Enjoy the current installment of “weekend reading for financial planners” – this week’s edition kicks off with the big announcement buried in the slow-news holiday season that the CFP Board is softening its experience requirement for new CFP certificants and offering an alternative to its Capstone course for those seeking to challenge the exam… changes the CFP Board has made unilaterally without a public comment period, even though the current-and-soon-to-be-former rules themselves were only put in place after such a process. Also in the news this week was an announcement by FINRA that it will soon begin sharing with state insurance regulators, on a monthly basis, disciplinary actions that suspend or bar registered representatives, in an effort to ensure that those problematic brokers don’t just switch to selling inappropriate insurance products instead of securities.
From there, we have a few interesting investment and retirement research articles this week, including a review of a recent study suggesting that the widespread practice of benchmarking could actually be causing (harmful) distortions in asset prices, to a nice summary of some of the best retirement research in the Financial Analysts Journal for the past few decades, along with a good article describing the key details and features of Master Limited Partnerships, and a brief study looking at how a standby reverse mortgage line of credit could actually be a way of hedging against a poor housing market (and ironically, will function even better if interest rates rise in the future!).
We also have several practice management articles focusing on younger/newer advisors in particular, from tips to earning credibility when getting started, the benefits of getting a “side hustle” to bridge the income gap while you find your initial clients, and an interesting look at the ways to structure succession plans that may have value for both newer advisors who will be the successors and also the advisory firm owners who may be trying to decide how to sell/transition to them.
We wrap up with three interesting articles: the first looks at how advice-centric advisors often fear or entirely eschew the concept of “selling” even though the reality is that they still have to sell themselves, their services, and their advice (and avoiding the sales conversation can impair their opportunity to help clients!); the second is a good cautionary reminder of how some clients go through a “honeymoon” phase with advisors, which needs to be managed or advisors may find themselves losing some clients quickly; and the last is an interesting new study suggesting that a client’s willingness to trust others may actually have a strong relationship to their willingness to invest in equities, which implies both that advisors who can build trust better may get their clients more comfortable owning stocks, and also that measuring a new client’s comfort in trusting others may actually be a helpful indicator regarding how comfortable they will be holding equities in times of volatility!
Enjoy the reading!
Weekend reading for January 3rd/4th:
CFP Board Softens Experience Requirements For New CFP Certificants & Reduces Capstone Requirement For Challenge Status (Michael Kitces, Nerd’s Eye View) – The big news this week, buried in the slow new cycles of the holiday season, was the CFP Board’s announcement of two new “initiatives” aimed at “creating new pathways” to CFP certification. The first was an announcement that, just two years after the Financial Plan Development “Capstone” course requirement was implemented, the Capstone requirement will be waived for those eligible for challenge status to the CFP exam who choose to submit a sample financial plan for peer review instead. The second is that the CFP Board will now permit a much wider range of experience to count towards the CFP experience requirement, including work “that indirectly supports” financial planners or the planning process, such as being an employee benefits administrator, a compliance officer, or a journalist. Notably, while the CFP Board’s current Capstone and experience requirements were both adopted after engaging stakeholders in a public comment period to set the rules as they are/were, the latest changes were done without any opportunity for stakeholders to comment and support or object, and have been already been approved by the Board of Directors to take effect in July of 2015.
Regulators Tackle Insurance License Loophole (Julie Steinberg, Wall Street Journal) – After an expose from the Wall Street Journal earlier this year about securities brokers who get barred from the industry by FINRA but go out and obtain a state insurance license to continue consumer abuses through fixed insurance products instead, FINRA has announced that starting next month, it will begin to provide state insurance regulators a monthly report of registered representatives who have been barred or suspended. Previously, the report was provided only to state securities regulators, and although state securities and insurance regulators could theoretically share the information with each other already, the flow of information was often non-existent or greatly lagged (and is now also being considered for reform). Ultimately, the goal is to make actions from state departments “practically instantaneous” when the event occurs that a broker is barred.
The Price All Investors Pay for Benchmarking (Michael Edesess, Advisor Perspectives) – A recently published a study entitled “Asset Management Contracts and Equilibrium Prices” makes the interesting case that benchmarking managers against an index causes investors to be more sensitive to manager fees, which in turn makes managers more likely to hug those benchmarks to avoid the risk of material underperformance (assuming they are loss averse about their own incomes), and that such a phenomenon en masse can actually distort asset prices (as managers will buy/sell stocks in a manner that forces their price to align with the benchmark, regardless of whether such a result is reflective of the actual value of the underlying stocks). The phenomenon is further exacerbated by the fact that a subset of buy-and-hold investors (especially those who purchase individual securities, and not just indexes themselves) who effectively remove a portion of securities from the available supply for trading; now, as managers seeking to hug benchmarks buy and sell securities that are no longer in even supply, their efforts to conform the available supply of securities to the benchmark can further distort their actual values. Similarly, the model also explains why high-volatility stocks tend to underperform; because there is more risk to the manager in not owning them (creating greater risk of benchmark deviations), managers are more apt to buy them, driving up their price if there is any limitation in supply, which then reduces their future expected return; more generally, benchmarking gives managers an incentive to stay fully weighted in large, risky securities, effectively reducing or eliminating any risk premium that might have been had for owning them (or worse, even inverting the risk/return relationship!).
After 70 Years of Fruitful Research, Why Is There Still a Retirement Crisis? (Laurence Siegel, Financial Analysts Journal) – As part of a special retrospective issue on retirement for the FAJ, Seigel looks back at how the US still faces a “retirement crisis” despite decades of research, with issues ranging from low savings rates and lack of knowledge and unskilled investing with poor market returns, to longevity and problematic regulations and the sheer impact of costs (both ordinary and agency). Notably, the reality is that the challenge of retirement income is largely a modern phenomenon, as just a century or two ago, life expectancy was only around age 40, and for the select few that lived long enough to retire, they would typically just live with their children/family for support; we find ourselves with the challenge we face today largely because of the incredible improvements to longevity we’ve had as a result of medical advances. Accordingly, Siegel looks at a number of leading articles from the FAJ over the years that have tried to tackle the challenge, including: because productivity improves workers’ standards of living at a real rate above inflation, retirees can’t merely keep pace with inflation or they will still lose ground to current workers (thus why retirees need the growth of equities to keep up); the question of whether “time diversification” exists (whether equities get less or more risky in the long run) is primarily a question of whether you believe that mean reversion exists in equity returns (but has big implications on the amount of equity risk that retirees or workers should take); how retirement is more about smoothing lifetime consumption than finishing with the most wealth (a commonly held belief today, but ‘controversial’ at the time it was introduced); how DB plans were undermined in the 1980s because originally they had to be funded above their liabilities to cushion against bear markets, but in the 1980s when inflation subsided actuaries lowered salary assumptions and left return assumptions high, producing a discounted funding mechanism that made pension plans reliant upon returns just to be able to pay at all; other articles discuss optimal partial annuitization, the impact of taxes, and more, and Siegel concludes with his own views that the DB vs DC distinction is wrong (that it should be income promises & guarantees versus asset accumulation & decumulation), and that the best solutions should probably include a portion of each.
The Need-To-Knows Of Master Limited Partnerships (Andrew Smith, All About Alpha) – Master Limited Partnerships (or “MLPs” for short) are often viewed as a way to invest in energy infrastructure in a tax-advantaged manner, and there are currently over 115 publicly-listed MLPs with a combined market cap of about $500B; this article delves much further into the details of the various ways that MLPs are structured as companies and their underlying business model. For instance, while many MLPs do focus on the storage and transportation of energy, there are some more focused on exploration and production of energy resources (e.g., finding and bringing them to the surface), while others are more focused on processing (i.e., transforming raw energy commodities into usable form). Regardless of the particular part of the energy supply chain, though, MLPs generally operate on a fee-for-business model – which means, like toll roads, they can collect their ongoing fees without necessarily being reliant upon or as sensitive to the prices of the underlying commodities themselves. The key distinction to MLPs from a tax perspective is that they are structured as pass-through partnerships (typically with an investment or holding company or a management team as the general partner, and investors as limited partners), which allows them to avoid the double-taxation of corporations and theoretically pass through a greater share of earnings to investors (but as a result of the Tax Reform Act of 1986, their particular publicly-traded partnership structure is specifically limited to the energy sector). On the other hand, it’s notable that in an MLP, the general partners do not have a fiduciary duty to act on behalf of the best interests of the limited partners (as would be the case in a corporation), though with MLPs control is ultimately distributed through all the combined shareholders which still provides some level of accountability. In practice, most MLPs pass through 80% to 100% of their cash flows every year as “yield” to the investors, producing what has been a relatively healthy cash flow in a period of overall low returns. On the other hand, the price of MLPs may still be volatile, and effectively subject to interest rate risk (as a “yield” investment) with potential price declines if/when interest rates rise; in addition, while MLPs don’t directly derive profits from the price of commodities, dramatic changes in commodity prices can affect the demand for the services that MLPs provide, ultimately impacting cash flows; and MLPs also face regulatory risks, including potential crackdowns on the energy sector due to environment risks that could adversely impact the business of various MLPs as well.
The Hidden Value of a Reverse Mortgage Standby Line of Credit (Wade Pfau, Advisor Perspectives) – Several research articles in the Journal of Financial Planning over the past few years have shown how establishing a standby line of credit with a reverse mortgage can enhance retirement outcomes, where the line of credit is used to support retirement spending strategically (e.g., to supplement while the portfolio is down, giving it time to recover and then repaying the line of credit). Yet as Pfau shows, an indirectly benefit of using the reverse mortgage strategy is that it becomes a form of hedge against property prices; because the available line of credit is guaranteed to increase every year (generally, by the 1-month LIBOR rate plus a lender’s margin and a 1.25% mortgage insurance premium), regardless of the value of the home, in an environment where home appreciation is very bad, the reverse mortgage may actually provide more available retirement funds than simply selling the house itself in the future. In the meantime, because the current reverse mortgage standard – the Home Equity Conversion Mortgage (HECM) – is a non-recourse loan, in situations where the loan does end out “underwater” the retiree’s other assets are still not at risk. Of course, there is a cost to set up the reverse mortgage in the first place, but for those who fear an extremely bad future housing market in the future, Pfau makes the case that may still be a price worth paying. And notably, because the growth rate of the line of credit is tied to LIBOR, in this case a rising interest rate environment actually increases the likelihood of the reverse mortgage growing to exceed the value of the home and producing greater cash flow availability for the retiree; in a Monte Carlo analysis (with inputs based on Shiller’s historical home price data since 1890), Pfau finds that with some moderate assumptions about future interest rate increases, the odds that the reverse mortgage produces more funds than just keeping the home exceeds 50% by age 82 and 90% by age 86!
4 Tips For Earning Credibility As A Young Professional (Laurie Belew, Investment Advisor) – Building trust with clients takes time, and while the industry has traditionally viewed having some “gray hairs” as a way to facilitate credibility and trust, Belew makes the case that age does not have to be a factor in the timeline for building trust. So how should younger advisors go about earning their credibility? Belew highlights four strategies: 1) really know your stuff, which in many ways is easier for a lot of today’s young advisors, who are entering the profession having already studied financial planning, earned a degree in it, and are getting the CFP certification at an early career stage (and if they’re not, Belew suggests that they should!); 2) act worthy of trust, by working hard to deliver on promises and exceed expectations, and recognize that professionalism is in the eye of the beholder, so you should be certain to communicate in a way that will engender trust to those being communicated to; 3) show initiative, as taking extra steps to build your reputation can be valuable not only to gain the respect of clients, but also your managers and/or owners of the firm; and 4) leverage your resources, recognizing that when clients trust the firm, they will tend to trust who the firm hires, and that can give you a head-start in earning your credibility with them, by simply focusing on living up to the professional expectations they already have of you.
The How and Why of Side Hustles for Financial Advisors (Kali Hawlk, XY Planning Network) – While the startup costs for advisor firms have become much less expensive than they once were, especially for firms prepared to operate virtually and can eschew the cost of a physical office, the greatest challenge is just filling the “income gap” that emerges between when the firm is launched and when the advisor ultimately has enough clients to generate a favorable income (which can otherwise deplete savings or force the new advisor to take on debt just to maintain personal living expenses). For many young planners today, the gap is being filled with “side hustles” – part-time work, often done on a freelance basis, that’s done on the side to help produce extra income (and can also potentially help gain some practical experience and expand your personal network). For some advisors launching a practice by departing an existing one, doing part-time work for the “old” firm can help bridge the income gap while the new one gets launched; for others, the side hustle has involved freelance writing projects, which also helped to build their brand and gain visibility to get future clients (a form of “getting paid to market“). Still others have tried writing financial plans for other firms as an independent contractor, doing part-time teaching on financial planning/literacy topics for a local community college, or becoming a financial planning research assistant. Of course, recognize that doing a “side hustle” – on top of trying to grow the business itself – does represent an extra commitment of time and effort… but then again, the fact that it takes some extra work is why it’s called a hustle in the first place! And for some advisors, having a side hustle can help to break up the monotonous difficulty of trying to build a practice from scratch.
Can Internal Succession Succeed? (Philip Palaveev, Financial Advisor) – Palaveev makes the case for the importance of advisory firms transferring by internal succession plans; just as in local neighborhoods, you want a majority of the houses to be occupied by the owners, who tend to invest themselves more into maintaining and advancing the community, so too does Palaveev suggest it’s important that most advisory firms remain owned by their advisors (and presumably, not by private equity or aggregators, or large institutional buyers). In many situations, though, the challenge is that the next generation (dubbed “G2”) can’t afford to buy the firm, and/or don’t want to take the risk, but Palaveev points out that it doesn’t necessarily have to be burdensome; as long as the deal is financed over a sufficiently long term, the after-tax profits of the firm should at least be close to servicing the obligation of the “succession mortgage”. In addition, succession plans can be implemented with a series of small incremental purchases rather than a potentially burdensome single large transaction; sales of a few percent at a time for the first 20%-40% of the succession transition can give the junior buyers experience and comfort to buy more, in addition to providing greater financial wherewithal to be able to do so (where profits from the early purchases help to fund the later transaction for the remainder). Alternatively, the firm owner could sell off a “moderate” chunk (e.g., 30% at once) but stay on board, helping both to facilitate the partial transition, and keeping interests aligned as both the original and new owners still have significant shares. In addition, Palaveev points out that some firms can simply employ a passive ownership strategy; as long as some of the firm has been transferred, the founder doesn’t necessarily need to sell all of it (after all, no one forced Bill Gates to sell all his Microsoft shares when he retired as CEO!), as the interests of the owners should still be aligned as long as the succession owners do have some material stake (though Palaveev suggests that passive owners should never be majority owners, or the working owners may grow to resent the situation, and that having a strong corporate governance structure is crucial to balance the interests). Other strategies to consider include: equity-based compensation (e.g., giving 1% shares as compensation each year, though Palaveev cautious such strategies can distribute ownership too widely); synthetic equity (e.g., compensation via stock options, phantom stock, stock appreciation rights, etc., which Palaveev also cautious against as being belittling and ultimately demotivating to future successors); and finding successors by acquiring smaller firms with young leadership that can rise up to drive both firms.
The Four-Letter Word that Kills a Financial Planner’s Hope of Earning an Honest Buck (Ronald Sier, See Beyond Numbers) – Sier believes that the best financial planners who make the biggest real difference in the long run are those who have turned advice into their real business, transitioning away from being product-selling-financial-planners into “meaningful” financial planners instead. Yet ironically, Sier notes that as many financial planners move away from a product-centric focus, they take on a highly negative reaction to the word “sell” (given all the negative stereotypes about salespeople), despite the fact that even as meaningful financial planners, it’s still necessary to be selling, even if it’s just themselves, their services, and their advice. Yet as Sier points out, there’s nothing inherently wrong with selling in the first place; the negative associations that most people have to selling is not actually to selling, but to bad selling or inappropriate products or something else fishy going on in the sales process. In fact, when people get a good service at a reasonable price to sold a real problem, it’s not a negative experience, but a positive one! Of course, even with positive outcomes, the reality is that often some persuasion is required, as people often need a little help to do what’s right for them (whether it’s fear of getting a shot from the doctor, or making an important financial change) and we’re all involved in selling/persuading others from time to time. Still, Sier suggests that as long as financial planners focus on ethical persuasion, there’s nothing wrong with this, either; it’s a win-win for the advisor and the client. And the key to ethical persuasion? Truly know your target clientele and what they need and that your solution is the right thing for them… and suddenly it won’t feel much like selling at all.
Beware The Honeymoon Effect (Julie Littlechild) – A recent study found that the so-called “honeymoon effect” is real, and that some people really do experience a love-induced euphoria early on that soon fades to a reality that is more harsh (and comes with much lower marital satisfaction). And as Littlechild points out, a similar effect can occur with advisors bringing on new clients, where early on nothing is too great an imposition, calls are returned quickly, and no one has made any mistakes… but eventually, the normal speed bumps of life crop up, and the positive aura can fade. Littlechild suggests that advisors can try to preempt this in the first 60 days by both having a clearly documented on-boarding process – so the advisor can ensure that the initial process during the formative trust stage goes as smooth as possible at least – and that additional actions to reinforce that the client made a good decision to work with you are a good idea as well, such as sending the client something tangible to welcome them (e.g., a book) or that a team member proactively reaches out to them when the first statement goes out just to be certain everything is clear. In addition, as with marriages, advisory relationships can also go astray if expectations are mismatched, so communicating with the client to define the services that will be provided, and documenting what’s been said, are crucial (Littlechild even offers a sample client service agreement). In addition, you may want to consider gathering client feedback with a 90-day survey, as “just” doing an annual survey may be waiting too long to catch clients who are becoming unhappy as the honeymoon glow fades (and again, Littlechild offers a sample new client survey). Of course, it’s also worth noting that the more clearly targeted the advisor is to a particular niche or type of clientele, the more likely the client will be a good fit and happy with the service in the first place!
Trust: A Factor In Portfolio Composition (Jacob Sybrowsky & Michael Finke & Hyrum Smith, Journal of Financial Planning) – Investing in equities requires a certain level of trust, both in the integrity that the financial system will provide a future payout for stocks, and also that the people (e.g., financial planners) the investor is working with are acting in their best interests to support their success. Accordingly, prior studies have found that those who are more trusting are somewhat more likely to invest in markets. In this study, the authors specifically examine whether trust in a financial planner can impact the allocations chosen by investors, and based on data from the National Longitudinal Survey of Youth (a dataset tracking individuals and their behaviors since 1979), find that trust does in fact impact equity allocations (separate from net worth and education, which are also positively associated with greater equity allocations). The significant implications of the research are that financial planners may be able to get clients more comfortable with equity investing by enhancing their trust, and that conversely seeking to understand a client’s general levels of trust in others may be remarkably predictive of their perceived risk of stocks and willingness to invest in them.
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.