eliza De Pardo, Investment Advisor) – The results are in from the FA Insight 2014 practice management benchmarking survey, and the overall news is good: growth is up, and nearly 3/4ths of firms characterized their recent growth as “significant” (the median growth rate last year was 6.7% in terms of clients, and 15.5% based on revenue). Notwithstanding some firms’ struggles, overall metrics for advisory firms were very strong; the median revenue per professional was a record-high $479,500 (after hitting a low of $363,600 in 2009, and the median overhead expense margin was a mere 36.8% (after hitting highs over 41% in 2008-2009), which lead to the average take-home income per owner (including both salary and profits) of a whopping $345,000 (up 50% since 2009!) based on a median 22.1% profit margin. However, only 1/3rd of firms reported that they’ve been able to achieve sustainable growth and avoid related negative side effects, steering this year’s study towards a theme about the importance of “growth by design”. When comparing the sustaintable-growth firms to the “growth-at-risk” firms, the authors found several additional notable factors: 85% of firms maintain some kind of strategic plan, but strategic focus is inconsistent and most firms lack the implementational detail to really ensure they’re executed; the top firms are increasingly focusing specifically on crafting a superior “client experience”; most firms have become very passive in their marketing, as only 43% attributed actual business development activities as the primary driver of their growth, though firms that were proactive in their marketing approach are growing more sustainably; and sustainable growth firms have focused heavily on operations and establishing workflows and a cost-effective staff infrastructure. Notwithstanding the positives, the study also notes that firms do face some significant threats, including new modes of service delivery (e.g., robo-advisors), cooling securities markets, and the industry’s human capital constraints and dearth of qualified talent.
The Business Of Breaking Away (Shirl Penney, On Wall Street) – There are lots of issues to consider for advisors considering whether to “break away” from a wirehouse and go independent, but the biggest issue is the most straightforward one: access to capital, especially given that the transition can take 3-6 months before (most) clients finish moving over and fee revenue gets fully underway again. In addition, there may be costs associated with the launch of the new independent business itself, and paying off a “deferred compensation” promissory note due to the departing firm. And of course, there’s a need to hire and staff up the new firm, a key issue given that the costs of human capital are typically the largest line item in the expenses of an advisory firm. In some cases, the independent broker-dealer or custodian the advisor is going to may be able to help with funding, whether a recruiting bonus paid up front, providing some cash up front in exchange for an equity stake in the new venture, or simply providing access to customized loans. Other key issues and factors to consider when thinking about breaking away: business structure of the new entity (sole prop, partnership, S corporation, or LLC?); review existing employer agreements and understand what information is permissible to take along under the Broker Protocol (the industry standard framework for advisors who are moving firms to minimize conflict during transitions while protecting financial firm proprietary information and uphold client privacy); handling the actual moment of “resignation” (a two-part process of Pre-Launch preparation before the actual Launch day); and focusing on the client transition process itself to make it as painless and seamless as possible for them (fortunately, a recent Fidelity/Cogent Research survey found 86% of newly independent advisors said all or most clients moved with them).
How to Build Your Firm’s Facebook, Twitter & LinkedIn Audiences From Scratch (Amy McIlwain, Financial Social Media) – or those advisors who have been thinking about trying to get started on popular social media platforms Facebook, Twitter, and/or LinkedIn, but haven’t gotten any further than just making a static page with no one actually following it, this article provides a great walk-through about how to actually invite people and build an audience on each (replete with images showing each step to take). In the case of Facebook, you’ll want to set up a “Facebook Fan Page” for your business (which is separate from an individual/personal page); once done, you can build an audience by inviting the friends of your individual Facebook account, or importing an email list of your clients to contact. In the case of Twitter, the process of more two-way – you need to consider both who you want to follow (the “Suggested Accounts” offered up by Twitter are a good place to start), and who you want to invite to follow you (again, the easiest first step is to upload an email list of your current clients, who will receive a nice email invitation to join Twitter and follow you). With LinkedIn, again the easiest first step is to use the “Add Connections” feature to upload a list of your clients (or see which ones already have LinkedIn accounts tied to their email addresses), but also consider checking out some LinkedIn Groups that are either relevant to you or to your target clientele.
The Tax Harvesting Mirage (Michael Edesess, Advisor Perspectives) – Tax loss harvesting strategies have become increasingly popular as technology better allows for it to be automated, but the caveat of this article is that the value of tax loss harvesting may be overstated. The primary issue is that when a loss is harvested, and a “substitute” security is purchased to avoid the wash sale rules, the process steps the cost basis of the investment down to the level of the loss, which means if/when the value ever recovers there will be a future gain in the exact same amount as the loss (unless the investment is donated or held until death); the situation is further complicated by the “risk” that the substitute security will bounce back during the wash sale period, creating a short-term capital gain while executing the loss harvesting strategy. To say the least, it means that just counting the immediate tax savings at the time loss is harvested as “tax alpha” will overestimate the true long-term value. Edesess goes further to suggest that since some loss harvesting could simply be done with annual rebalancing, that the “true” benefit of continuous monitoring for tax loss harvesting is just the incremental improvement over the opportunity already present when rebalancing (and comparisons to a pure buy-and-hold strategy were also done). On this basis, Edesess runs a Monte Carlo analysis over an investor’s lifespan of almost 60 years (from age 30 until death) and finds that continuous tax loss harvesting added only 14bps-17bps/year (depending on return assumptions) of additional performance in the long run, and that’s before netting out any transaction costs incurred as a result of the additional trading and turnover. Edesess also notes that these results are dramatically below the advertised tax alpha of many of today’s “robo-advisors”, a result of both their narrow view of tax alpha based on the loss but not offset by the future gain, and also because it appears their “baseline” comparison assumes no tax loss harvesting ever while Edesess finds that merely doing so annually (with rebalancing) still captures much of the benefit.
Has Indexing Gotten Too Big? (Chris Phillips, Vanguard) – Indexing and ETFs have grown tremendously in popularity over the past decades at the expense of declining flows to actively managed funds, but some in the investment community are raising the question of whether the pendulum is swinging too far in favor of indexing. The criticism is not merely one of active managers jealous of the growing market share of index funds; in theory, if “too many” people all indiscriminately buy the same sex of index funds, the markets could actually become less efficient as there are not enough active managers left to arbitrage away price anomalies, and such inefficiencies could enhance the opportunities for skilled active stockpickers. However, it doesn’t appear we’re necessarily close to this point yet; relative to all mutual funds, index funds and ETFs constitute only 35% of equity and 17% of fixed income open-end funds, and compared to total investable dollars in the asset classes (based on market capitalization), indexing constitutes only 14% of equities and 3% of fixed income markets. Phillips also points out that if markets were becoming less efficient, bid/ask spreads should widen over time, yet in the past 6 years since the financial crisis, bid-ask spreads have significantly narrowed from an average of about 7bps down to only 2bps (and the median bid-ask spread for S&P 500 constitutents is now down to the minimum of 1 penny); in addition, as the share of indexing has risen, there is no measurable increase in the relative performance of active managers. Phillips does ultimately acknowledge that markets could theoretically become “too” indexed (e.g., if every investor did so), but that from a practical perspective at least a small cohort of active managers would realistically remain, keeping the market efficient for the (majority) still indexing at that point.
Do Active Funds Have a Future? (John Rekenthaler, Morningstar) – While the majority of currently invested assets remain in actively managed funds, the majority of new dollars are now flowing heavily in favor of ETFs and index funds; in fact, only $134B (which is about 32% of net fund flows for the past 12 months through June 30, 2014) went into actively managed funds. And of that amount, almost $30B of it was actually money flowing into target-date funds (primarily as the default investment option in employer retirement plans), which means at best only about 25% of net fund flows were the result of active decisions to invest into actively managed mutual funds. When digging into further detail, it appears that virtually all active fund flows are actually flowing to just four categories: international stock, allocation funds (more than half attributable to target-date funds), sector funds, and alternatives, with the remaining categories (commodities, taxable bonds, U.S. stocks, and municipal bonds) all experiencing net outflows. Of the active management holdout categories, international stock is the largest by far, but Rekenthaler notes that may still be built heavily on the back of good international-fund performance of the 1990s; the Vanguard Total International Stock Index is now leading the typical foreign large-blend fund by about 70bps/year over the past decade (and Vanguard Emerging Markets Stock Index is up by 45bps/year). Ultimately, Rekenthaler suggests that indexing still stands poised to continue to gain, and to say the least, in a world of “core and explore” the trend is clearly towards a passive core and active on the periphery at best. In addition, Rekenthaler points out that while investing can’t become 100% passive for everyone, it actually is possible for the entire mutual fund industry to become passive, with active management from hedge funds, individual buyers, and other non-mutual-fund parties fulfilling the function of setting market prices and maintaining basic market efficiencies.
Phased Retirement: How Washington Is Leading The Way (Mark Miller, Reuters) – This fall, the Federal government is launching a new program that will give prospective retirees who have reached their eligible retirement age (under CSRS it’s age 55 with 30 years of service or age 60 with 20 years; under FERS it’s age 60 with 20 years of service, or 30 years of service and the minimum retirement-eligible age) the option of cutting their work to half-time while collecting half their pension. The measure is viewed as a cost savings opportunity for the government – as once employees opt for their phased retirement but continue to work part-time a few more years, the government no longer needs to make contributions to their pension plan (compared to what their obligation would have been if the employees stuck around full time). But beyond pension costs, the phased retirement is also intended to help manage the “brain drain” of talent and expertise as the aging workforce retires, given that by 2017 a whopping 31% of Federal civilian workers will be eligible for retirement; in fact, a requirement of the phased retirement approach is that phased retirees will have to spend at least 20% of their time mentoring younger employees. If the phased retirement approach works well in the government program, some expect it may expand more rapidly into the private sector as well (where only 11% of employers have some version of phased retirement and only 4% have formal programs), especially given a survey earlier this year showing that 64% of workers at all ages envision a phased retirement involved continued work with reduced hours (for reasons ranging from financial need to a desire for more income to simply a preference to “stay involved” or because they enjoy their work).
10 Tips for Advising Clients About Medicare (Ann Marsh, Financial Planning magazine) – The average couple at age 65 is likely to need $261,000 to cover all of their out-of-pocket (not covered by Medicare) health care costs for the rest of their lives, but helping clients navigate Medicare effectively can help to mitigate this impact. For instance, if clients have specific medical conditions that necessitate certain drugs – especially ones that aren’t available in generic form – be certain to shop around for Medicare Part D coverage to find a prescription drug plan that can help reduce the drug costs. Other tips include: be certain clients do enroll in Medicare at age 65 (in the 6-month window that starts 3 months before their 65th-birthday-month) unless they are still working and covered by an employer’s qualified group health plan (note: post-employment COBRA is NOT a valid reason to delay Medicare enrollment!); Medicare Parts A and B are standardized at the Federal level, but Part C Advantage plans vary locally so it pays to shop around; clients should fill around what Medicare Parts A and B do not cover by buying a Medigap supplemental plan (the most common version is Medigap Plan F); be aware that increases in income, even if a large one-time event like a severance/deferred comp payment or the sale of a home, can trigger an income-related adjustment that increases Medicare premiums (though if income goes back down, so too does the premium in subsequent years); and clients don’t need to change their Medicare Part A and Part B plans if they move, but they may want to change their Part C coverage to a new local plan (though be certain to check if the plan’s required PPO networks or HMO facilities are appealing).
Is The 4 Percent Rule Too Low Or Too High? (Wade Pfau, Journal of Financial Planning) – It’s been 20 years since Bill Bengen first published his article on what has come to be known as the “4% rule” but there is still much debate about whether the 4% rule is actually too high, or too low, as a baseline for retirement spending. Pfau identifies the factors and criticisms on both sides. Reasons why the 4% rule may be too high include: limited historical experience (while the 4% rule is based on 100+ years of U.S. market data, that’s still a limited data set relative to everything markets could possibly throw at investors in the future); fees and investment performance (the 4% rule must be reduced by fees, and investors who execute their portfolios poorly and fail to earn gross index returns will lag on their withdrawal rate as well); the impact of taxes (also a material factor reducing actual spendable income in retirement); bequest motives (the 4% rule assumes no desire to leave a legacy behind and that the retiree is willing to spend down the entire portfolio); and the danger of outliving the (typically 30-year) planned time horizon. On the other hand, reasons the 4% rule may be too low include: portfolios today are more diversified than the simple 2-asset-class portfolios typically used in the research; some clients are older and/or unhealthier and have shorter-than-30-year time horizons (supporting a higher-than-4% rule); efficient drawdown/liquidation strategies may further extend portfolio survival and/or allow greater spending; and more dynamic spending (e.g., willingness to cut spending if recent market performance is poor) can go a long ways to improve the safe withdrawal rate. Ultimately, Pfau notes that while some of these factors are based on our market assumptions in the first place, many are factors that could/would be adapted and customized based on specific client needs and circumstances to craft their own individualized/customized safe withdrawal rate.
Can An Algorithm Be A Fiduciary? (Suzanne Barlyn, Reuters) – While much focus on the rise of the “robo-advisors” has been on whether clients will stay the course during turbulent markets without a human advisor to communicate with, a related question has arisen: are there impediments to an RIA executing on its fiduciary duties under the SEC if there is no human advisor contact (beyond an operational customer service rep) between the investment advisory firm and the firm’s clients? Certainly, it is crucial for an advisor to determine a client’s risk tolerance, but the current robo-advisor platforms do go through such a process using online questionnaires that clients can complete. And the advisor must prudently construct the portfolio itself, but ultimately the robo-advisor platforms still often have a centralized investment committee and a software screening process to select investments, not unlike many human advisory firms. In fact, some advocates point out that automation (via a robo-advisor) can potentially reduce human errors in trading – at least, to the extent the robo-advisor’s algorithms are programmed properly, which means managing and monitoring their own algorithms for programming errors may actually be a core function of a robo-advisor’s fiduciary duty.
The Latest Threat To Financial Advisors (Bob Veres, Financial Planning magazine) – While there’s been much warning of the threat to advisors by robo-advisors, Veres points out that the financial planning profession has faced a number of “mortal” challenges over the decades, each that sharply question the relevance and value of financial planners, and that the end point is not the extinction of advisors but an evolutionary response that moves them further along the value chain. For instance, the “do-it-yourself” trend of the 1980s and 1990s, with the rise of Money magazine branding itself as “America’s Financial Planner”, was supposed to threaten the existence of “expensive” advisors when a cheap magazine could tell investors everything they needed to know with their “10 Funds To Buy Now” articles. Then it was the rise of the discount (online) brokerage firms, again raising the question “why pay all that money for professional advice when even a baby in a crib can buy and sell stocks?” More recent threats include not only the robo-advisors, but also large brokerage firms shifting to “fee-based advisors” that Veres suggests is analogous to drug sales representatives opening up “medical” offices to sell their products under the guise of medical advice. Obviously, none of these “threats” have ended the market for financial planners, but Veres does acknowledge that each undermined and commoditized a function previously delivered by advisors, as the robo-advisors are now doing to the core aspects of portfolio construction, tax-loss harvesting, and rebalancing, forcing them to move to higher ground and perhaps accelerating their evolution to that next stage. The bottom line: the advisory model isn’t likely to die any time soon, but advisors should recognize that constant and continuous evolution to move up the value chain is not only inevitable, but will be an ongoing necessity.
What Don’t More Advisors Look Like Lazetta Braxton? (Charles Paikert, Financial Planning magazine) – In a 2011 report on workforce diversity in financial services, a SIFMA survey of 18 large firms found that only 8% of brokers/advisors at those firms were “people of color”, and estimates from industry executives are that at independent advisory firms African Americans may constitute no more than 1% to 2% of all advisors. Notably, the industry has recently begun to tackle its lack of gender diversity, with women making up about 25%-30% of advisors, but CFP Board consumer advocate Eleanor Blayney points out that this may simply be a function of the fact that the industry is recognizing the amount of wealth that women control, and that while some gender diversity efforts may succeed the initiatives might only be occurring in an effort to follow the money – which means the historic income and wealth gap between black and white Americans may be exacerbating (or at least slowing a response to) the problem. As a result, the racial diversity needle doesn’t appear to be moving much, as many firms note that they don’t even see African-American applicants for their advisory positions; this dearth of diversity in financial services unfortunately may also be becoming self-perpetuating, as already-not-diverse small firms may not feel culturally welcome to minorities, and newer minority advisors looking to enter the industry struggle to find mentors to connect with. Few large firms seem willing to tackle the issue directly either (of large broker-dealers that Financial Planning magazine contacted, only Raymond James was even willing to comment on the record that they’re trying to improve it). Notwithstanding these challenges, the growing portion of the U.S. population is projected to be over 40% by 2025 (up from 1/3rd today), and wealth is rising amongst many segments of the African-American community (including 1.9 million African-American small business owners). So what else can be done to fix the problem? The article suggests that the biggest issue is simply that there’s no awareness; financial planning isn’t on the radar for a large part of the African-American community, and financial planning academic programs may be best positioned to introduce planning to a more diverse group of future advisors. In the meantime, organizations are also aiming to improve opportunities to connect with mentors, and there is a burgeoning Association of African American Financial Advisors trying to grow into a national organization to create a more welcoming environment.
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!
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.