Enjoy the current installment of “weekend reading for financial planners” – this week’s edition kicks off with the big news that yet another state, Maryland, has now jumped into the fiduciary fray, with its own version of a rule that would require brokers operating in the state to meet a fiduciary standard of care, given ongoing concerns from state legislators about the potential consumer consequences of President Trump’s order to review (and potentially further delay or kill) the Department of Labor’s fiduciary rule. Also in the news this week was a discussion from SEC regulators suggesting that they may be focusing less now on creating new rules for robo-advisors, and instead simply looking to apply the existing principles-based fiduciary regulation under the Investment Advisers Act of 1940 to the robo-advisor business model (with a particular focus on whether robo-advisors, or human advisors using “robo” tools, are probably explaining how broad, or narrow, the scope of their financial advice really is).
From there, we have several articles on the new tax law, including how many small businesses are taking a fresh look at the ideal business entity structure (with some pass-through businesses considering whether to become C corporations for the new 21% corporate rate, and some C corporations considering whether to switch to pass-through status to take advantage of the new 20% Qualified Business Income deduction), a discussion of whether some employee advisors at broker-dealers may want to switch to become independent contractors to take advantage of the new pass-through deduction, how some couples may want to use the “Married Filing Separately” filing status to preserve the pass-through deduction where one spouse is a business owner and the other has (even higher) non-business income, and a look at how the change in tax rates from 2017 to 2018 creates interesting opportunities over the next two months for people to engage in “tax rate arbitrage” by contributing to IRAs for the 2017 tax year and then converting them in the current 2018 year at lower rates.
We also have a few marketing-related articles this week, from tips to squeeze more value out of your client communication and events (by focusing on how to expand or better leverage or re-purpose the content), to how having a narrower niche or target market allows you to build rapport faster with clients by getting to know their common needs and issues (which makes you look like a mind-reader when you can tell them what’s on their minds before they even say it!), and how clients begin to develop a deeper relationship with a professional in as little as 3 extra minutes of the professional listening and making clients feel like they’re heard and cared for.
We wrap up with three interesting articles, all around the theme of selling and business incentives: the first explores a recent research study that finds it’s not the lower fees of robo-advisors that are attracting clients, but the transparency of those fees (and their subsequent performance reporting systems), which has important lessons and implications for all advisors; the second looks at how business model incentives may help to contribute to the unique (and not necessarily pro-long-term-investor) way that brokerage firms typically develop their client statements and websites; and the last provides a good reminder that even if we’re in the business of advice and not product sales that we’re all still selling something to clients, which means perhaps we should focus less on trying to avoid discussions about sales altogether and instead focus more on the most productive ways to ethically “sell” and help clients to reach better financial outcomes!
Enjoy the “light” reading!
Weekend reading for February 24th – 25th:
Maryland Jumps Into Fiduciary Fray With Legislation Requiring Brokers To Act In Best Interests Of Clients (Mark Schoeff, Investment News) – This week, the Maryland state Senate became the latest to introduce potential new legislation that would require brokers operating in the state to meet a fiduciary standard. As a part of the “Financial Consumer Protection Act of 2018“, Maryland lawmakers are stating that a state-level fiduciary duty is necessary to protect Maryland consumers in light of the ongoing threats to roll back the Department of Labor’s fiduciary rule since President Trump mandated a re-assessment of the rule after he took office. The legislation would require that anyone effecting transactions in securities accounts would be required to act as a fiduciary, disclose any compensation (including commissions), and also would have required affirmative disclosure of any material legal or disciplinary events before working with a client. Notably, a similar piece of legislation was set to be introduced in the Maryland House, but the Financial Services Institute (which has been lobbying on behalf of independent broker-dealers against a full-scale fiduciary rule) was able to get the House version removed, under the auspices that state legislators should wait for the SEC to propose its own fiduciary rule. However, Maryland legislative staffers note that the legislation was actually crafted to not be duplicative with Federal fiduciary laws (as overlapping disclosure and recordkeeping requirements were eliminated), and at the same, the Financial Services Institute has already been claiming it is heavily influencing the SEC’s looming fiduciary proposal (raising concerns about whether FSI is pushing states to wait for the SEC to act simply because it’s already successfully watering down the SEC’s fiduciary proposal below what states are trying to enact).
SEC Puts Advisors On Notice Around Robo Advice (Kenneth Corbin, Financial Planning) – In a recent webinar event, the SEC’s Division of Investment Management cautioned that the SEC will be scrutinizing the nature of disclosures from robo-advisors (or financial advisors who use “robo” tools), to affirm that the firm properly discloses the scope of advice being given; in other words, if the firm advertises that it provides full-service financial planning, it should be using tools that effectively evaluate the full picture (which might, for instance, include whether to pay off loans first and not invest at all), and if the robo solution is only focused on allocating an investment portfolio, that narrower scope should be explained instead. Notably, this isn’t actually a substantial change of the existing rules that apply to any investment adviser with respect to having clear advertising and disclosures regarding their services; instead, it’s simply a re-affirmation of the SEC’s prior 2017 guidance that all the standard rules that all to all investment advisers will continue to apply to robo-advisors as well. In fact, the SEC has noted that the broad scope of the principles-based fiduciary rule under the Investment Advisers Act eliminates the need for a lot of new regulations for robo-advisors, and that the SEC is instead focused primarily on simply applying the existing fiduciary rules properly to a new computer model of advice. At the same time, though, new robo-advisor models do present either new scrutiny to old conflicts of interest (e.g., firms that primarily implement robo-advice with their own proprietary products), and perhaps some additional scrutiny on both the quality of the robo questionnaire if it will be relied upon so heavily for implementing the client’s portfolio (given the reduced reliance on human advisors in such models) and also the way that questionnaire results are mapped to actual recommended portfolios.
To C Or Not To C-Corp: Pass-Through Business Are Rethinking Their Status In Wake Of New Tax Law (Ruth Simon, Wall Street Journal) – The introduction of the new pass-through business deduction for 20% of Qualified Business Income represents a substantial tax savings potential for many pass-through businesses (effectively reducing the top tax rate on pass-through businesses to “just” 29.6%), yet the Tax Cuts and Jobs Act of 2017 also reduced the top tax rate for C corporations from 35% to just 21%… raising the question of whether pass-through businesses, despite the new deduction, might want to eschew the pass-through structure altogether and just switch to C corp taxation anyway. Of course, the caveat is that C corp owners can’t get their profits out of the C corporation without either paying an additional layer of taxes on dividends (and/or keeping the profits inside the business and selling it and paying capital gains tax rates instead), and paying 21% corporate rates plus up to 23.8% in long-term capital gains or qualified dividend rates is not as good as the pass-through rate (even if not eligible for the pass-through deduction). In fact, some C corporations are now looking to become pass-through businesses instead, because they are eligible for the pass-through deduction and making an S election will bring their rates down significantly! In general, it seems that businesses looking to sell soon, and/or that are taking out substantial ongoing profits as cash flows will (still) tend towards pass-through business structures, but rapidly-growing businesses that are raising capital and/or heavily reinvesting their cash anyway may prefer C corp status to “only” pay 21% now, as while they will eventually have to pay taxes on future capital gains or qualified dividends, if the business is growing enough, the tax deferral (21% now, and capital gains or qualified dividends not taxed under years or decades in the future) may still be compelling.
Unintended Consequences For Broker-Dealers Under The Tax Reform Law (Stephen Wilkes & Livia Aber, Wagner Law Group) – Under the Tax Cuts and Jobs Act of 2017, pass-through businesses, which include not only partnerships, LLCs, and S corporations, but even sole proprietorships, are eligible for a pass-through business deduction of 20% of their Qualified Business Income. However, the deduction is fully phased out for “Specified Service Businesses”, which includes those in financial services and brokerage services, once taxable income exceeds $415,000 for individuals (or $207,500 for individuals), and is not available at all to employees (who receive their income as W-2 wages, rather than via any type of pass-through or sole proprietorship business). As a result, financial advisors who work as employee advisors at a broker-dealer will not be eligible for the new 20% pass-through deduction, while those at independent broker-dealers (and operate as independent contractors) will be eligible for the deduction, though they will still phase it out at higher income levels, and employee advisors at broker-dealers may even want to switch to independent status, and be recharacterized as an independent contractor, just to get the better tax treatment on their commission income. However, the reality is that the IRS has specific rules (a 20-factor test via Form SS-8) to determine if someone should be treated as an independent contractor in the first place (with some additional rules in the context of broker-dealers under IRC Section 3121(d)). And even if an advisor does convert to independent status with their broker-dealer, they must now pay the full amount of their 15.3% self-employment FICA taxes, and will lose access to worker’s compensation and unemployment benefits, along with any other employee benefits (e.g., health insurance and 401(k) plan) that the broker-dealer provides. Nonetheless, the differential in tax treatment for employee vs independent broker-dealers will at least trigger many to take a fresh look at their status and whether the trade-offs of changing status (in particular, from employee to independent to take advantage of the pass-through deduction) may be worthwhile going forward in 2018 and beyond.
When ‘Married, Filing Separately’ Lowers Your Tax Bill (Laura Saunders, Wall Street Journal) – The tax status of “Married Filing Separately” is used only rarely in certain tax situations where couples have very uneven income levels and it’s more beneficial to file separately (despite being a married couple, and despite a number of implicit penalties that the tax code includes for doing so, such as a number of tax credits or deductions that are automatically halved for those who are Married Filing Separately anyway). However, with the new pass-through deduction for 20% of qualified business income, the “Married Filing Separately” status may see newfound interest. The reason is that dual-income couples will have more trouble taking advantage of the new deduction, because both wages limits and Specified Service limits on the deduction kick in for married couples once joint income reaches $315,000) – which means the spouse of a business owner who has even higher income can cause the business owner’s Qualified Business Income to lose the deduction (as their joint income exceeds the phaseout thresholds). For instance, if a business owner earning $150,000 was married to someone that had $300,000 of wages, the couple would be ineligible for the QBI deduction, but by filing separately, the business owner may be able to better retain the deduction (as then the income threshold is $157,500, the same as it is for any single individual, so $150,000 of “just” business owner income would still be eligible). Of course, the other “common” reasons for filing separately as a married couple remain, including to separate other qualification thresholds (e.g., to get medical expense deductions for one spouse based on just one spouse’s income), to lower state income taxes (in certain states where it’s feasible), or to separate the couple’s liability for each others’ tax obligations. Nonetheless, the QBI deduction now introduces a material new reason for couples to consider filing separately, in cases where a business owner’s income is under $157,500 but a much-higher-income from a spouse is disqualifying the deduction on their joint tax return.
New Tax Law Provides Opportunity For Tax-Rate Arbitrage On Roth IRAs (Ed Slott, Investment News) – The Tax Cuts and Jobs Act of 2017 reduced most individual tax brackets by 1% to 4%, from the 15% bracket being reduced to 12% to the 28% bracket down to 24% and the top 39.6% bracket reduced to only 37%. As a result, during the next two months, there is a unique opportunity for individuals to make IRA contributions that are deducted at the “old” higher 2017 tax rates, which can then be converted in 2018 at the “new” lower tax brackets, producing an immediate tax arbitrage benefit (relative to “just” contributing directly to a Roth IRA in 2018 with after-tax dollars at the new current 2018 rates). Of course, many clients already made after-tax non-deductible contribution to IRAs in order to subsequently convert them (as a so-called “backdoor Roth contribution); but the key point here is that even if (and especially) if the individual could have made a pre-tax IRA contribution or a direct Roth contribution, that it may be better to make the traditional contribution first (deducting at last year’s rates) and then convert this year at current-and-lower rates instead. Similarly, any clients who already did a Roth conversion last year should also take a fresh look at whether they want to keep the conversion (at last year’s slightly higher tax rates), or recharacterize instead (as while TCJA prohibits Roth recharacterizations going forward, the IRS has confirmed that 2017 conversions can still be recharacterized) and then re-convert in 2018 at the lower rates. The latter strategy may not be appealing if the conversion has already risen significantly in value, but if it is flat (or has even declined) the recharacterize-and-reconvert approach (or what Slott calls a “reverse-and-replace” strategy) may be appealing, as a $100,000 Roth conversion at last year’s 28% tax brackets that this year are only taxed at 24% would produce an immediate 4% tax bracket arbitrage (or $4,000 of hard dollar tax savings) by undoing and redoing the Roth conversion.
How To Squeeze More Value Out Of Client Communications (Julie Littlechild, Absolute Engagement) – While frequent and proactive client communication is often cited as a major factor for why clients keep their advisors (and lack of communication is a common reason for firing them), the challenging reality is that it takes a lot of time to create effective client communication. Which is why Littlechild suggests that if you are going to be sending out regular and proactive client communication, you should look for ways to leverage that communication in multiple ways or channels. For instance, perhaps you’re considering a potential workshop event for clients about how to keep their personal data safe and secure, for which you’re going to invite an expert to speak, send out invitations to clients, and (hopefully) run a successful event. Alternatively, Littlechild suggests that you can leverage the event even further by: 1) Expanding the audience (why just invite clients? You can also invite prospects, local centers of influence, or even members of the local media); 2) extending the value (e.g., ask the speaker to record a 60-second intro to the video on the importance of the topic you can use for marketing purposes, get the speaker’s permission to video record the presentation so you can send it to clients or prospects who didn’t attend, then take video clips and share them on social media, make a Powerpoint slide of three big points from the speaker and then post the image on social media, or put the full video on your website behind a call-to-action to request someone’s email address); and then 3) Re-purpose the content as well (e.g., write a blog post on the big lessons from the workshop, or have the video transcribed into a blog article via a site like Rev.com, shoot your own two-minute video on why the topic is so important, and create a series of social media posts based on the specific lessons of the workshop and why they’re important). More generally, the fundamental point is that any time you’re sending out communication to a particular client or a subset of clients, also be thinking: 1) how can I extend the reach further; 2) how can I extend the value (by taking pieces to share in other formats); and 3) how can I further re-purpose the content to leverage further?
Be A Mentalist And Develop Faster Rapport With Clients (Steve Wershing, Client Driven Practice) – The “mind-reading mentalist” has long been an attention-grabbing show, but Wershing points out that it’s compelling to watch (or experience) precisely because it feels so incredible when someone can “read your mind” and fully understand (or even anticipate) what you’re thinking. And the principle isn’t applicable only in the context of performances and TV shows; instead, it’s highly relevant in the context of financial advisors, where we spend a great deal of time in the data-gathering phase trying to better learn about and understand our own clients as well. Yet in the traditional data-gathering process, the whole point is that we have to ask questions and learn what’s on their minds, because we don’t know until we ask. By contrast, when advisors focus on a niche or other well-defined target market, one of the advantages is that you can so effectively learn the needs and issues of your prospective clientele, that you can give them a “mentalist” kind of experience when they meet with you, asking questions or raising questions that show them you understand what they’re thinking even before they say it aloud! In fact, the whole point of effectively defining a clear target market is to be able to understand the unique needs, wants, and desires that separate them from everyone else… which means your ability to understand, and then address, those needs, wants, and desires, can create instant rapport with prospective clients as credibility is immediately established as you begin to ask questions and raise issues that shows you know what they’re thinking before they even say it!
Get Someone To Like You In 3 Minutes (Maribeth Kuzmeski, Red Zone Marketing) – In the book “Blink“, Malcolm Gladwell explores research that shows how the likelihood of surgeons being sued boils down to the fact that those who were not sued spent an average of 3 minutes longer with each patient than those who were sued… where the primary purpose of the extra 3 minutes was to allow time for patients to talk and ask questions, and where the surgeons could show they cared by listening and responding to the questions. As a result, even if someone did go awry in the procedure, and someone got sued, it wasn’t the surgeon who took the time to allow for questions and build a relationship with the patient (in as little as 3 minutes!), but the internist or radiologist or someone else who was involved in the procedure that got sued instead. Because in the end, we don’t typically sue people we like. Ultimately, Kuzmeski notes that the point is not necessarily about how to avoid getting sued (although obviously that’s good, too!), but simply that you really can meaningfully change your relationship with a prospective or current client in as little as 3 minutes by asking some questions, listening, and demonstrating that you care… which can begin to happen in as little as 3 minutes of really taking the time to listen and show that you care!
Transparency, Not Low Fees, Drives Consumer Loyalty For Digital Wealth Providers (Josh Book, Parameter Insights) – When robo-advisors first showed up with their much-lower-than-traditional-advisors price point, and began to gather assets, the implicit assumption was that their success was coming from the fact that they were just flat out cheaper (and easier to use) than the incumbents. However, research from Parameter Insights finds that in reality, the success of digital wealth platforms is less about just their pricing (and lower cost), and more about the way they can transparently communicate their pricing (and the relationship between pricing and performance) and effectively report their performance results (which similarly relates back to transparency). Which is important, because it means the path to even greater success for digital platforms is not necessarily about trying to scale up to get even cheaper, but instead is about creating more effective performance reporting and transparency about their results to deepen their trust. Which, notably, has significant implications for not just digital wealth platforms and robo-advisors, but humans as well – that in the end, while cost matters, the biggest winners are not the ones that price the cheapest, but the ones that are the most transparent about their fees (and their performance results), because fee and results transparency is a fundamental basis for establishing trust itself.
Incentives And Behavioral Design: Brokerage Firm UI (Daniel Egan) – Established brokerage firms are well known for often having old and “outdated” brokerage statements that are hard to read, and for many, their online experiences aren’t much better. In some cases, this is simply because it’s difficult to upgrade legacy technology tools and reporting systems. But Egan points out that unfortunately, there are a number of incentives that limit the appeal for brokerage firms to upgrade their systems to provide better reporting in the first place. After all, while fee-only fiduciary advisors are paid by clients without any incentive for more trading activity, brokerage firms themselves generally still only make money when customers trade (either via trading fees, compensation for order routing, or shelf-space payments and revenue-sharing agreements with asset managers and product manufacturers). Which means if a brokerage firm could come up with statements that did a good job showing clients how well diversified their portfolios were, and the improved results they were achieving by trading less… it would damage the brokerage firm’s business (by reducing trading activity!). Similarly, brokerage firms make substantial income on the interest rate spread (or expense ratio) of client cash holdings, which means it’s a positive for brokerage firms to have clients not fully invested (unless they’re actively trading what they’ve invested, of course). How might this be expressed in the websites or statements for brokerage firms? Egan suggests a number of options, including: make gains and losses feel more emotional (e.g., color them green and red) so they want to take action; shorten the time horizon for reporting to make clients fixated on short-term less to compel more trading; emphasize individual positions (not overall asset allocation) to encourage narrow framing and limit awareness of the benefits of diversification; emphasize fear and greed by highlighting the biggest winners and losers; don’t include a default for dividends and interest to be reinvested to build cash; make cash look more “safe” to encourage it to be held; and don’t mention the impact of inflation on cash (t0 make people more comfortable holding cash). Of course, the unfortunate point is that virtually all of these behaviorally driven mechanisms to encourage clients to hold cash or trade more is in fact exactly how most brokerage firms do present information to clients. Which perhaps indirectly helps to emphasize why financial advisors so often wants clients to log into the advisors’ own portal, and not the brokerage firm’s – as fiduciary advisors, with very different incentives, often present (or at least, want to present) such information to clients very differently!
“I’m Not Selling Anything” (Seth Godin) – Given the modern day stigma around sales and salespeople, it’s common for many industries and professionals to distance themselves from salespeople, including amongst the financial advisor community. Yet as Godin points out, any and every business is ultimately selling something. At the most basic level, we’re still selling “connection”, or “forward motion”, or a new way of thinking, a better place to work, or a chance to make a difference. In fact, Godin argues that if you’re not trying to make things better – which involves selling something to create forward progress that changes the customer/client status quo – then why are you here in the first place? Of course, it’s fair to recognize that you’re not trying to “sell too aggressive”, or invade a prospect’s space, or steal their attention inappropriately, or push them to do something that doesn’t match their goals. Ideally, selling should still be done in a client-centric manner, to achieve those higher-level aspirational goals. But that means that perhaps it’s time to stop saying “we don’t sell” – when in reality we do – and instead start talking about more honest, ethical, and client-centric ways to do the “selling” that it really takes to help clients achieve better outcomes?
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.