Enjoy the current installment of “weekend reading for financial planners” – this week’s reading kicks off with a discussion from Mark Hurley about whether it will soon become a lot more expensive for advisors to acquire clients, whether through popular custodian referral programs or other channels.
From there, we have several financial planning technical articles this week, including a look at whether the shortfalls in the Social Security disability fund may prompt Social Security reform sooner rather than later, whether income-oriented portfolios increase or reduce the safe withdrawal rate, another way to look at why it’s beneficial to delay Social Security benefits, a discussion of “DING” and “NING” trusts used to avoid state income tax liabilities for clients in high-tax-rate states, a look at how the new cost basis reporting rules are shaking out after the first several years, and a roundtable discussion from the Journal of Financial Planning about the new health insurance exchanges and how they’ll work.
We wrap up with three interesting final articles: the first is a blog from Angie Herbers about whether the tendency for advisors to form 3-person teams may be contributing to young employee turnover (as the saying goes, “three’s a crowd” and it may apply in advisor firms, too!); the second suggests that the real problem for many overspending clients is that they’re spending too much money having people do things for them; the third is an interesting interview with Vanguard founder Jack Bogle (who is as spirited as ever in criticizing the financial services industry and suggesting reforms); and the last is a good reminder that notwithstanding all the great advice planners give their clients, many could stand to take their own advice a little more often as well, or ever consider hiring their own planner to get a helpful nudge! 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 September 7th/8th:
The Gathering Storm – In this article, Mark Hurley of Fiduciary Network looks at how the cost for advisory firms to capture new clients may soon be about to rise, especially for the subset of firms that have been actively generating new clients through referrals from the branch networks of the big RIA custodians. While in the early years generating clients through custodial referrals have been big business, as the channel shifts from being an innovative approach to a more competitive one, the dynamics may look more like the mutual fund business, where early on mutual fund companies had lucrative management fees and often kept a portion of the upfront sales loads as well but now keep none of those loads and may have to rebate as much as 80% of their management fees just to be considered; at this point, one asset management firm has suggested it takes $40 billion of AUM just to break even on marketing to the wirehouse channel (which makes it almost impossible for newer, smaller mutual funds to succeed in the space). Similarly, while participating in custodial referral programs was free early on, now many charge the greater of 0.25% of client assets or 25% of management fees in perpetuity, and on top of that firms must increasingly hire dedicated teams of marketers to call on the branches just to stay competitive. One firm is now waiving the client’s entire first year fee just to have a chance at the business (in addition to what must be paid to the custodian). On the other hand, given the ultra-low client turnover of advisory firms, this is arguably still very profitable in the long run for the firm, but it does represent a new progression in the competitiveness of the space. The end result of this trend will be a squeeze on the profit margins of custodial referrals, and while it may take several years to play out, Hurley predicts that net pricing for the channel will soon collapse to the point that only large firms that can generate sufficient volume will find it economically viable, and may itself be a precursor to more competitiveness for clients in other channels as well. The bottom line: the most successful firms will accept this inevitability, and view the coming changes as an opportunity to establish other competitive advantages.
Disability Is The Other Social Security Fight We Need To Have Now – From Reuters, this article by Mark Miller makes the point that while there is a lot of concern about Social Security retirement benefits and the associated trust fund being depleted sometime around 2035, there is a more immediate problem: the Social Security disability benefits trust fund depletes in 2016, and if nothing is done the end result would be an immediate 20% cut in benefits to about 9 million disabled people and an additional 2 million dependents (the other 80% of benefits would still be paid from current payroll taxes). The “fix” for the problem is relatively straightforward: Congress can simply reallocate a small portion of payrollt ax revenues from retirement to disability, and shifting just 0.1% of revenue would equalize the long-range outlook of the disability and retirement trust funds (notably, they’d both still be scheduled to run out, but at least they’d both have until the 2030s before doing so, allowing for more time to craft a more comprehensive long-term solution). However, it’s not clear whether the fix will be so easy to pass in Congress, as some are raising questions about whether the disability program is running amok with out-of-work baby boomers claiming fraudulent disability benefits while they wait for their retirement benefits, with 9 million disabled workers now, up from only 5.9 million a decade ago. On the other hand, it may simply be that the baby boomer demographic overall has reached the age where it’s most likely to be disabled, and the increase may be less a matter of fraud and more a simple issue of a large segment of the population aging. In any event, stay tuned, as this will have to be a discussion in Congress by the end of 2015 to avert the cutoff in disability benefits (or otherwise reform the program).
Do Income-Oriented Portfolios Reduce Safe Withdrawal Rates? – On Advisor Perspectives, Geoff Considine digs into the interesting question about whether income-oriented portfolios (as opposed to those focused on total return) may actually result in lower safe withdrawal rates, despite their intuitive appeal for consumers. The basis for total return portfolios dates back many decades, to the idea that investors should be indifferent to whether their returns come from price gains or dividends, as long as the company reinvests the capital for productive use and/or simply uses the cash flow to buy back shares instead of just paying it out. Considine suggests there is an important difference, though – that because dividend payments tend to be more consistent, there is less estimation risk; in other words, there is less of a danger of predicting a widely inaccurate return where there is an underlying dividend cash flow than when there is not. Accordingly, Considine tests out three different portfolios: one built on a classic total return approach, the second using predominantly high-dividend ETFs, and the third that aims for a minimum cash flow yield of 5% and then maximizes the return with whatever is left. Notably, using this approach, the total return portfolio does in fact sustain a higher safe withdrawal rate (4.15%) than the maximum yield portfolio (only 3.55%). However, the total return portfolio has more estimation risk than the yield portfolio; the latter starts out at a 5.4% yield initially, which gives it a reasonable expectation of an approximately-5.4% yield next year (though a large portion of that yield must be reinvested over time to keep up with inflation), while in the case of the equity portfolio the fact that it may have a three-year average annual total return of 17.7% says remarkably little about its expected return next year or in the long run. Of course, this greater estimation risk is arguably part of why equities have a higher expected return in the first place, but Considine nonetheless raises an interesting point about whether this is given enough credence when discussing with clients.
Do Not Invest Social Security Benefits – The decision about when to take Social Security benefits is increasingly popular, as clients consider whether to spend from the portfolio and delay benefits, or draw on benefits early to preserve the portfolio or even add to it. Given that the average client will live to approximately age 84, and over that time horizon the benefits are adjusted to be actuarially fair, it turns out that the implied risk-free real return underlying Social Security benefits is about 3% (in other words, no matter when the client starts between age 62 and 70, if the client lives to age 84 they’ll end out with approximately the same cumulative amount if it grows at a 3% real return). The challenge in today’s environment, though, is that the real risk-free rate isn’t 3%, it’s close to 0% (especially with any drag for investment expenses); accordingly, the only way a client can possibly achieve the requisite return is with a highly equity-centric portfolio, which itself is very risky (and the return outlook for equities isn’t great, either). Given this return outlook, the author argues that clients can’t possibly generate a reasonable risk-adjusted return to match the implicit real return they would be getting from delaying Social Security (at least if they have an average life expectancy), and as a result should avoid taking benefits early to invest them.
Gimme Shelter – In Financial Advisor magazine, this article looks at the income tax planning strategy of “DINGs” or Delaware Incomplete gift Non-Grantor trusts. The basic goal of such trusts is to shift investment income from a high-tax state like California into a state that doesn’t impose income or capital gains taxes on trusts for out-of-state beneficiaries (as is the case in the aforementioned states); at the margin, this can save clients on upwards of 10% state income tax rates. A recent IRS ruling has opened the door for Nevada to create similar trusts (dubbed the “NING” for Nevada instead of Delaware). The strategy is generally only relevant for those with multi-million dollar investment portfolios; for instance, a $5 million portfolio with 6% in taxable interest, dividends, and capital gains faces $300,000 of income and a potential $30,000 state tax liability (at a 10% rate), which makes it worthwhile to go through the costs of setting up the trust (especially if it will compound for several decades). To make the strategy work, though, the trust must not be a grantor trust (or it would still be taxed in the grantor’s home state); instead, it must be a non-grantor trust, which also typically means the client must relinquish at least some control over the trust assets. Of course, too much control can trigger income tax consequences, and a series of private letter rulings over the past decade have varied in their views of whether the strategy could legitimately avoid the gift tax liability while achieving the income tax goals. Recent PLRs in 2013, though, appear to be leaning in favor of DING/NING strategies when structured with the proper limitations. Notably, many of the trust companies that facilitate these trusts have open architecture to work with advisors, allowing the advisor to continue to manage the account on behalf of the trust, even while achieving the client’s income tax benefits/goals. However, given that in the end states don’t have to rely on IRS private letter rulings, and there are still significant upfront costs to the strategy, clients will probably not find the risks and costs worthwhile unless trust assets are significant.
The Brave New World Of Cost Basis Reporting – From the Journal of Accountancy, this article provides a good overview of the current state of the cost basis reporting rules, which require brokers and custodians to report to investors (and the IRS) the cost basis and gains and losses of the investments sold in their portfolio. However, the requirement has been phased in over time, which in turn has created additional confusion. As it stands now, “covered securities” – which must be reported on – have included equities since the start of 2011, mutual funds since 2012, and although the requirement for “the rest” (including debt instruments, options, and other complex investments) was originally supposed to kick in for 2013 it was delayed and will take effect in 2014 instead (with a few especially complex securities like STRIPS, convertible bonds, foreign debt, not covered until 2016). The end result is that advisors and their clients now have to break investments into numerous “buckets” – including short-term gains/losses of uncovered securities, short-term gains/losses of covered securities, long-term uncovered securities, and long-term covered – each of which are reported on a separate Form 8949 that supplements Schedule D (with additional versions for short- and long-term investments that were sold outside of a brokerage account and not reported on Form 1099-B). Additional complications arise in the case of wash sales (where brokers/custodians may not know about adjustments due to wash sales in other accounts), and publicly traded partnerships (where the brokers/custodians won’t know the true cost basis because they don’t have all the accounting data for partnership adjustments to basis); short sales closed out at the very end of the year may also be reported for the wrong year by the broker (based on the settlement date after December 31st, even if the trade occurred before December 31st). In the long run, most clients will likely have covered securities and the rules will be simpler, but for the time being the complexity will remain, and erroneous and “corrected” Form 1099-Bs may still be coming for several more years while all the reporting rules are worked out.
What You Need to Know about the Affordable Care Act and Health Insurance Exchanges – From the Journal of Financial Planning, this article is a roundtable interview with several experts regarding the Affordable Care Act, the upcoming launch of the new Health Insurance Exchanges, and how it will impact planning for clients. The new rules will present several new choices for clients to consider about buying their health insurance, and will introduce new tax planning opportunities for clients to try to maximize their premium assistance tax credits. Initially, most clients won’t be impacted, as the group insurance marketplace for large employers – where most get their coverage – will not change much, though clients in the small business environment, the uninsured, and those who wish to retire early and bridge the gap until Medicare begins will find new opportunities to get insurance on the exchanges. The health insurance exchanges themselves – one for individuals, and another for small businesses – are essentially online marketplaces where consumers will be able to shop for and purchase their insurance coverage, with the hopes that such an online environment will make it easier for consumers to shop and compare and increase the competitiveness of coverage. For the uninsured in particular, health insurance exchanges will also be the way they avoid the “individual mandate” – a new penalty tax that will apply for those who don’t get health insurance. Policies on the exchanges will be required to offer minimum essential benefits, be guaranteed issue, and have unlimited lifetime coverage, which will introduce new planning flexibility for clients but also make the coverage more expensive; limitations on how much more older people can be charged relative to young people means that the pricing may ultimately end out being more favorable for those in their 50s and early 60s, but pricier for those in their 20s and 30s. In the near term, as the insurance exchanges open on October 1st, advisors can check out the cost of coverage for clients in their state by going to www.HealthCare.gov.
One Reason for Young Advisors’ High Turnover Rate: Triangulation – From Angie Herbers on the ThinkAdvisor blogs, this article looks at how just with couples, two’s company and three’s a crowd, so too is the situation in advisory firms where often one senior advisor is supported by two associate/junior advisors. The problem that emerges is inevitably, the senior advisor forms a stronger bond with one advisor over the other, and the “left out” advisor feels slighted and leads to turnover (or alternatively, the two junior advisors form an “alliance” against the firm owner, which doesn’t end well, either). Some advisors suggest that being the senior in the midst of two juniors allows them to be the “objective” third party that can help settle disputes, but Herbers suggests that the advisor not well trained in mediation is as likely to end out in the middle of the dispute as resolve it, especially since they’re often not “disinterested” parties to the matter themselves. So what’s the solution? Herbers suggests a better team approach is a “diamond” structure, with one senior advisor, two lead advisors, and only one associate. Notably, although there are more people involved and potentially more feelings to be hurt, Herbers finds that the dynamics just aren’t the same with a four-person diamond; at worst, if two team members bond, the other two can bond as well, and there’s not a solo person left on their own (and if a problem arises, it’s hard to dismiss an issue raised by “half the team”). The bottom line: as advisors grow their practices, it’s important to pay attention to the personal dynamics, not just professional development and client service, and focus on teams of two or four, but not three.
What to Ask When Clients Overspend – This article makes the interesting point that for a lot of clients with spending issues, their challenge stems from having a high “GTIR” or “Guy-To-Income-Ratio”. In this context, the term “guy” is not meant to be gender-biased, but simply refers to any person, male or female, your client pays to perform a task they prefer not to do. For instance, why does the client’s car always look so neat and clean? If the client responds “I’ve got a guy for that; he comes over every Saturday morning and does the inside and out right in my garage for $75” there might be a GTIR problem, especially if there’s also a “guy” for mowing the lawn, cleaning the house, organizing events, washing windows, house-sitting dogs, manage the pool, etc., etc. The author suggests that as baby boomers became more affluent, they significantly increased their GTIR – in a manner the generation that lived through the Great Depression never did – and it’s driving the baby boomer retirement shortfall. While having a “guy” for lots of things may be fine and affordable for very affluent clients, when there are half a dozen or more “guys” for a client who’s only earning $60,000 per year, it’s a significant problem. So the next time you’re talking to clients who can’t figure out why there’s never much money left at the end of the month, consider asking if there’s a GTIR problem.
A Legend Still Pines for the Good Fight – From MorningstarAdvisor magazine, this article captures an interview from the 2013 Morningstar Investment Conference between Don Phillips and Vanguard founder John (Jack) Bogle, who despite all his years and successes still sees ample opportunities for financial services reforms. For instance, Bogle suggests that money market funds should have an NAV that starts at $10 but is allowed to float, to reduce the risk that taxpayers might end out being forced to bail out a money market fund crisis. In terms of retirement, Bogle sees three issues: the underfunding of Social Security (Bogle advocates changing the cost of living adjustment, along with a slightly older retirement age), the “grotesquely” underfunded defined benefit plan (states more of a concern than corporations) still relying too often on an 8% future return, and the difficulties with defined contribution plans (Bogle suggests they should be made less flexible to eliminate the temptation for using the funds inappropriately). Of course, Bogle also advocates seeing more index funds in retirement plans as well, to help keep the costs down; Bogle is generally supportive of target date funds as well (given many have low, index-fund-like costs), but notes that the target date fund glidepath may not be appropriate given the implicit value of Social Security benefits for most retirees. Bogle also speaks to the problems of executive compensation in corporate America, and suggests that its shareholders – including and especially the fund industry itself – that is failing in their implicit obligation to speak up, and also that the fund industry may be getting so complex their boards may not even be able fulfill their own fiduciary oversight obligations. Notably, a few of these positions actually disagree with Vanguard itself (for instance, the company recently advocated on behalf of a steady $1 NAV), but Bogle simply points out that he’s standing for what he believes in.
4 Ways Advisors Should Take Their Own Advice – This article makes the important point that notwithstanding all the valuable advice that financial planners provide to their clients, they often overlook the same issues in their own financial, professional, and personal lives. For instance, many advisors go independent to control their own destiny, maximize the return for building their book of business, and monetize their practices at the end, yet the overwhelming majority of planners are neglecting their own succession planning, despite how planners often urge their own small business clients to focus on the issue. Similarly, while advisors routinely emphasize the importance to clients of saving and reinvesting for long-term financial success, advisors too often fail to sufficiently reinvest into their own business’ people, processes, and protocols (e.g., by hiring lower-wage or temporary staff that maximize short-term profit but leave the business with a weak infrastructure for the longer run). Another challenging area is that while planners, by virtue of their business and profession, routinely craft financial plans for their clients, few have engaged a planner themselves to help with their own comprehensive wealth management, allowing potential key areas in life insurance coverage, asset protection, and tax and estate planning to be overlooked. And finally, despite the fact that planners are so focused on helping clients articulate their goals in order to craft a plan to pursue them, the author laments that few planners can effectively focus themselves and articulate their own goals. Ultimately, more planners should perhaps consider taking some of their own advice: if these critical professional and personal items can’t get taken care of, write a check and have a skilled financial planning professional help do them for you… even if you’re a financial planner yourself.
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. You can see below his new Bits & Bytes weekly video update on the latest tech news and developments, or read “FPPad Bits And Bytes on his blog!
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!