Enjoy the current installment of "weekend reading for financial planners" - this week's issue starts off with a summary of some of the final comment letters submitted regarding the SEC's request for information for a cost-benefit analysis about a uniform fiduciary standard. Why industry organizations like SIFMA and NAIFA indicated that a fiduciary standard would significantly increase compliance costs and force advisors to stop serving middle market clients, the results of a Financial Planning Coalition study found that fiduciary advisors generate significantly more revenue - suggesting that revenue growth could more than offset any higher costs - and that there are no statistically significant differences between the number of middle-market clients that fiduciary vs non-fiduciary advisors currently serve.
From there, we have a wide array of technical articles, including: a discussion of the ongoing Commission on Long-Term Care established by the American Taxpayer Relief Act to propose structural solutions to the country's long-term care challenges; a great overview of the coming new health insurance rules and how to start planning for them; a discussion of the importance of disability insurance for both clients and advisors themselves; a look from Ed Slott at how the Net Unrealized Appreciation strategy may be a little less appealing at today's long-term capital gains tax rates; and an intriguing analysis by Moshe Milevsky that in some circumstances equity-indexed annuities with guaranteed living benefit riders might actually produce slightly more income than a simple single-premium immediate annuity.
There are also a number of investment-related articles this week, from a review of recent applied research by Harold Evensky in the Journal of Financial Planning, to a discussion by Bob Veres of five new investment approaches being implemented by advisors that appear to have value, to a look at whether it's time to acknowledge that the efficient frontier of mean-variance optimization is more like an efficient "range" because ultimately neither the inputs to the model nor the preferences of investors are really as precise as a strict interpretation of Modern Portfolio Theory implies. There's also a good review of the recent Active Share research and why "hyperactively managed" funds may be best outperformers of all actively managed funds.
We wrap up with an article from industry veteran and luminary Richard Wagner, who suggests that financial planning could become the most important profession of the 21st century, as we human beings collectively become increasingly cognizant of the powerful role that money exerts in our lives, and the unique contribution that financial planners can bring to the table in helping clients to navigate those forces effectively. Enjoy the reading!
(Editor's Note: Want to see what I'm reading through the week that didn't make the cut? Due to popular request, I've started a Tumblr page to highlight a longer list of articles that I scan each week that might be of interest. You can follow the Tumblr page here.)
Weekend reading for July 13th/14th:
Fiduciary Duty Boosts Revenue, Not Compliance Costs: FPC - Last Friday was the deadline for comments to the SEC on its request for information about the costs and benefits of a potential uniform fiduciary standard, and the Financial Planning Coalition submitted its comment letter to the SEC encouraging the regulator to move forward on implementing a uniform fiduciary duty. Their comments were supported by an Aite Group study which found that 55% of RIAs and 46% of registered representatives acting as fiduciaries (i.e., hybrids) experienced more than 10% in annual asset growth from 2007 to 2011; only 29% of non-fiduciary registered representatives experienced such growth. The results were similarly favorable to fiduciary advisors over non-fiduciary advisors for revenue growth and growth in the amount of assets managed per client. The underlying point - serving as a fiduciary is a positive that boosts revenue, which contrasts sharply with the comment letter submitted from SIFMA that indicated its large member firms were facing increased compliance costs of $5 million annually to upgrade their compliance, supervision, and training systems, and NAIFA's comment that 84% of its members anticipate an increase in their compliance costs under a fiduciary duty; if the Financial Planning Coalition's results hold true across the industry, SIFMA's and NAIFA's projected cost increases could be far outpaced by higher revenue for those firms and advisors that would more than make up for the transition expenses. The NAIFA comment letter also claimed that its advisors would likely have to increase minimums and abandon middle-income investors under a fiduciary duty, yet the Financial Planning Coalition pointed out that under the Aite study, only 16% of RIAs and registered reps who transitioned to a fee-based business in the past 5 years dropped "mass market" clients with less than $100,000 in investible assets, suggesting that the challenges of serving the middle market are industry-wide and not unique to fiduciaries.
Long-term Care Clock Ticking For U.S. Congress - From Reuters, this article provides an overview of the Commission on Long-Term Care, a 15-person panel composed of nonpolitical healthcare experts whose job is to come up with new ideas about how to finance and deliver long-term care to the aging American (i.e., baby boomer) population, after the Community Living Assistance Services and Supports (CLASS) Act was repealed earlier this year. The panel has less than 3 months remaining in its term to come up with ideas for solutions, against a backdrop where the strapped Medicaid program pays for about half of all long-term care (but only for those who spend themselves down to indigent levels), Medicare provides limited coverage for skilled nursing care, and the long-term care insurance industry struggles with carriers leaving the market and policy prices that are up about 20% from just last year. The challenge, of course, is that many of the potential solutions are from polarized opposite extremes of the political spectrum, including at the most basic level whether the approach should be driven by government-sponsored social insurance programs or a more private market approach (or most likely, a hybrid of the two). There are a few promising ideas coming forth already, though, including simplifying insurance options (long-term care choices are very complex, and could be simplified with a standardized, limited set of product options, which was found to be an effective approach with Medigap policies), offering coverage as an option attached to private Medicare plans (making it easier to administer, and providing some synergies because health plans would be encouraged to manage seniors' chronic conditions better to keep them out of nursing homes attached to the same plan), and adding long-term care protection to social insurance programs (with a modest premium or tax that applies to everyone, theoretically keeping costs down through universal coverage), though this last option of expanding social insurance programs may be less likely in today's political environment.
A New Way Of Thinking About Employer-Sponsored Health Care Coverage Strategies - From the Journal of Financial Planning, this article looks at the ongoing impact that the Affordable Care Act and the upcoming insurance mandates - particularly the employer "Play or Pay" rules - are having on health care costs and the health insurance marketplace. One of the big trends in recent years has been rising premiums for health insurance, especially since the Affordable Care Act was passed, which the author attributes rather directly to a series of cost control limitations that were eliminated by the legislation; for instance, effective in 2010 insurers were prohibited from requiring cost-sharing for preventive care services, and were required to extend dependent care coverage to a wider range of ages, and notably some of the most significant rules changes (such as the prohibition against any pre-existing condition exclusions) don't take effect until 2014. Yet at the same time, these eliminations were intended to be offset by mandating coverage for a larger number of Americans, hopefully adding more healthy people to the ranks of the insured to offset some unhealthy individuals who might begin to get coverage, such as the "Play or Pay" tax for large employers. The article provides detail on the Play or Pay tax, along with the coming new health insurance exchanges, qualified health plans, and essential health benefits, and more. Ultimately, employers will have many decisions to consider from here, ranging from continuing to offer current coverage as is, switch plans or change employer contributions, drop coverage and pay the penalty (with or without adjusting employee salaries to compensate), or self fund. Advisors will increasingly face these conversations with employer clients (and sometimes their impacted employees) in the coming months and years.
Disability Insurance: Are You Protected? - This article from Financial Planning magazine provides a good reminder of the importance of disability insurance, not only for clients but for advisors themselves. From the advisor context, the reality is that with so many firms that are sole proprietors or small partnerships, a disability - and the value of disability insurance - is important not just for maintaining the family's standard of living, but can also be the difference between survival or collapse of the business as well, either by providing payments to support the business or at least providing enough support to the advisor that the income of the business can be reinvested into the firm to keep it afloat during the recovery period. For those who wish to specifically support the costs of the firm, consider business overhead expense insurance in addition to personal disability insurance protection (though advisors often face extra scrutiny in underwriting because of their knowledge of the products and potential for abuse). Notwithstanding the importance of disability insurance - as disability is the top reason for foreclosures and bankruptcies, and for most people their career and human capital is their single largest asset - adoption of disability insurance is still low, with only 25% of American workers having coverage (and most of that through less favorable employer group plans). Much of the shortfall is driven by the sheer cost, which may be 2% to 4% of the individual's income to cover about 60% of earnings (which is paid on an after-tax basis), as well as stringent underwriting (which often requires shopping amongst multiple carriers who treat health conditions differently). Yet the bottom line is that one of the main reasons disability insurance coverage is expensive is that it's so likely to be used (far more than life insurance for younger adults in particular), but that's also why it's so necessary.
New Approach To A 401(k) Tax Tactic - In Financial Planning magazine, IRA guru Ed Slott looks at the popular retirement planning strategy of extracting employer stock from a qualified plan to take advantage of the Net Unrealized Appreciation (NUA) treatment, and notes that with the onset of the new 3.8% Medicare tax on net investment income this year, the tactic has become a little less appealing than it once was. The problem is that withdrawals from employer retirement plans are not directly subject to the 3.8% surtax - they're not treated as net investment income - while the gains from NUA are potentially subject to the tax (not to mention the new, higher 20% maximum capital gains rate that also took effect this year under the American Taxpayer Relief Act). Thus, while last year the opportunity was to trade a maximum ordinary income rate of 35% for a 15% long-term capital gains rate (a difference of 20%), this year it's a top 39.6% ordinary rate versus a 23.8% maximum capital gains rate (a difference of only 15.8%) as the top capital gains rate has effectively risen by nearly 50%! Ultimately, the spread between ordinary income and capital gains remains - it's smaller, but it's still valuable - so the NUA strategy isn't entirely dead. But a more client-specific analysis will be necessary, that really delves into how much appreciation there is for the stock (if the tax rate spread is 15.8% but the stock has limited appreciation to begin with, there's just not much savings on the table) and what the client intends to do with the proceeds (how much time would there have been to earn tax-deferred growth just keeping the money inside the plan?). Slott's conclusion: the greater the appreciation, and the sooner the client may need the money, the more NUA remains relevant (especially if the client can otherwise navigate the four capital gains tax brackets to avoid the top 23.8% rate).
Annuity Anomaly: EIA + GLB > SPIA? - In Research magazine, retirement "quant" Moshe Milevsky looks at today's marketplace of equity-indexed annuities (EIA), especially those that are combined with guaranteed living benefit (GLB) riders (as now nearly 75% of all EIAs include a GLB), and comes to a surprising conclusion: in some cases, due to what appears to be a pricing 'anomaly', with the right combination of age and need the EIA + GLB can actually produce income that is comparable or even superior to a single premium immediate annuity (SPIA). The essence of the EIA + GLB is similar to a variable annuity with a guaranteed living withdrawal rider; in both cases, the client contributes a lump sum with the insurance company and the money is invested (though the actual investment of the cash value is different, as with a variable annuity the funds are invested in underlying subaccounts and the insurer must set aside reserves to provide for the guarantee while with an EIA the insurer keeps the assets in its general account and simply uses a portion of the funds to buy options derivatives to provide the upside). From that point forward, the company tracks both the cash value of the annuity and the level of a hypothetical "benefit base" against which future retirement income can be taken. Yet when Milevsky crunches the numbers, the conclusion is that in some cases an investor who buys a SPIA that will begin in a few years actually gets less income than the EIA with a GLB, which is even more notable given that the EIA still has some upside (albeit limited) until income begins, and furthermore than the EIA is still liquid until income begins (albeit still impacted by surrender charges, but that's still far more liquid than a SPIA that has no cash value!). Ultimately, which solution comes out ahead still depends on specific contracts and ages, though in general Milevsky finds that EIAs has the potential to be superior for those in their 50s and 60s, while SPIAs begin to clearly dominate for those in their 70s and beyond. So how is this possible? Milevsky posits that the EIA benefit comes in part from lapse-supported pricing - the guarantee is slightly more favorable for an EIA + GLB because some people will liquidate the contract without using the GLB, while everyone who buys the SPIA will use it because they're locked in at purchase; in addition, SPIAs price at very specific ages, while EIAs with GLBs price in bands that may slightly favor a particular age. In the end, Milevsky notes that VAs are often still superior to EIAs in this context of retirement income, but for those considering SPIAs, an EIA with a GLB should at least be evaluated for comparison.
New Research May Spur Changes to Investment Strategies - In the Journal of Financial Planning, financial planner Harold Evensky highlights a series of recent applied research articles related to investment strategies that may be of interest to advisors. Top articles from late 2012 and early 2013 include: Wade Pfau's "A Broader Framework For Determining An Efficient Frontier for Retirement Income" (previously reviewed in Weekend Reading) which examined how to balance retirement solutions amongst total return portfolios, single premium immediate annuities (SPIAs), inflation-adjusted SPIAs, and variable annuities with guaranteed income riders; David Blanchett's "When To Claim Social Security Benefits" on Social Security optimization strategies; Gregg Fisher's "Dividend Investing: A Value Tilt In Disguise" (also previously reviewed in Weekend Reading) which suggested that the benefits of high dividend stocks may be nothing more than a value tilt (and that after controlling for value, a dividend tilt was actually negative!); "Shedding Light on 'Invisible' Costs: Trading Costs and Mutual Fund Performance" by Edelen, Evans, and Kadlec, which found that many mutual funds have trading costs almost equal to their expense ratios (and with greater variability), but that measuring the cost requires a deeper analysis than just looking at fund turnover; "The Arithmetic of Investment Expenses" by William Sharpe which suggests that investment expenses should be considered by looking at the ratio of final wealth of high-cost versus low-cost options (the differences are very noticeable after years of compounding); and finally "Adding 'Value' To Sustainable Post-Retirement Portfolios" by Gupta, Pavlik, and Synn, which looking at adding a tactical overlay to a strategic portfolio based on valuation-based factors that tend to mean revert (e.g., price-earnings, price-to-book, and price-dividend ratios) and found that the adaptive strategies provide superior results to the passive, strategic approach.
The Five Best New Investment Ideas - Advisor conversations increasingly are referring to Modern Portfolio Theory as outmoded, old-school, or outright irrelevant in today's investing environment, yet beyond paying more attention to the news and potential downside risk, it's not clear what most advisors are actually doing to change their investment process. In this Advisor Perspectives article, Bob Veres highlights the best five "New Age" investing ideas he's heard amongst advisors so far. The first is from Jerry Miccolis at Brinton Eaton, who has adapted his use Modern Portfolio Theory to rely on more dynamic inputs that acknowledge things in the world are always changing, and therefore that things like volatility and correlations must be continuously monitored and updated - an insight that is long since accepted in the corporate world (where Miccolis previously worked and published on Enterprise Risk Management), but is still rather new to being implemented in the portfolio context. Ken Solow of Pinnacle Advisory Group has a somewhat similar approach, labeled as "tactical asset allocation" where the asset allocation is adjusted dynamically based on changing market conditions, including and especially managing the volatility of the overall portfolio and adjusting it upwards and downwards as volatility rises and falls in the markets. Mark Toborsky at Blackrock looks at diversifying beyond just the 'traditional' asset class volatility approach, instead diversifying amongst the underlying risk factors from duration to equity risk to economic changes to currency and interest rate shifts (diversifying amongst these is notable because some of them might impact multiple asset classes at once, revealing a traditional asset-allocated portfolio is not actually all that well diversified). Stephen McCourt of Meketa Investment Group uses scenario planning to understand what needs to change in the portfolio to make it more durable, and Patrick Geddes of Aperio Group is focusing on creating portfolios by investing in a subset of the highest quality companies within broader indices.
End The Charade: Replacing The Efficient Frontier With The Efficient Range - From the Journal of Financial Planning, this article puts forth the concept that instead of trying to identify portfolios that lie on the efficient frontier under Modern Portfolio Theory, that instead we should view portfolio design as targeting an efficient "range" that is close to the frontier but will never be exact, due both to the fact that our estimates of return, volatility, and correlation are not entirely precise anyway. The article notes that in many ways, this has always been done, as few advisors and investors actually implement the exact portfolio implied by the mean-variance optimization process, which often has allocations perceived as extreme to a small subset of asset classes (and can be extremely sensitive to small changes in the inputs); instead, the outcomes are constrained until the portfolio is more diversified and appears more desirable, which raises the question of whether the whole process was a charade to begin with. Of course, even Markowitz as the founder of mean-variance optimization has long noted that portfolio design is more than just the mathematical optimization alone and that applying judgment in necessary. In addition,the reality is that many investors have preferences a bit more complex than just maximizing return and minimizing volatility, from tying investments to goals, to socially responsible investing (which limits the field of available investment choices), to outright investment biases (like the preference for investors to overweight allocations to their home country relative to foreign stocks). Ultimately, the article doesn't really delve into how to construct "efficient range" portfolios, but instead simply tries to acknowledge that advisors who are currently building portfolios near the efficient range should not feel guilty for violating the tenets of Modern Portfolio Theory and in fact are executing a reasonable portfolio construction approach.
Why Hyperactively Managed Funds Outperform - From Research Magazine, Texas Tech professor Michael Finke looks at some recent research from Antti Petajisto on active management, finding that - despite some popular notions - some active managers really do provide value, albeit from amongst a crowd of other managers that don't do much but charge higher fees for index-like performance (dubbed "closet indexers"). In fact, the key distinction between the good managers and the bad ones was how active they actually are, and in particular by how much they are willing to deviate from their benchmarks (labeled "active share"); when Petajisto (and co-author Cremers) look at managers based on their active share, the surprising results was that the most active managers did in fact generate alpha net of management fees, even though the majority of funds remained closet indexers that underperformed. And not only was active share from a manager associated with outperformance, but the researchers found that active share persists, too; in other words, funds with high active share today are significantly more likely to have high active share in 5 years (and continue to outperform other active funds). Notwithstanding this value of the most active of active managers, the question arises as to why so many mediocre fund managers that hug their index are allowed to remain; why aren't investors just buying the highest active share funds, or a straight low-cost index? Some research suggests it may be related to marketing; excess performance attracts cash, but then investors become less return sensitive, which means some managers with big early wins are incentivized to start hugging the index once the fund grows. While some of the conclusions about active share are still being debated in the research, the initial conclusion at the least is that while high active share may or may not add positive alpha, paying active management fees for low active share clearly results in negative alpha.
Financial Planning Saves The World - From industry veteran and luminary Richard Wagner, this article posits that the financial planning profession could be the most important authentic profession of the 21st century. That's not to say that the value of recognized professionals like doctors, lawyers, and theologians don't matter - along with a whole host of other people who bring value to the world - but Wagner notes that money, and our relationships to money, spans across and transcends above all these other professions, which in turn means "they" (all other professions) need "us" (financial planners). And as history (and a rising segment of psychology) has shown clearly, establishing a healthy relationship with our financial resources is not something that comes naturally to us; we all need some professional assistance in this regard. Getting help is important, too, as unhealthy relationships with money can be connected to waste, violence, antisocial behaviors, and a whole host of other problems, and they are problems largely ignored by macroeconomists who merely view human beings as units of consumption, not the complex individuals with needs, wants, goals, and values, as financial planning inherently views them. Wagner recognizes that for many existing financial planners, these may not have been the weighty responsibilities that they first signed up for, but it doesn't matter at this point; the profession is advancing beyond its low-responsibility sales roots, at the same time that rising economic affluence is making money more central in the lives of almost everyone (at least relative to our roots of centuries and millenia past). So where do we go from here? Wagner suggests that we need to get better at recognizing the force and impact that "modern" money has in our world, and that financial planning has a unique and crucial role to play in saving the world from the disasters that otherwise occur when the forces that money exerts go unmanaged.
And although it's not specifically included here for Weekend Reading, I'd also highly recommend checking out Bill Winterberg's "FPPad" blog on technology for advisors, including his weekly "FPPad Bits And Bytes" update on tech news and developments!
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!