Enjoy the current installment of “Weekend Reading For Financial Planners” – this week’s edition kicks off with the industry news that the SEC is gearing up for the next wave of examinations as it continues to examine the rollout and initial impact of Regulation Best Interest, with a focus in the coming year on whether and how broker-dealers have changed their product shelves, are reviewing the costs of their products, and are managing the conflicts of interest embedded in those costs, as the brokerage model continues to adapt to a more advice-based future.
From there, we have several articles around the theme of retirement planning, including why it’s better to encourage clients to make small New Year’s resolutions to get on track for retirement (not to plan big New Year’s resolution changes), why it’s so important to consider the true meaning of the word “income” when talking about what a portfolio can produce (especially in a world where many forms of “income”, such as immediate annuities, actually include a material return-of-principal component), how to reframe the way Social Security claiming decisions are presented to get clients more comfortable delaying, and how to mathematically quantify the advice benefit of getting clients to use tax-deferred retirement accounts.
We’ve also included some investment-related articles, including a discussion of why clients should not be dissuaded from investing despite markets reaching “all-time new highs”, tips on navigating the emerging world of sustainable investing ratings (which lack the uniformity of more industry-familiar MPT-based metrics like alpha and Sharpe ratios), whether advisory firms should be concerned about the recent wave of money market fee waivers, and how advisors can talk clients through some risks of investing in the hot new Wall Street trend of SPACs (which as it turns out, may, unfortunately, be far better for their sponsors and early investors who redeem out than the actual long-term investors that would buy and hold them).
We wrap up with three interesting articles, all around the theme of looking to the future year and future decade of the 2020s: the first looks at how the new advertising rule from the SEC will not only open the door to RIAs using client testimonials, but may also spawn a new wave of third-party advisor rating sites that help to further promote good advisors (and also bring greater negative scrutiny to the bad ones); the second looks at how the intersection of zero-commission trading and new technology may spawn a new wave of (stock-level) portfolio customization for advisors and their clients; and the last looks at how, even as the world of financial advice becomes more mature and established, there’s still a long way to go in becoming a bona fide and recognized profession, where the coming battle may not necessarily be about implementing a uniform fiduciary standard for all but instead getting clearer about titles and labels so consumers better understand who’s in the advice profession and who’s an agent of the financial services industry… and then let the consumer choose which they want to work with (once they clearly understand the capacity of each)!
Enjoy the ‘light’ reading and hope you’re having a safe and Happy New Year!
SEC To Begin Focusing Reg BI Exams On Broker-Dealer Products, Costs, And Conflicts (Tracey Longo, Financial Advisor) – As 2021 begins, so too will the next wave of SEC examinations on how broker-dealers are implementing last year’s June 30th effective date for Regulation Best Interest (Reg BI). For the first six months, the SEC had declared that its primary concern was simply whether broker-dealers were making a good-faith effort to comply with Reg BI; now, however, the SEC is shifting its focus to examine whether broker-dealers have developed and implemented actual written policies and procedures pursuant to Reg BI and whether they are actually following those policies and procedures in practice. In particular, the SEC is looking to see: changes that broker-dealers have made to their product offerings, especially regarding the removal of higher-cost products when lower-cost options are available (e.g., using the lowest-cost share class available); how broker-dealers and their brokers are considering costs when making a recommendation (and the associated documentation of those recommendations); how the broker-dealer is evaluating complex products in particular (including what information was available, and how it was used); and the processes that broker-dealers are using to identify and address their conflicts of interest. Ultimately, the SEC still isn’t necessarily anticipated to aggressively enforce violations that it discovers at this point (still in the first year of implementation), but discrepancies and issues discovered in its current exam cycle will likely be used as the foundation for where the SEC will first turn for more aggressive remediation policies (and more aggressive enforcement actions against those who fail to remediate) in the future.
Tiny Changes To Help Clients Achieve Their Retirement Savings Goals (Anne Tergesen, The Wall Street Journal) – The turn of the new year is often a time for New Year’s resolutions focused on making the big meaningful changes we want to make in our lives… but actual research on behavior change suggests that, in practice, making small changes is a better approach to actually engaging in meaningful change (and being able to follow through on it and actually have it stick). Especially coming off 2020, a year of significant financial and other stresses for many… and consequently a time where many will feel entirely too stressed out or overwhelmed to make any really big changes. Accordingly, BJ Fogg – author of “Tiny Habits: The Small Changes That Change Everything” – suggests a number of alternative ‘not big but meaningful’ strategies for 2021, including: keep the bar clear, but low, such as simply boosting retirement contributions by 1% (as one of the biggest ways to de-motivate yourself is to choose goals that are too vague or overly ambitious, such that they can’t really be achieved, which eventually leads us to stop even bothering to try… while a small win, like increasing savings by 1% and doing it successfully, increases the odds we’ll then want to follow through and increase it another 1% from there!); help clients calculate and see the long-term positive impact of small changes (as in practice, we often resist small changes because they seem too minor and ineffective, and underestimate the impact of how compounding can accumulate those changes over time); when making changes, think of them as experiments, and anticipate that not all of them will work and stick (but some will), which further reduces the stakes (if you’re not happy with the change, it’s OK, you’ll be allowed to take it back) and reduces the need to make all-or-none changes that in practice can be very hard to stick with; and be certain to celebrate when you have a success, even if it’s just a small win (got the paperwork to increase the retirement contribution by 1%!), because any opportunity to celebrate a positive outcome literally releases the feel-good neurotransmitters in our brains that not only feel good, but are actually a key part of ingraining (positive) habits!
The Four Levels Of Income (John Rekenthaler, Morningstar) – As a part of the SECURE Act, the Department of Labor has provided (interim final) Regulations requiring 401(k) plan administrators to translate a defined contribution account balance into an estimated “lifetime income” stream at retirement, calculated as the amount of monthly payments the retiree would receive from a single premium immediate annuity (either Single Life, or Joint And Survivor) purchased with what their account balance is projected to be in retirement. Yet the reality is that payments from an annuity are not actually “income” – at least, not all of them, as in practice lifetime annuity payments are a combination of actual income, a return of the account owner’s own original principal, and the mortality credits from all those others who bought the annuity as well but didn’t survive long enough to receive their principal and income payments. As a result, comparing an annuity’s “lifetime income” – which includes a return of principal – with the “income” from a retirement portfolio (which is typically just the actual income, from bond interest to stock dividends) creates an apples-to-oranges comparison that makes the annuity option appear to provide more “income” than it actually will. Of course, the irony is that defining “income” from a portfolio in practice can also be murky, as Rekenthaler notes at least four different types of investment approaches with associated differences in the “income” they produce, including: Growth portfolios, where income may come from dividend-paying stocks and the yield on TIPS (which, notably, include a component of return in the form of inflation adjustments to the underlying price of the TIPS bond itself); Preservation portfolios, where income is driven more by the interest on bonds and the yield on cash (and where, short of default risk, principal itself is not in play nor even at risk); Erosion income strategies, such as buying premium bonds (where the yield may be higher but the bond price itself amortizes down to par over time) or writing covered call options (which can erode over time as winners are called away and losers are retained); and Exit strategies, where assets are converted ‘entirely’ into income, from spending down assets to delay Social Security, to buying an outright lifetime annuity. Ultimately, though, the key point is simply that when comparing “income” strategies, it’s really important to get clear on what we’re calling “income”, or not, in the first place, because all strategies definitely are not the same.
Reframing Social Security Claiming Decisions (Mary Beth Franklin, Investment News) – Careful consideration about the timing of when to begin Social Security benefits is a staple of retirement planning, in a world where more than half of households over age 65 rely on Social Security benefits for the majority of their income, and even more affluent clients still want to maximize the dollars on the table that they have spent a lifetime paying into. And it’s a high-stakes decision, where the difference between claiming as early as possible (at age 62) and delaying as late as possible (until age 70) results in a 76% difference in lifetime income payments. Or viewed another way, delaying the claiming decision is the equivalent of giving up those dollars in the intervening years, in exchange for a higher lifetime inflation-adjusted “annuity” payment thereafter. Still, though, Social Security Administration data suggests that payoff isn’t compelling enough (or simply isn’t feasible) for many, with nearly 40% of men and 35% of women claiming their benefits as early as possible. To accentuate the differences, Franklin suggests that advisors reframe how Social Security itself is discussed, by describing age 62 as the “minimum benefit age” or the “reduced benefit age”, and age 70 as the “maximum benefit age”. And instead of talking about “breakeven ages” – the point at which delaying benefits results in more total dollars over time than the payments initially given up, but can encourage (or create the fear of) a “gambling” mentality – consider framing the outcome of delayed claiming as a “gain” in income (and simply appeal to the retiree’s opportunity to gain additional income by waiting). Which is especially important with couples, where the failure to delay the higher earner’s benefit can result in a double-whammy, reducing not only their benefits by claiming early but also the amount of the widow(er)’s benefits that would be available if the higher earner died before their breakeven age anyway.
Quantifying The Value Of Retirement Accounts (Aaron Brask, Advisor Perspectives) – Taking advantage of tax-deferred retirement accounts, from IRAs to 401(k) plans, is one of the most popular strategies of retirement planning. Yet the irony is that few ever talk about the actual economic quantifiable benefit of doing so… or measure the benefits in the wrong way, by looking at the tax savings and failing to recognize that as pre-tax accounts, withdrawals will still ultimately be taxable. Which means the real value is not the tax savings, but the growth opportunity on those tax savings while they’re deferred – aka the time value of money – along with the fact that rebalancing and ongoing dividends and interest can be reinvested without any ‘tax drag’. In today’s marketplace, this means investors face annual taxes on the ~1.5% dividend yield of a stock portfolio and ~3% yield on Treasuries, plus the ongoing capital gains exposure of annual rebalancing, which, assuming a 15% tax rate on dividends/capital gains and 25% on ordinary income, can amount to ~44 basis points of tax drag (on a 60/40 portfolio). Brask models historical rolling 20-year periods (since 1968) to compare the actual final wealth outcomes of taxable investment portfolios (considering both the ongoing tax drag, and the impact of accumulated capital gains at the end) to the value of a tax-deferred retirement account (netted down for taxes in the end), and finds that, overall, the average wealth difference amounted to 1.7% of additional annualized return for tax-deferred retirement accounts (and slightly higher for those portfolios that have a heavier bond component, or more rebalancing or other turnover, all of which contributed to higher ongoing tax drag, which at higher tax rates resulted in some scenarios with as much as 2.7% per year of ‘excess’ returns from the retirement account’s tax-deferral benefits). Notably, the analysis does assume that tax rates remain constant, though, while in practice tax rates may change (e.g., where accumulating very significant wealth in the retirement account results in higher future tax brackets to unwind that account), which can tilt the benefits towards a Roth-style account instead.
Should Clients Still Buy Into Markets At All-Time Highs? (Nick Maggiulli, Of Dollars And Data) – Despite the tumultuous nature of 2020, both in terms of the pandemic and the economy, and the markets themselves, 2021 will kick off with markets sitting near all-time highs… raising the question of whether advisors should consider not fully investing new clients right away, and either waiting (e.g., for a pullback) or at least dollar-cost averaging into markets over time (even if on average, doing so just reduces long-term returns). Yet the reality is that markets only actually spend about 5% of the time at or near their all-time lows (i.e., the “best” price), and instead on average for risk-based assets (e.g., stocks), making new all-time highs is generally a bullish indicator in the near term, as all-time highs and their positive momentum tend to simply beget more all-time highs as the growth continues (clearly not indefinitely, but often for longer than cautious investors may anticipate). In fact, in structural bull markets, “new highs” can reign for years or even nearly a decade at a time (as they did throughout most of the 1980s and 1990s, where markets never spent less than 500 days below an all-time high before making a new one), and overall the S&P 500 has been within 5% of its all-time highs nearly half the time since 1950! And while the distribution of returns when stocks are not at all-time highs do skew positively, returns over the next year when stocks are at all-time highs is still almost a perfect normal distribution of returns (i.e., it’s no more but also no less likely to get better returns in the year that follows new all-time highs), and the results are even more consistently good when examining the next 3 years of returns after all-time highs are reached (and also look even better with international stocks than with US stocks, as well as with gold!). The key point, though, is simply that for markets to keep growing, almost by definition they can and must continue to make new all-time highs… which means being at all-time highs isn’t necessarily the sign of a pullback or impending crash, but simply the normal process of growth itself.
Navigating The World Of Sustainable Investing Ratings (Deborah Nason, CNBC) – The rise of Socially Responsible Investing (SRI) and Environment, Social, and Governance (ESG) filters, now broadly grouped into the category of “sustainable investing”, is creating a new framework (beyond the traditional Morningstar-style boxes and Modern Portfolio Theory metrics) for evaluating whether or not to invest in particular companies. The challenge, though, is that there isn’t necessarily a universally accepted framework for what factors, exactly, are most pertinent when evaluating companies for sustainable investing (or evaluating the ratings of those companies for the providers that offer such ratings), raising the question for advisors of how exactly to navigate the growing range of tools, from MSCI’s ESG ratings to Morningstar’s Globes ratings (which measure different underlying factors with different methodologies and therefore can come up with different ratings for the same company). Which means as a starting point, it’s necessary to look under the hood and understand the actual rating methodology of the provider, and in particular what factors they weigh (or not) when issuing ESG ratings. It’s also suggested to consider the “materiality” of an ESG issue, as not all issues have the same impact on all companies (e.g., material issues for Exxon will include more environmental factors, while for Facebook the material issues will generally be those across the social [not environmental] domains). In fact, some providers – like As You Sow – don’t just rate companies on an aggregation of factors, but also flag companies with a particularly material factor (e.g., a multi-national firm that is actually burning down the Amazon for new development). In turn, some advisory firms actually blend together different ratings from multiple providers, given the range of ratings (and the fact that different providers have different data sources, and may spot something that others missed).
Should Advisors Be Concerned About Money Market Fee Waivers? (Bernice Napach, ThinkAdvisor) – In a near-zero yield environment, more and more money market funds have been partially or fully waiving their management fees, from Vanguard’s direct-to-consumer funds to Schwab and Fidelity’s own internal money market funds. And in the extreme, some smaller money market funds have been closing to new assets altogether in the face of the low-yield environment. Ultimately, the issue is simply that with yields so close to zero, there simply isn’t room for the asset managers to charge fees (fully or at all) on their money market funds without causing the yield to go below zero… a death knell for any money market fund, where getting little or no yield may be frustrating, but getting a negative yield such that the money market fund doesn’t even maintain its current value, and would send investors racing for the exits. In the aggregate, though, such fee waivers are costly for platforms – with one estimate that Fidelity alone lost out on $247M of revenue from its money market funds in just Q2 and Q3 of this year due to its fee waivers. But for large financial services firms, it’s not necessarily fatal – Schwab’s lost revenue from money market fee waivers was estimated to be more than offset by a 4% increase in other management and administration fees across the organization – and in practice, money market fee waivers were also common throughout the 2009 to 2015 time period, and ultimately the companies made it through just fine.
How SPACs Destroy Investor Wealth (Robert Huebscher, Advisor Perspectives) – One of the hottest investment trends of 2020 has been the SPAC – short for Special-Purpose Acquisition Company – a unique form of IPO where investors put money into what is effectively a ‘shell’ company, whose sole purpose is to acquire a private company in the subsequent 2 years that it wants to become public, effectively shortcutting and bypassing the IPO/registration process for the acquired company itself by allowing it to simply merge itself into the “already-IPO’ed” publicly traded SPAC instead. In fact, SPACs accounted for nearly 50% of all IPO volume in 2020… even as new research from Michael Klausner and Michael Ohlrogge, aptly entitled “A Sober Look At SPACs“, is revealing lackluster outcomes, and that the purported benefits of the SPAC may not be manifesting in practice. The core issue is that the SPAC ends out being far more profitable for the sponsor that brings the SPAC to market, than for the investors that put their own dollars into the vehicle, driven by the fact that the SPAC sponsor typically retains 20% of the ownership of the entity without contributing their own money in the first place. In addition, investors who do not actually follow through on the SPAC acquisition – and instead choose to exercise what is typically an option to redeem their investment in the SPAC back for their original capital plus an allocation of interest – also benefit… leaving the investors who actually follow the SPAC structure from initial investment to final acquisition holding a substantially diluted share (by the investors who choose to redeem and not remain, and the sponsor that may have effectively captured 20% of the capital upfront in the first place). In fact, the researchers found that of 47 SPACs that actually completed their acquisition mergers between January 2019 and mid-2020, on average they only retained about 2/3rds of their original cash to be deployed into the acquisition deal (with the investors following through effectively facing an upfront loss of 1/3rd of their investment between upfront fees and subsequent dilution!)… which then may be made even worse if the SPAC has to raise additional capital to fulfill the acquisition (which further dilutes the investors who remain with the deal, but not those that redeem or cash out up front). And even after the SPAC consummates its deal, the outcomes aren’t much better, with the average SPAC return of -35% after 12 months (and the median a whopping -65%!), though ‘higher quality’ SPACs (larger, and run by more experienced executives) fared better with 12-month returns of ‘just’ -6% on average (albeit still a -35% median). Of course, as with so many unique investment opportunities, most SPACs seem to still claim that their SPAC and strategy is different… but overall, the research suggests that at least this first generation of SPACs may be more valuable for those who organize the SPAC than the investors who actually invest in them for the long run?
New SEC Marketing Rule May Bring Fresh Scrutiny To Advisors (Kenneth Corbin, Financial Planning) – The recently announced update to the SEC’s marketing and advertising rules has been hailed for its permissiveness to (finally!) allow financial advisors to use client testimonials and share the positive stories of success they have had with their clients. Beyond just testimonials, though, the SEC’s new advertising regulations will also let advisors leverage third-party ratings and review sites, prompting clients to leave reviews, and citing the advisor’s average ratings and reviews in their own marketing materials. Which may not only increase the popularity of existing third-party review platforms like Yelp, but is also anticipated to spawn a new wave of “Advisor Rating” sites for consumers… leading to a greater level of visibility for good advisors who receive good ratings, but also a new level of scrutiny on bad advisors whose bad advice and services may now become more publicly visible. And even for good advisors who try to leverage the good reviews, compliance consultants anticipate a wave of initial scrutiny from the SEC on how RIAs communicate and promote their third-party ratings, and whether they’re properly representing all the reviews (and not just cherry-picking the rest). Still, though, to the extent that “sunlight is the best disinfectant”, the general view of the advisor community thus far is that the new rules will better allow good advisors to tell their stories… and for consumers to better spot and avoid bad advisors with the additional visibility and scrutiny that third-party rating platforms may provide.
The 2020s Will Be The Decade Of Customization For Financial Advisors (Ben Carlson, A Wealth Of Common Sense) – Over the past nearly 70 years, the way investors invest (and the ways financial advisors help them to do so) has changed substantively, from the individual stock investing boom of the 1950s (when nearly 90% of all trades on the New York Stock Exchange were executed by retail investors, as contrasted with barely 5% today), to the 1960s when the star mutual fund manager was born, the 1970s that witnessed the emergence of the index fund, the 1990s when the ETF was first born, and the 2010s that brought the rise of the robo-advisor (and, more generally, a new wave of technology that brought newfound operational efficiency to investing). Now, Carlson suggests that the 2020s will become the era of customization for financial advisors in their work with clients, driven by three core trends: Direct Indexing, which makes it possible not just to eschew mutual funds and ETFs and to buy (and tax-loss-harvest) the stocks of an index directly, but also facilitates a wide range of “custom indexing” solutions where advisors can adapt a client’s “indexed” portfolio to their specific preferences; ESG investing, driven by a clear preference of younger investors for a more value-based investing approach (and a desire to express those ESG values preferences into the allocation of their portfolios); and what Carlson calls “Defined Outcome Investing”, with vehicles from structured notes to defined-outcome ETFs, that will make it possible for investors to set tighter preferences around their risk/return outcomes (e.g., using options to protect against the downside in exchange for giving up a certain level of ‘excess’ upside). Notably, across all three, the underlying key is the combination of zero-commission stock trading, plus technology to manage a high volume of clients and holdings efficiently at scale, that makes it possible in a way that was never feasible in the past (and may still be too complex for most investors to implement themselves, thus why Carlson suggests these areas will primarily be the domain of financial advisors, at least for the 2020s).
The Financial Advice Profession: Are We There Yet? (Tony Vidler) – There has long been a debate amongst the financial planning community about whether we should call ourselves an “industry” or a “profession”… or whether the reality is that we’ll eventually be a profession but we’re not there yet. Vidler suggests that ultimately, the answer will be both – even professionals are themselves situated within an industry (as Doctors as Professionals are still part of the Medical Services industry at large) – but when it comes to the Profession part, we really are not there yet, and may not be for a while to come. Because at its core, being a Profession means not just adhering to high ethical (e.g., fiduciary) standards, but also having a clear delineation of who can (and cannot) hold themselves out as professionals, and whether the public accepts that those who do hold out as such really do have a differentiated level of education and experience that merits such professional status. Which is notable because not only is a fiduciary standard not uniform amongst the industry, but the financial advisor title itself is not well regulated, which means consumers can’t count on the depth of education and experience from those who use the label (as they can for, say, a doctor or a lawyer). Still, though, that doesn’t necessarily mean that the only path forward is a uniform fiduciary standard for everyone; to the contrary, just as medicine has a wide range of levels and services they can provide (doctors can only do some tasks, while pharmacists do others, nurse practitioners do a subset of those, etc.), Vidler suggests that there can (and in fact should be) a wide range of providers, including commission-based brokers, because not every consumer wants a comprehensive level of advice (i.e., sometimes they really just want to buy a product, and want something to help facilitate that transaction). More generally, the key point is to recognize that we don’t need to lump every service under the financial services umbrella into the same basket – the teller in their first two weeks in the bank branch is simply not performing the same service as the CFP professional in private practice with a coterie of ongoing clients – and the endpoint is really about creating clear labels so the consumer knows what they should expect in the first place… and then let them choose whether or what level of advice they wish to receive.
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, and Craig Iskowitz’s “Wealth Management Today” blog as well.