Enjoy the current installment of "weekend reading for financial planners" - this week's edition kicks off with the big news that now Fidelity is throwing its hat into the "robo" ring, with a new automated investment advice solution called "Fidelity Go" that, like Schwab's own effort, will function as a distribution channel for Fidelity's own proprietary mutual funds for a portion of the investment assets. Also in the news this week was a settlement between Vanguard and the state of Texas driven by a whistleblower allegation that the company may be setting its costs at a below-market rate as a tax avoidance scheme (and raising the question of whether further tax-related lawsuits may eventually force Vanguard to raise its fees).
From there, we have a few technical financial planning articles this week, from a look at the ongoing rise of Deferred Income Annuities (also known as Longevity Annuities) and why advisors should consider them, to a discussion of why factor investing strategies (e.g., a value-tilt or a small-cap tilt) continue to persist despite the fact they are "known" and theoretically should be arbitraged away, a look at the "investment portfolio of the future" as advisors increasingly shift to "core" investing with index funds and "satellite" positions with an ever-widening range of alternative investments, and discussion of a recent EBRI study that found while retirement spending declines by more than 20% for nearly 1/3rd of retirees in the first 6 years of retirement, a material number of retirees increase their spending early in retirement (and not just those who are affluent).
We also have a couple of practice management articles this week, including: the latest Cerulli data, which finds that despite prior predictions, the number of financial advisors actually increases last year (albeit by just 1.1%) as large firms increasingly hire junior advisors to deepen their teams and formulate succession plans; a look at the importance of really asking your clients what they truly value, recognizing that what we think clients appreciate may not really be what they value most; and the last looking at how financial planning may change in the coming decade as technology increasingly impacts the way advisors do business and serve clients.
We wrap up with three interesting articles: the first looks at how the coming Department of Labor fiduciary standard could actually become a disruptive threat to RIAs (even as it benefits consumers), as RIAs simultaneously lose their differentiating fiduciary factor and face an onslaught of new competition from sales-oriented fiduciary advisors who may prove more capable at gathering clients and assets; the second is a cautionary note from former SEC Investment Management Division director Norm Champ about the problems that may arise if the SEC proceeds with its anticipated proposal to outsource RIA exams to a third-party examiner; and the last raises the interesting question of whether the entire retirement paradigm of "work now for financial freedom later" is the wrong approach, and whether a series of periods of work followed by periods of "mini-retirement" may ultimately be the more fulfilling "retirement" approach of the future.
Enjoy the reading!
Weekend reading for November 28th/29th:
With RIAs Deliberately Not In Mind, Fidelity Investments Launches "Fidelity Go" Robo-Advisor (Brooke Southall, RIABiz) - Late last week, news broke in the New York Times that Fidelity is joining the ranks of automated investment advice providers, with a new platform dubbed "Fidelity Go" in Fidelity's SEC filing. Unlike other "robo" platforms, though, Fidelity Go will not be purely passive; instead, it will use a combination of Fidelity mutual funds and Blackrock ETFs (and the Fidelity money market), and be managed by Geode Capital Management (a formerly internal active management subsidiary of Fidelity with almost $200B of AUM that was spun off in 2003). Notably, the launch of Fidelity Go for consumers doesn't change Fidelity's plans to launch a robo-advisor-for-advisors technology platform as well (as Fidelity's partnership with Betterment Institutional winds down), although critics point out that the Fidelity Go effort is still yet another instance of Fidelity competing at least partially against the RIAs on its institutional platform (although arguably it is more competition for other robo platforms like Schwab Intelligent Portfolios, Wealthfront, and Betterment). So far, Fidelity Go has solely been used internally by a few hundred Fidelity employees, with a $5,000 minimum investment required, and will be rolled out on a pilot basis in early 2016 to the public with an expected cost of 0.1% - 0.2% (on top of the underlying mutual fund and ETF costs).
Vanguard, Facing Whistle-Blower Cases, Agrees To Pay Texas Taxes (Jesse Drucker, Bloomberg News) - It has been several years since whistleblower David Danon, an attorney who served in Vanguard's tax department from 2008 to 2013, first alleged that Vanguard was underpaying taxes, and now the company has reached its first settlement agreement. In this case, Vanguard will pay several million dollars in back taxes (albeit without any penalties) to the state of Texas. The whistleblower issue has focused on the question of whether Vanguard is deliberately underpricing its services just to avoid generating a profit for tax purposes, particularly regarding the advisory support services that the Vanguard parent company provides to its mutual funds; Danon alleges that the agreements at being made "at cost" instead of priced based on an "arm's length" agreement as required under state and Federal laws for affiliated companies. Notably, in addition to making claims to the Texas tax authorities, Danon has also raised the issue with the tax authorities in California, the Internal Revenue Service, and the SEC. If additional tax authorities also begin to assess further taxes or potential penalties on Vanguard, it raises the question of whether the company will be forced to reprice some of its intra-company services to market rates, which could ultimately raise its mutual fund and ETF costs for consumers.
Why Advisors Should Use Deferred-Income Annuities (Michael Finke, Advisor Perspectives) - With the accumulation phase towards retirement, the time horizon is generally known (with a planned retirement date). But the fundamental challenge of the decumulation phase of retirement is that the time horizon is unknown, due to the uncertainty of longevity and when mortality may or may not occur. In turn, this leads advisors to just assume arbitrarily long time horizons in retirement, such as "assume everyone lives to age 95". Yet the problem of this approach is that assuming assets have to last so long - far past life expectancy - may unnecessarily curtail retirement spending in scenarios where retirees merely live to their life expectancy. For instance, a retiree who wants to spend about $45,000 at age 85 needs to set aside $25,000 today (assuming it's invested into a safe bond), even though there's only a 60% probability of living that long; on the other hand, if 10 retirees pool their money together, knowing that only 60% of them will need the payout at the end, then on average they only have to fund 60% of the retire goal per person, in order to cover it for all the survivors. And the later they payments go - and the lower the likelihood very many of them are alive - the less it takes per person to secure the payments for the group. This is the fundamental principle of an annuity, and in particular a Deferred Income (also known as a Longevity) annuity, and Finke notes that the implied mortality credits of the strategy can be vastly superior to fixed income bond portfolios, especially later in life. An additional benefit to the longevity annuity is that, when purchased inside of a retirement account (as a "Qualified Longevity Annuity Contract" or QLAC), retirees can also defer required minimum distributions as late as age 85 - and while it's not necessarily a good deal to buy a QLAC just to defer RMDs (at least compared to diversified portfolios - it's more compelling compared to bonds!), for those who value the longevity-hedging aspect for retirement income, the fact that the QLAC provides RMD deferral is a beneficial added kicker, especially at the highest tax brackets.
If Factor Returns Are Predictable, Why Is There an Investor Return Gap? (Jason Hsu, Research Affiliates) - While there is significant evidence to suggest that certain factors (e.g., small-cap, value) can effectively predict future market returns, the fact that such phenomena are known theoretically means that all investors should take advantage of the known opportunities and they should cease to work. After all, the data is fairly straightforward - when market valuation is at high or low extremes, it tends to mean-revert, providing 'clear' guidance about when to over- or under-weight, and the same appears to be true for other factors like value, small-cap, momentum, and low-beta (i.e., low-volatility). So why haven't these excess returns been arbitraged away? Hsu suggests that ultimately, the persistence of these factors is driven by the behavioral biases of investors - our tendency to overextrapolate the recent short-term into the long-term indefinite future, combined with herding behavior in short-term investing, "inevitably" causes prices to overshoot in one direction or the other, and then mean-revert (which creates the longer-term investment opportunity). And ironically, the fact that investors chase these factor phenomena in the short-term, and then periodically abandon them (in part because they overshoot in buying them in the first place), means the factors themselves are cyclical in moving in and out of favor (which, again, creates a persistent opportunity to buy/sell them at favorable times to earn excess returns). Hsu suggests that the cyclicality of factor returns is further emphasized in the institutional marketplace, which tends to hire and fire managers based on recent performance, inevitably further amplifying how factor trends move in and out of favor (over-hiring managers on an already favorable trend, and over-firing those in a 'temporarily' unfavored factor). In fact, Hsu ultimately suggests that it may be individual investors, who don't go through the cycle of being hired and fired (because they manage for themselves and not third parties), that may actually be best positioned to operate as a factor contrarian to take advantage of the market opportunities. Assuming, of course, that the investor doesn't fully succumb to the behavioral biases themselves!
The Investment Portfolio of the Future (Bob Veres, Advisor Perspectives) - As publicly traded markets get more and more efficient, advisors are increasingly adopting forms of "core and satellite" approaches to portfolio construction, where the "core" is a broadly diversified portfolio using low-cost index funds or ETFs, and the remaining "satellite" (which might only be 10% or 20% of the portfolio) are invested into various alternative investments (including not just alternatives like managed futures but also less liquid versions like direct real estate). Veres highlights one advisor who is implementing this approach using what he calls an "Opportunity Fund", arranged as a "3c-1" fund under the Investment Company Act. This structure can be used to create a form of private mutual fund, without going through the full registration process for investment companies, and where each client (up to 99) gets their own customized portfolio. Yet by using the mutual fund structure, with dollars pooled together, it becomes possible to more efficiently deploy into various sometimes-illiquid alternatives; for instance, the pooled dollars have more buying power when negotiating with managed futures fund managers or funds that invest into peer-to-peer small business loans, and can be deployed more efficiently to buy direct real estate investments or into angel investing opportunities. Of course, many of these are highly risky and often illiquid alternatives, but that's the whole point of investing in them in a pooled manner, to both support diversification and manage the investment/implementation costs (not to mention that the "Opportunity Fund" itself is only a small percentage of the client's total assets in the "satellite" portfolio). And with the recent JOBS Act loosening the rules for angel investing and crowdfunding, the phenomenon may become even more common. On the other hand, even with the 3c-1 fund wrapper for some efficiencies, it still has significant complexity to manage and implement, the value of the investments can be difficult to determine (which presents challenges in proper investment performance reporting for clients), and it may require a separate custodian that handles non-traditional investments like Millennium Trust Company, as typical custodians like Schwab, Fidelity, and TD Ameritrade may refuse to hold them.
In Surprise, Spending in Retirement Rises in Many Households (Danielle Andrus, ThinkAdvisor) - A recent study from the Employee Benefits Research Institute (EBRI) found that while the average household decreases its its spending by about 10% when transitioning into retirement and almost 15% by the sixth year, a material subset (46%!) actually increase their spending in the first two years of retirement. And by the sixth year of retirement, 1/3rd of households are still spending more than they were prior to retirement. Notably, the increase in retirement spending is not limited to affluent households taking advantage of their free time to become world travelers; EBRI found that the higher spending levels were distributed fairly evenly across all income levels. In other words, what EBRI found was that households engage in a wide range of trajectories with post-retirement spending; at the extremes, 1/3rd of households were spending more by the sixth year of retirement than they were prior to retirement, even as over half of households had already dropped their spending by at least 20%. When drilling down to the underlying expenses, EBRI found not surprisingly that the biggest drop in spending was for transportation costs (falling an average of 21% in the first two years of retirement), followed by non-durable spending (on goods like gifts, clothing, dining out, utilities, vacations, etc.) which declined an average of 16.5%. Notably, EBRI's data also found that the median mortgage payment in retirement was zero, suggesting that the average household still views paying off the mortgage as a retirement goal (or a moment when it's safe to transition into retirement).
Advisor Headcounts Rise After Years of Decline (Paul Hechinger, Financial Planning) - While the number of financial advisors has been in decline for nearly a decade (down almost 13%), the latest research report from Cerulli finds that the advisor headcount actually rose by 1.1% last year, from 305,610 in 2013 to 308,938 in 2014, which was the first uptick since 2005. In the near term, the shift to advisor growth seems to be driven by the ongoing expansion of team-based financial planning, particularly as larger advisory firms hire more junior/"rookie" advisors to support senior advisors, either to deepen client service for their top clients or to prepare for their own future succession plan. Also notable in the hiring trend is that 28% of new advisors are female, compared to only 14% for the industry as a whole, suggesting that gender demographics may finally be slightly improving. On the other hand, while the total advisor headcount rise, representation of advisors across the channels is still shifting, with a whopping 14% of wirehouse mega teams uncertain about whether they will remain in their firms over even the next 12 months (compared to just 5% of advisors at other firms). Cerulli also finds advisors are increasingly streamlining workflows and upgrading technology, both to refine their practices and possibly in preparation to retire out and sell the business. Overall, Cerulli now projects that the advisor headcount will continue to drift higher for the next 3 years, but will ultimately turn lower again in 2019 as the number of baby boomer advisors who retire begins to accelerate. On the other hand, an intervening bear market may still accelerate the declining advisor trend, both because down markets make some advisors just give up and exit their practices, and also because tighter revenues may slow the pace at which larger firms continue to hire junior advisors onto teams.
How To Understand What Clients REALLY Value (Julie Littlechild Blog) - Most advisory firms are created on the basis of a founder who has a vision of how to create value for clients, who goes out and builds a business to deliver on that value proposition. Yet as Littlechild notes, in the advisory world a surprising number of firms are all articulating a substantively similar value proposition to each other, and most such firms also try to articulate their value based on their own perspective (e.g., "industry-leading financial planning" or "gold standard service") rather than through the eyes of the client. And ultimately, Littlechild suggests that this may simply be because we're so focused on delivering services in a manner that's relevant to us (as the advisors) that we don't even fully appreciate and understand what clients actually value; for instance, Littlechild notes that in the end the value of her insurance advisor was not great service or a great product, but the fact that when she got sick the disability insurance allowed her to spend valuable time with family while she fought and recovered from thyroid cancer. So how can advisors surface these 'real' value insights from their own clients? The starting point is to ask them. Littlechild suggests asking a few of your clients to spend 15 minutes (e.g., at their next review meeting) talking about some of their greatest client experiences (outside of your own firm), to understand what they truly value. A deeper dive with some clients might also ask them why they actually selected you as an advisor, how they describe your services/value to others who ask for a referral, etc. The key is that you're looking for the ways your clients appreciate your value and describe it, outside of usual industry terms, that you can emphasize in your own marketing, and try better to deliver on within the business itself.
Veres: It’s The End of The World As Advisors Know It (Bob Veres, Financial Planning) - In this article, Veres aims to provide a glimpse of financial planning in the future, told through the eyes of "Rip Van Planner" who fell asleep in 2015 and awoke in 2022 to take a look around at what had changed in the world of financial planning. Significant shifts for financial planning in the future include: no more quarterly updates with clients, as account aggregation ensures all client financial planning and investment data is updated in real time to track progress towards goals; advisors are no longer paid based on commissions (that's only for salespeople), and the AUM model is declining as well, with advisors paid retainer fees billed directly out of the portfolio or for younger clients paid on a monthly basis out of their bank account instead; clients pay advisors primarily for the coaching and personal accountability when they're ready to get serious about their financial lives, not just for the financial projections that can be done in a spreadsheet or on a website; and clients engage with advisors virtually through online web tools, and use the web exclusively to search online to find an ideal advisor based on the advisor's specialization.
The New Financial Services Ecosystem (John Lefferts Blog) - For much of the past century in the financial services industry, insurance agents were insurance agents, RIAs were investment advisors, and stockbrokers brokered stocks, with little overlap from one to the next. Yet as all channels increasingly converge towards the delivery of advice, the lines are blurring, which appears likely to culminate in some sort of broad-based fiduciary standard (e.g., the widely anticipated Department of Labor rule to be issued in 2016). While the fiduciary-oriented RIAs have long advocated for this outcome, and for the most part are cheering it, Lefferts notes that some RIAs may regret what they've asked for, because a broad-based fiduciary standard also eliminates their fiduciary differentiation. As a result, while some of the lowest-quality "advisors" (product-centric brokers and insurance agents) may be forced out, the homogeneity of advisors all being fiduciaries after the rule is passed could actually result in an even more competitive landscape for today's advisors. And Lefferts suggests that in such an environment, today's RIAs may actually be the biggest losers in the future competitive battle, given that other segments of the industry have traditionally been more proactive and successful in sales and business development; if forced to do business development as fiduciaries, they may quickly begin to take market share back from the RIAs, particularly given today's dearth of young advisor rainmakers to be successors in RIAs. In other words, an aggressive new strain of "fiduciary salespeople" is about to be unleashed into the fiduciary advisor ecosystem, and it's likely to be disruptive; if RIAs want to compete in the future fiduciary world they have advocated for, the pressure may be on for them to seriously step up their marketing and business development capabilities.
Investment Advisers Don’t Need Mystery Monitors (Norm Champ, Wall Street Journal) - In recent testimony before the House Financial Services Committee, the director of the SEC's Division of Investment Management noted that the agency is working on a proposal to create third-party compliance reviews for registered investment advisers. The idea of the approach is not to fully replace SEC exams, but to supplement them, given that the SEC only examines about 10% of investment management firms each year. Yet as Champ (a former director of the SEC's Investment Management Division himself) points out, the SEC has gone down this road in the past - before the 2008 financial crisis, the SEC mandated that companies issuing securities use credit-rating agencies to sign off on the company's creditworthiness, and as we discovered when credit agencies are paid by the companies they're evaluating, they don't necessarily have the right incentives to deliver the harsh message of a poor credit rating. The outcome was so disastrous for the SEC that just a few years later, the 2010 Dodd-Frank reforms required the SEC to remove the credit-rating agency mandate from its rules, and set up a new regime for the SEC to oversee the credit-rating agencies as well. Similarly, in 2003 the SEC mandated that all investment-management firms vote each proxy for stocks held in their portfolios... which firms responded to by simply outsourcing the reviews of hundreds of proxies to third-party "proxy advisory" firms, and in the process created a duopoly of proxy voting as there were only two prominent proxy advisory firms with the scale to do the work (and now 10 years later, the SEC is working on new guidance to lessen the power of the duopoly). In this context, Champ suggests that the SEC's exploration of mandating third-party examinations risks going right back down this road of earlier failed attempts to outsource what should ultimately be a government regulatory function, given that outsourced exams mandated by the SEC would give the exam providers little incentive to produce quality exams or keep costs down, and similar to proxy advisory firms eventually risk a scenario where the examining firms develop their own agendas that have little to do with safeguarding investors. Ultimately, Champ notes that the most egregious problem with the proposal may simply be that the SEC is turning a blind eye to its own failings; with 450 examiners completing about 1,100 exams per year, perhaps its time for the SEC to focus on its own productivity problem, and figure out how to increase the examination rate above an average of just two exams per examiner per year?
If You Work Your Whole Life, You’re Doing It Wrong (Chris Reining, Mr. Everyday Dollar) - The classic view of retirement is that we work for 30+ years to save and accumulate for 30+ years of freedom in retirement; for those who want to retire early, they try to cram in even more work in the early years, and spend even less, to accumulate savings faster and have a longer period of post-work freedom. And arguably while either of these are better than just consuming everything you earn immediately and living paycheck-to-paycheck, Reining suggests that perhaps the "all work up front, all freedom later" isn't the best approach either. Instead, Reining suggests, based on the writings of Tim Ferriss (of "4-Hour Workweek" fame), that perhaps the ideal is a series of periods of work followed by periods of freedom, or what he dubs "mini-retirements" from time to time. The point is not just to be a vacation (which is too short), or a sabbatical (which is usually a one-time event), but instead to perhaps save up 1-12 months of spending money and then take time off from work to "go live your life", whether it's traveling someplace special, working on something special/important to you, or check off some bucket list item. Of course, the caveat is that with a series of regular mini-retirements, it may be hard to ever save for that final point of freedom from work. Yet as Reining notes, interviews with those who are dying and their regrets about working too much and not spending enough time enjoying life suggests that most of us might actually be happier with a lifetime of mini-retirements anyway?
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.