Michael Kitces’ weekend reading for financial advisers

Enjoy the current installment of “weekend reading for financial planners” – this week’s edition kicks off with a summary of this week’s Department of Labor hearings on the fiduciary proposal. While arguments were heated on both sides (which variously argued that fiduciary duty will either drive costs down for investors by eliminating conflicted advice, or drive them up by raising compliance costs!), the rule still appears to be on track for implementation in 2016, with perhaps just some adjustments to make it more “workable” in practice.

From there, we have several practice management articles this week, including: a look at how despite the rise of technology solutions Cerulli finds that the number of self-directed investors has significantly decreased in the past 5 years and the number of “adviser-reliant” consumers is on the rise; a summary of the latest FA Insight benchmarking study on People and Pay in advisory firms, which finds that RIAs are enjoying record profit margins and productivity, but that the lack of young talent may soon begin to take a toll; a discussion from industry practice management guru Philip Palaveev about how “flat” organizations with little hierarchy sounds good in concept but fails in practice, especially in advisory firms; tips from Mark Tibergien on a different approach to strategic planning; and a look at how the aging adviser population is leading to an increased number of practices that have to fold due to the sudden death of the owner, and how custodians are often compelled to act quickly, especially when the firm lacks a continuity plan, which may include cutting off the advisory firm’s staff access to clients, and even shifting clients over to the custodian’s self-directed platform, retail branch advisers, or even other firms.

We also have a few technical planning articles, from a look at the rise of “private exchanges” for health insurance in mid- and large-sized firms, the latest research from S&P that finds actively managed funds are so struggling to generate outperformance that they’re not just underperforming net of fees but the majority in most categories (especially equities) are even underperforming before fees, and a discussion of the current research on how much retirees really need for retirement income and how the common 70%-80% replacement rate may actually be significantly overstating what most retirees really need (especially those with above-average household income).

We wrap up with three interesting articles: the first covers some of the latest polling research from Gallup, which finds that adoption of financial planning is on the rise across the country, especially amongst those who are still saving and aren’t yet retired (perhaps a result of the pressure of technology on commoditizing the value of investment-only solutions for accumulators?); the second is a discussion of the new Schwab Executive Leadership Program, which is taking cohorts of 30-35 future leaders from advisory firms and putting them through a year-long MBA-style program in management (and getting rave reviews for the quality and beneficial impact of the program from its participants); and the last is a discussion of how the market’s sustained inability to make materially new highs since last Thanksgiving could be a troubling sign that the positive feedback loop for investors is breaking down, which risks culminating in a fear-driven bear market if the bull market cycle doesn’t underway again soon.

And be certain to check out Bill Winterberg’s “Bits & Bytes” video on the latest in adviser tech news at the end, including a discussion of Envestnet’s acquisition of Yodlee, a new integration of up-and-coming financial planning software Advizr with Orion Advisor Services, and a look at whether automated investment services (i.e., direct-to-consumer robo-advisers) are losing their exclusivity as established financial services firms increasingly launch their own.

Enjoy the reading!

Weekend reading for August 15th/16th:

Here’s What’s Next for DoL Fiduciary Rule (Andrew Welsch, Financial Planning) – This week the Department of Labor conducted four days of public hearings on its proposed fiduciary rule, with an astonishingly wide range of participants giving testimony, including insurers and asset managers, attorneys and compliance officers, investor advocates and CEOs, and more. And perhaps not surprisingly, the breadth of participants led to a wide breadth of testimony, with fiduciary advocates insisting that the rule would save investors significantly on costs due to currently conflicted advice, and opponents suggesting the rule will cause costs to skyrocket instead (due to compliance) and that many of today’s large financial services firms will be forced to move away from delivering advice altogether (Michael’s Note: Even though those firms maintain to the SEC that their advice is negligible and solely incidental to their brokerage services in the first place!). Notwithstanding the arguments to and fro, though, the momentum now appears to be with the proponents of the new standard, and participants on both sides are indicating that they anticipate the DOL will move forward, albeit with some modifications in light of recent hearings and public comments (and a second 15-day comment period will open soon) to make the rule more ‘workable’. Accordingly, larger firms are reportedly already beginning to make preparations for some version of the new rule to be enacted next year, although some critics suggest that even if the DOL gets its rule implemented by the end of 2016 (as support from President Obama is crucial, so the DOL aims to finish the rule while he remains in office) it may still face a future court challenge.

Cerulli Finds That Robo-Advisers Will Need Humans — Yes, Humans — to Grow Business (Emily Zulz, ThinkAdvisor) – While technology innovations will continue to transform how financial advice and services are delivered, a new report out from Cerulli suggests that if anything, technology automating some aspects of a client’s financial life will increase demand for personalized financial advice delivered by humans. In fact, over just the past 5 years – as technology tools for investors have burst onto the scene – Cerulli finds that the number of investors who identify as self-directed declined from 45% to 33% across all households, while those who are “Adviser-Reliant” (i.e., regularly consult a financial adviser) rose from 34% to 43%. The driver is simply that, notwithstanding all the information available online, “most households just do not have the fundamental understanding of financial topics that would allow them to feel comfortable making decisions solely by themselves.” Accordingly, technology tools that draw investors in may simply drive demand for personalized advice, rather than take business away from advisers. A similar trend has emerged in the medical world, where platforms like WebMD and FitBit were once seen as threats to medical for medical and fitness professionals, but instead have simply made consumers more interested in experts to apply that information to their unique challenges. Ultimately, then, Cerulli sees a world where technology helps consumers be more informed, and to work more collaboratively with financial advisers, and that ultimately will drive rising demand for advisers in the long run.

Pay, Productivity & Profits Up for RIAs — Can It Continue? (Charles Paikert, Financial Planning) – The RIA business continues to fly high, with the latest 2015 FA Insight Study on People and Pay showing a highest-ever median operating profit margin of 26.1%, and record productivity of $528,500 of median revenue per professional. The growing size of firms is also driving a notable increase in the demand for professional management positions to help firms operate; since 2009, median Chief Operating Officer compensation has seen a 7% per year increase, and pay for office managers has been up 4%/year as well. Median increases in compensation for the rising number of employee advisers has been slightly more muted, with associate adviser pay growing at 2%/year and lead advisers up almost 3%, though the FA Insight study notes an interesting pay-for-talent effect – the firms that pay more for talent, particularly when using incentive-based pay, really are seeing superior productivity by their advisers, leveraged further by the adoption of specialized management and technical support positions. Notably, though, only 1/3rd of firms compensate exclusively with incentive-based pay; the most commonly emerging model is a hybrid of base salary, plus a bonus incentive tied to overall firm metrics (e.g., revenue, profit, and AUM growth, along with individual incentives like getting new clients or new assets from existing clients), which allows firms to incentivize and reward employees but keep fixed costs lower to manage profit margins and leave more room to absorb the impact of a future bear market. Notwithstanding the favorable results for RIAs, though, the study cautions of some storm clients on the horizon – the biggest being the industry’s slow-motion demographics challenge, and the lack of sufficient young talent coming into the industry to replace aging advisers and firm owners. The squeeze for talent is leading firms to step up on their hiring practices (Michael’s Note: or outsource to financial planner hiring/recruiting firms!), and a shift from trying to hire away from other RIAs or wirehouses (which is increasingly expensive) to finding new talent (e.g., college graduates) instead.

Why Flat Organizations Fail (Philip Palaveev, Financial Advisor) – While it may seem like an appealing egalitarian ideal to treat all employees equally, Palaveev cautions that “flat” organizations with little structure or differences in position, compensation, recognition, opportunity, or ownership create more problems than they solve; when career progression for advisers and other staff employees is “too flat”, it can cause dissatisfaction, low morale, and turnover. In other words, Palaveev suggests that in the end, differences in position and compensation and recognition are crucial; otherwise, those who perform best will begin to feel that the system is not fair to them (they’re contributing more than the others and not being rewarded accordingly), and leave. More generally, without a hierarchy to climb (i.e., status levels), motivated staff can’t tell if they’re actually making progress in their careers, and the lack of milestones can be highly demoralizing and demotivating (or worse, employees try to come up with their own often-misguided milestones, like trying to curry favor with the firm owner instead of focusing on improving the business). And in the end, some hierarchy allows for the leadership necessary to help get things done (e.g., a car where every seat has a wheel and pedals is actually harder to steer than one with a single wheel and driver). So what should firms do? Palaveev offers several suggestions: identify and recognize top lead advisers who are performing well (you may fear recognizing top performers for fear of offending the weaker performers, but failing to recognize top performers just offends them instead, which is worse!); develop a hierarchy to progress in the firm that rewards performance with higher status levels (and commensurate compensation); remember that while rewarding with compensation is important, rewarding with public recognition is equally or even more crucial; and realize that these issues apply not only to staff, but across partners as well, so if partner contributions really are uneven, adjusting compensation or even ownership to recognize that reality is crucial to avoid undermining or creating conflict within the partnership.

Are you Zooming In or Zooming Out? (Mark Tibergien, Investment Advisor) – While advisory firms may be founded with a particular strategic goal in mind or just by accident or good circumstance, Tibergien suggests that as a firm grows, it becomes increasingly necessary to have a conscious strategy. In fact, setting a clear strategic vision may be especially necessary for advisory firms, which otherwise tend to be very similar to each other without a clearly differentiated vision, mission, and unique value proposition. Yet the classic approach to strategic planning – setting a long-term business vision for the next 5 years or so, and then designing an operational/tactical plan to implement in the next 12 months, just doesn’t work in today’s rapidly-changing business world. Instead, Tibergien suggests considering an approach created by John Hagel (co-chairman of Deloitte’s Center for the Edge), which he calls “Zoom In-Zoom Out”, where businesses first “zoom out” to look at long-term trends over the next 10-20 years and create a vision around those findings, and then “zoom in” to focus on just the next 6-12 months and work on 2-3 initiatives that are “needle movers”. The key point here is both that zooming in to just 2-3 initiatives makes it feasible to really focus resources and something done (rather than spreading too thin), and also that “zooming out” is crucial to avoid missing out on very broad long-term trends (e.g., Kodak inventing the digital camera but failing to recognize its secular growth, or Microsoft dominating the desktop but missing the secular shift to personal mobile devices). Zooming in also allows a focus that makes it possible to gain a real foothold in a new market and achieve critical mass before competitors show up (“fast follower” new competition is actually rare once a company gets a clear foothold in a new space), and avoids allowing the company to become so “overdiversified” that it can’t be an effective leader in any area. As Tibergien notes, this maps surprisingly well onto advisory firms as well, where those that have a clear niche focus gain far more traction and growth than a broad-based “overdiversified” base of clients.

Advisers’ Deaths Without Transition Plans Force Custodians Into Action (Mark Schoeff, InvestmentNews) – When a sole proprietor investment adviser passes away, the RIA firm itself dies as well, forcing custodians to act immediately to shut down the master account, freeze the debiting of fees, and suspend trading. While the increasingly swift actions of the custodians are technically legal and appropriate, in practice it makes the process of transitioning an adviser’s practice and clients more difficult, as the firm’s staff can no longer act on behalf of clients (which unfortunately is appropriate, as the client’s agreement with the firm died with the adviser). And the rapid intervention of custodians, while legally appropriate, also further undermines the ability of a sole proprietor advisory firm to be sold (or even just continued by the staff or a surviving spouse) after the death of the adviser, as clients are almost immediately reverted to self-directed accounts, and may then be solicited by the custodian’s direct-to-consumer advisers in local branches, and/or referred out to other advisers on the platform. The increasing focus on adviser succession and continuity planning is bringing the issue into further focus (especially after the passage of the recent NASAA Model Rule 203(a)-1A that would require state-registered investment advisers to have a continuity plan, and rumors the SEC is working on a parallel rule as well), though even with a continuity/succession plan in place, it’s still necessary for clients to re-sign a new limited power of attorney document with the new adviser to re-activate discretionary management of the adviser. The confluence of forces is also leading small/solo advisory firms to adjust from viewing a continuity plan in the event of death or disability as a “nice-to-have” to something that they must have from a growing number of continuity-planning solutions providers for independent advisers.

Are Private Exchanges Really The Next Big Thing? (Katie Kuehner-Hebert, LifeHealthPro) – Private health insurance exchanges are a version of health insurance marketplace, similar to the state and Federal health insurance marketplaces, but created by and operated for a single employer; similar to the public exchanges, the idea of private exchanges is typically to give employees a wider range of choices about which health plans they wish to select, and more control over the type of plan, level of benefits, and associated cost (towards which employers commonly provide a flat dollar amount). A typical private exchange might offer employees a list of 10-12 different health insurance plans (across a range from bronze to silver to gold to platinum plans), and also access to voluntary benefits like coverage for critical illness, accident, hospital indemnity, dental, vision, disability, group life insurance for the employee and spouse/dependents, and even pet insurance. Now that the Affordable Care Act has been in place for a few years, private exchanges are beginning to grow rapidly; enrollment in private exchanges doubled from 3 million to 6 million participates from 2014 to 2015, with mid-sized employers contributing most to the increase. Enrollment is projected to double again in 2016 to 12 million, and reach a whopping 40 million participants by 2018 as employers increasingly make the shift, especially large employers that so far have been slower to adopt the platforms (in part because large-employer plans already shared many commonalities to private exchanges, and the cost savings and long-term benefits for them are less clear at this point). Notably, the method by which private exchanges roll out is varied as well; participants include large health insurance brokers and consulting firms, as well as some carriers providing them directly, with varying levels of available customization. Some large firms are also using health insurance exchanges as a way to provide health insurance coverage options for retirees, although notably with the availability of public market health insurance exchanges as well, retirees who aren’t yet eligible for Medicare already have a range of health insurance choices available in today’s marketplace.

Surprise! Fees Not Reason Active Investing Loses vs. Passive (Bernice Napach, ThinkAdvisor) – A recent study from S&P Capital IQ and S&P Dow Jones Indices looked at the comparison between active and passive funds over the past decade, and found that when it comes to managed equity funds, their fees are not the reason they’re underperforming their respective benchmarks. Instead, the reason is worse – they’re simply underperforming, period. The study found that only 8% to 16% of actively managed funds beat their benchmarks after fees, but only 23% to 49% (depending on the equity asset class) outperformed excluding fees; in other words, the majority of active funds were underperforming over the past 10 years even based on gross returns. The only exception was large-cap value funds, which performed slightly better; 41% of large-cap value funds outperformed net of fees, and a slight majority (53%) outperformed on a gross return basis. When it came to bond funds, however, active management opportunities and results were better, with the majority of funds in 8-of-11 bond categories outperforming based on gross returns, some by large margins (81% of emerging market debt funds, 65% of muni bond funds, and 64% for global income and intermediate investment grade bond funds). However, on a net-of-fees basis, bond funds still struggled, just with barely a majority (51% of intermediate bond funds and 53% of global income funds) outperforming their benchmarks. Notably, the study also found that segments of the market typically celebrated for active management – such as small-cap stocks or high-yield bond funds – also didn’t hold up, with only 14% of actively managed small-cap funds beating their benchmarks, and a mere 7% of actively managed high-yield bond funds. And the majority of actively managed funds underperformed in the 2000-2002 and 2008 bear markets as well; the only winning category was large-cap value (where 64% beat the benchmark in 2000-2002, and 78% won in 2008). Of course, the classic caveat that “the past is not prologue” still applies, but ultimately the conclusion of the study is that there seem to be an increasing level of headwinds for actively managed funds trying to outperform, and that when it comes to equities in particular the problem isn’t just fee-drag but perhaps the possibility that there just isn’t as much alpha on the table to capture in the first place.

How Much Income Do Retirees Really Need? (Michael Finke, Research Magazine) – The most common academic approach to determining income needs in retirement is to set a “replacement rate” like 80%, where a pre-retiree earning $100,000/year (gross) is assumed to need 80% of that or $80,000/year of spending in retirement; the approach is actually just meant to be a rule of thumb to determine what the pre-retiree is spending (if we assume an effective tax rate plus savings rate equals 20%, then a replacement rate 80% of pre-retirement income is simply replacing 100% of pre-retirement spending to avoid a “consumption discontinuity” heading into retirement). However, Finke notes that in practice, by the time we subtract out 7.65% of FICA taxes, a 15% savings rate, and then start pulling out work-related commuting expenses, and possibly a lower effective tax rate (especially if a blend of traditional and Roth IRA dollars have been accumulated), a replacement rate of 70% or even less might be more realistic. In addition, the reality is that because our income and raises are uneven throughout our lifetime (our biggest raises tend to come early on, though our nominal income tends to peak in the final years before retirement), and our expenses are uneven as well (higher while raising children, and lower as an empty-nester, especially if/when the mortgage gets paid off as well) in practice many people will save very little in the early years and a large percentage of income in later years, such that even a 70% replacement rate may actually still overstate smoothed pre-retirement spending. However, the biggest caveat is that while spending through the transition from pre-retirement to retirement tends to remain stable, research by Morningstar’s David Blanchett finds that spending declines significantly during retirement, as even increasing health-related costs are more than offset by spending decreases in other categories (and higher-income individuals tend to experience an even greater relative decline in retirement spending in their later years). In fact, when you put it all together for affluent individuals – that due to high savings rates, their replacement rate in retirement is already less than 70%, and tends to decline further throughout retirement, one data set suggests that by their later years of retirement the top income quintile is only spending 36% of their pre-retirement income!

More Nonretired U.S. Investors Have a Written Financial Plan (Jeffrey Jones, Gallup) – The latest broad-based consumer survey from Gallup (outreach to 1,005 households with more than $10,000 in investable assets) finds that an increasing number of households have adopted a written financial plan to help them achieve their goals. Retirees are more likely than non-retirees to have a financial plan (at 43% vs 36% respectively), but nonretired investors have seen the largest increase in adoption of financial planning in recent years (the current 36% in 2015 is up from an average of just 26% in 2011). Notably, a total of 70% investors say they have some kind of financial plan, but barely half have actually crafted a written plan; those without a plan most commonly cite either a lack of time to craft one, or simply not having thought about it. On the other hand, Gallup finds that those who do have a written plan are very likely to follow it, with 92% saying that once it is written, they follow it “very” or “somewhat” closely, and 88% indicating that they track it and review at least once per year. And Gallup does find that those with financial plans are most likely to be developing it with the help of a professional adviser, with 80% of those having more than $100,000 of investable assets developing the plan with an adviser, and 64% of those with less in assets still having worked with an adviser. In terms of the focus of a financial plan, the most common element is retirement planning (for income in retirement or savings leading up to ), followed by insurance planning, budgeting, and asset allocation (and then tax planning, estate planning, and debt management, followed by education savings in a distant last place). Michael’s Note: Although not directly acknowledged in the Gallup reporting, the rising trend of advisers driving clients towards adopting financial plans seems likely related to the increasing pressures of commoditization of investing, and advisers seeking to adopt financial planning (and deliver it to more and more clients) to avoid those forces of commoditization.

Schwab Goes Big On RIA Training (Jamie Green, Investment Advisor) – To help address both the industry’s ongoing demographics woes (a lack of young advisers coming into the industry, especially with the experience to operate increasingly large independent advisory firms), in late 2012 Schwab Advisor Services announced its “Schwab Executive Leadership” program, a year-long program that graduated its first 32 students in 2014 and has another 34 underway in 2015. The program is targeted primarily at the internal successor leaders of mid-to-large sized RIAs on the Schwab platform, who may have risen through the firm’s ranks as an “employee adviser” and need some training in how to think about people and marketing, and the skills to act like an entrepreneur (other participants also include COOs, leaders of a firm’s investment team, and more). Participation for the year costs $6,000, and begins with an in-person “keynote” event, ends with another in-person “capstone” event, and in between includes weekly videos to watch “world-class faculty” and have a live call with the teacher every Friday; also included is a broad online learning environment, and a coaching element. Of course, it’s not new for broker-dealers and custodians to offer ‘enrichment’ programs to improve the advisers on their platforms, but often such programs are fairly ‘light-weight’ or just a thinly-veiled strategy to help encourage adoption of the company’s products or services; in this case, however, the rising leaders who have gone through the Schwab program are speaking of it very highly, as one of the most valuable learning experiences they’ve ever had (almost as though it’s an extension of an MBA program), not to mention the benefits of networking with similar rising leaders at other firms across the country. Notably, though, a key aspect of success has been the importance of buy-in from the founding principals of firms who nominate employees to participate; after all, if the firm’s existing leadership isn’t ready to let the next generation of leaders begin to implement, the training won’t produce any value. Still, participants are speaking so highly of Schwab’s unique program, it appears likely to become in even greater demand in the coming years, and one wonders if the approach will be adopted at other competing custodians in the next few years as well.

The Positive Feedback Loop is Broken (Josh Brown, Reformed Broker) – Our brains are wired to seek rewards and avoid loss or negative outcomes, and the feedback loop of feeling pleasure in good outcomes and pain in negative outcomes are the feedback loops that guide our behaviors. In a bull market, that positive feedback loop is what helps to condition investors to buy, hold, and buy far, as the continued uptrend means portfolio values continue to rise and investors just want to keep buying more. In such an environment, market pullbacks are brief and recoveries are V-shaped, as investors rush in quickly to take advantage of the perceived-to-be-temporary opportunity amidst the positive feedback loop. Yet eventually the feedback loop can break down – markets draw down and don’t bounce back quickly, and the investor that was continuing to buy finds that each purchase is not happening at higher and higher prices, but flat and lower ones, setting off doubts that further slows new investment activity. Brown notes that ultimately, this is the mechanism by which market peaks are formed – although in reality, “peak” is a misnomer, because the slow breakdown of the feedback loop rarely looks like an actual peak with a sharp incline and then a sharp decline, but instead is a process of leveling off for a period of time, breaking down the positive feedback loop, until eventually a critical mass of selling occurs. Accordingly, if you look back at even known-to-be-“sharp” market crashes like 1987 or 1929, the crash did not actually begin from the market’s peak; the crashes came weeks or a few months after the highs, as the market started to grind sideways, the feedback loop broke down, and then the real decline began, as enthusiasm shifts to doubt and then confusion and then frustration and finally fear. In this context, Brown notes that today’s market conditions are actually concerning; the S&P 500 has not actually made any material upwards progress since Thanksgiving of 2014 after years of compound annual returns of nearly 20%/year, and beneath the market’s surface it looks even worse, with the average S&P 500 stock down 15% from its 52-week high across vast swaths of market sectors (with the overall price index being held up by appreciation in a small number of large high-flying stocks). Ultimately, Brown notes that this pattern does not mean any surety of a coming market crash, and that it doesn’t appear as though a broad-based market fear and anger has really set in yet; nonetheless, it makes the point that if the positive feedback loop is not restored soon, there’s a risk that we shift from a positive feedback loop to a negative one… which is basically how a market crash occurs.

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 adviser technology I’d highly recommend checking out Bill Winterberg’s “FPPad” blog on technology for advisers. You can see below his latest Bits & Bytes weekly video update on the latest tech news and developments, or read “FPPad Bits And Bytes” on his blog!