Weekend Reading For Financial Planners (Oct 29-30) 2022

Author: Adam Van Deusen

Team Kitces

Adam is an Associate Financial Planning Nerd at Kitces.com. He previously worked at a financial planning firm in Bethesda, Maryland, and as a journalist covering the banking and insurance industries. Outside of work, he serves as a volunteer financial planner and class instructor for non-profits in the Northern Virginia area. He has an MA from Johns Hopkins University and a BA from the University of Virginia. He can be reached at [email protected]

Read more of Adam’s articles here.

(Mark Schoeff | InvestmentNews)

While investment management was at the heart of the financial advisor value proposition in decades past, advisors today frequently offer a much broader suite of services to their clients. And given the wide range of outsourced investment management solutions (e.g., Turnkey Asset Management Platforms [TAMPs], Outsourced Chief Investment Officer [OCIO] and back-office trading solutions, and model marketplaces), advisors are increasingly turning to these platforms while focusing their time on other aspects of the financial planning process and growing their business. In fact, a recent report from WealthManagement.com and FlexShares found that 32% of RIAs outsourced investment management in 2022.

At the same time, outsourcing investment management does not absolve RIAs (which are subject to a fiduciary standard) of the responsibility to ensure that these outsourced providers are providing the advisor’s clients with high-quality service.

Amid this backdrop, the Securities and Exchange Commission (SEC) this week proposed a major new regulation that would establish formalized due diligence and monitoring obligations for investment advisers who hire a third party to perform a “covered function”, with the goal of ensuring consumers receive a high level of service when their adviser outsources certain responsibilities (and that the advisory firm is ensuring its outsourced service providers are adhering to their contribution of the advisor’s fiduciary responsibility). Such “covered functions” would be those that are necessary to provide advisory services, and could harm clients or the adviser’s ability to serve them if not performed or performed poorly. According to the SEC, such covered functions are generally focused on the “investment management” side of the advisory business (purely administrative or clerical functions are excluded), and could include providing investment guidelines, creating and providing models related to investment advice, creating and providing custom indexes, providing investment risk software or services, providing portfolio management or trading services or software, providing portfolio accounting services, as well as other sub-advisory services.

Under the proposal, an adviser would have to take several steps before outsourcing a covered function, including assessing potential risks and the service provider’s competence, as well as the service provider’s own subcontracting arrangements to others. Advisers would have related books and records requirements as well. In addition, there would be a requirement on ADV forms to provide “census-type” information about all third-party vendors.

The proposal is now open for a 60-day comment period, but some industry representatives, including the Investment Adviser Association, have already noted their opposition to the proposal. Opponents have noted that RIAs are already subject to a fiduciary obligation – which would include ensuring reasonable outsourcing providers – and that the regulation, with its very specific requirements about what RIAs must specifically do and document to vet their service providers, could be particularly burdensome on smaller RIA, which frequently outsource investment functions and would face increased administrative and compliance hurdles.

Altogether, if implemented, the new regulation would reinforce the fiduciary obligation RIAs have to their clients with respect to using outsourcers, but increase the level of formalized due diligence and reporting requirements when using third-party services. Though given the potential breadth of “covered services” (many such providers can be found throughout the Kitces Financial AdvisorTech Directory), a wide range of RIAs (not just those using TAMPs and similar investment management services) would likely face an increased compliance burden from the new regulation… for which it’s not entirely clear if greater regulation is needed, and whether in practice many advisors were already failing to vet their outsourcing providers in the first place!?

(Tracey Longo| Financial Advisor)

The use of independent contractors has grown in a variety of industries during the past several years. Doing so allows companies to hire labor without having to offer the full suite of benefits (and provide the full suite of employee protections) they are legally required to provide for bona fide employees. But the growth of this model has raised concerns, particularly among Democratic officials, that this shift toward an independent contractor model leaves many contractors especially vulnerable, as their income is often more precarious than W-2 employees and, by definition, they don’t benefit from standard legal protections for employees. This has led to back-and-forth guidance from Washington, as the Obama administration broadened the definition of who counts as an employee (making it more challenging to label a worker an independent contractor), while the Trump administration subsequently narrowed the types of workers who must be considered employees.

And now, the Biden administration’s Department of Labor (DoL) has proposed a rule that would require that workers be considered as company employees when they are “economically dependent” on the firm (again making it harder to label a worker an independent contractor). Criteria to determine whether a worker is an employee would include, among others, workers’ opportunity for profit or loss, how permanent their jobs are, and the degree of control a company exercises over a worker.

In the financial services space, the independent broker-dealer model could come under fire as a result of this rule, as the relationship between registered representatives working as independent contractors and their affiliated broker-dealer could come under scrutiny (given the level that registered reps are economically dependent on their broker-dealers, given that the broker-dealer holds the rep’s license and technically clients are clients of and make payments to the broker-dealer and not the rep). Given the potential impact the proposed DoL rule could have on this arrangement, the Financial Services Institute (FSI), an industry trade group for independent broker-dealers, has come out strongly against the proposal, and has requested additional time to comment on it (the current comment period lasts until December 13, and FSI has asked for an extension until January 12). The organization has said the proposal would lead to confusing court interpretations, and require representatives to take time to defend their independent contractor classification. It also claims that the rule would make it more challenging for independent broker-dealer representatives to sell their business if they wished.

In the end, the proposed DoL rule is the latest volley in a political battle over the status of independent contractors. But this tug-of-war is not new to the independent broker-dealer industry, which prevailed in a similar battle with the IRS, though increased attention to the broader independent contractor issue with the rise of the ‘gig economy’ could challenge this advisor business model once more (at least until the political winds on this issue shift again?). Though notably, while in most industries the debate over independent contractor status revolves around contractors who want the protections of employees that their companies are refusing to provide by labeling them as contractors, arguably the independent broker-dealer community is unique because independent advisors typically want to remain as contractors in order to retain the independent to control, manage, build, and eventually sell, their own independent advisory firms.

(Andrew Welsch | Barron’s)

The buzz around direct indexing has increased significantly over the past year, from a wave of acquisitions of direct indexing platforms by large asset managers to the dramatic decrease in the required assets needed to use direct indexing. And with reduced fees and transaction costs involved in direct indexing, the potential use cases and client profiles that could benefit from direct indexing have expanded from a predominantly tax-informed strategy for high-net-worth investors to a way for a wider range of investors to express investment preferences and build portfolios around concentrated positions, among other uses.

And the competition has heated up among asset managers to provide direct indexing services to advisors and retail clients on their platforms. In April, Charles Schwab introduced its Schwab Personalized Indexing platform, available to advisors and retail clients with a $100,000 account minimum. Fellow mega-asset manager Fidelity countered with its Fidelity Managed FinFolios direct indexing offering, available to investors with a significantly lower $5,000 minimum account balance. And now, Fidelity has introduced a new direct indexing platform for advisors, the Fidelity Institutional Custom Separate Managed Account (SMA), available now to select clients and broadly to RIAs and other wealth managers next year. The Custom SMA platform includes 10 tax-managed equity strategies, and the company plans to add more.

Ultimately, the key point is that as companies continue to roll out direct indexing platforms, advisors will have the opportunity to choose the option that fits best for their client needs, whether it is one that includes advanced tax management features, advanced Socially Responsible Investing screens, the ability for advisors to implement their own custom strategies, or just a user-friendly interface that makes implementing a direct indexing approach more efficient!

(Bruce Kelly | InvestmentNews)

Advisory firm profitability depends on a variety of factors, from organic client growth and fee levels to overhead costs. And for firms charging on an Assets Under Management (AUM) basis, the performance of client portfolios can play a major role in determining firm profits in a given year. In a year like 2021, which saw strong stock market returns (e.g., the S&P 500 provided a total return of 28.7%), increased portfolio values serve as a tailwind to firm profitability.

According to the InvestmentNews Adviser Benchmarking Study, RIAs produced an average operating profit margin of 30.6% in 2021, up from 23.6% in 2020. Firms benefited from strong stock market returns as well as relatively stable labor costs and an influx of new clients, according to the report. Perhaps unsurprisingly, market performance was the biggest driver of AUM growth (with firms gaining an average of 12% in AUM from appreciation in client portfolios), but new client growth (6.9%), client contributions (5.2%), and M&A (1.8%) also contributed to a net average of 21.4% AUM growth for RIAs. Clients with around $1 million of assets represented the largest portion of RIA clients at 23%, followed by clients with $2 million (19%), and those with about $500,000 (18%).

While 2021 was a banner year for RIA profitability, the industry faces several headwinds in 2022, from weak stock and bond market returns to continued inflation that could drive up employee compensation levels. At the same time, firms who are able to increase their client growth, limit total overhead expenses (perhaps buoyed by reduced office costs amid the continued popularity of remote and hybrid work?), and build in operational efficiencies could dampen the blow of poor client portfolio performance and set themselves up for greater profitability when a new bull market arrives!

(Jennifer Lea Reed | InvestmentNews)

RIA merger and acquisition (M&A) activity has been hot for the past few years. On the supply side, aging firm owners looking to sell have provided a range of opportunities for those looking to buy. And on the demand side, private equity firms have joined large RIA aggregators and others in the hunt for highly profitable acquisition targets. But the hot M&A activity of 2020 and 2021 occurred at a time of high firm profitability buoyed by a strong stock market, as well as low interest rates to buoy those making acquisitions through debt financing. But the rising interest rates, elevated inflation, and weak stock and bond market performances seen so far in 2022 raise the question of whether the brisk pace of RIA M&A will continue.

At least so far in 2022, deal flow and valuations appear to be strong. According to Fidelity, the number of completed RIA deals is up 25% over the past year, with the strongest activity among firms with less than $500 million of AUM. Valuations have hovered around multiples in the mid-teens of earnings before interest, taxes, depreciation, and amortization (EBITDA), though these have varied based on firm characteristics. For instance, firms with strong organic growth and young management teams might fetch a larger multiple than those with aging clients and little growth. Notably, buyers are not only looking to purchase firms outright, but are looking for minority stakes as well. And while valuations for these deals are similar to full acquisitions, they do often come with some protections for investors, such as information rights or a board seat.

But while deal flow and valuations have remained firm so far, some cracks in the armor are beginning to show. For example, while in recent years multiple buyers might have lined up to purchase a firm at elevated valuations, now there might be only a single buyer willing to meet that price. In addition, acquirers with significant leverage on their books might start to pull back from acquisition activity in the higher interest rate environment. And while many acquirers are willing to look past temporarily weaker profits caused by poor market performance (as long as the underlying business is strong), reduced earnings in the current market environment could dampen valuations. In addition, acquirers might become more wary of growing labor costs if compensation rises in the inflationary environment.

Altogether, it appears that there remains a strong pool of willing RIA buyers and sellers in the marketplace, though the pace and structure of activity could shift moving into 2023. For advisory firms considering a sale, this environment heightens the importance of continued client growth and potentially transitioning key management functions to the next generation (though, ironically, doing so could make selling the firm less desirable?) to fetch the best price from a group of acquirers who might be increasingly cautious.

(Mindy Diamond and Jason Diamond | WealthManagement)

In the highly competitive talent landscape, advisors with a solid book of business can receive lucrative signing offers from broker-dealers. Often, these deals are structured as forgivable notes, which can be a win-win situation for both sides: the advisor receives a large upfront payment, and the firm can use the length of the note to keep the advisor at the firm. Notably, the length of these notes have been extended in typical length, from what was seven to nine years in the past, to sometimes as long as 11 or 13 years now, tying the advisor to the firm for an even longer period (and allowing the broker-dealer to amortize the recruitment payment over a longer period of time, relieving pressure on its own balance sheet).

Of course, signing a forgivable note does not mean that the advisor must stay with the broker-dealer for the entire term of the note. While the advisor must pay off the remaining balance of the note if they leave early, this amount could be reasonable if they are near the end of the note’s term. Such reasons for leaving the broker-dealer could include the firm not meeting their expectations (for culture, technology, and/or the platform it provides), or perhaps receiving another offer at another broker-dealer (some of which are willing to pay off the forgivable note from the previous firm in addition to making a recruitment payment of their own). Or in some cases, the purpose of a switch is simply to find a lower-cost provider that allows the advisor to reduce their own fees and better compete for clients, as in practice platforms with higher forgivable notes often have higher cost structures for the advisor and their clients (which is how the platform recoups its own costs for paying the forgivable notes in the first place!).

Notably, in addition to the financial cost of paying off the note, there are other potential downsides for the advisor to moving before the end of the forgivable note term. These include building a reputation as a ‘serial mover’, which might dissuade future firms from making an offer if they do not think the advisor will stay for the length of the note (or longer). In addition, the advisor will want to be aware of how changing firms burdens their clients, who might be reluctant to move along with the advisor (and the associated administrative hassle) multiple times in a relatively short period.

In the end, a recruiting deal with an associated forgivable note represents a commitment from both the firm and the advisor. And while this commitment is not immutable on the part of the advisor, careful consideration of the potential costs (and benefits) of leaving the firm early, including the additional costs that the forgivable note itself may be adding to the advisor’s practice, is important not only for the advisor’s short-term finances, but also for their relationship with their clients and their long-term reputation within the broader industry!

(Ieva Gailiūtė and Kotryna Brašiškytė | BoredPanda)

$1 million has long been the net worth target of many Americans. The term ‘millionaire’ brings cachet, even if it doesn’t buy as much as it might have in the past due to inflation. And while there are almost 7 million millionaires in the U.S. today, they all got there in different ways. To get a sense of how different people amassed their million(s), a thread on the AskReddit subreddit asked millionaires to explain how they made their money.

Several of the commenters came into their money suddenly, through an inheritance, lottery winnings, injury settlement, or by marrying a millionaire. Others received job-related windfalls as a result of cashing in stock options from companies that went public. Still others amassed their wealth over the course of several years by working high-paying jobs and maintaining a high savings rate. But other commenters took the slow road to their wealth; these “millionaires next door” took a variety of paths to building assets, from saving in company retirement accounts to purchasing rental properties to starting a business that grew in value over time.

Ultimately, the key point is that there are countless ways to amass a million dollars, and each millionaire has different needs and preferences for their money. And so, whether it is helping a client consider their goals for a financial windfall or helping a retired couple create retirement income and charitable giving plans, advisors can play an important role to ensure that millionaire clients can sustain and enjoy their wealth!

(Russ Alan Prince | Private Wealth)

When financial advisory clients think about how they will use their wealth, the first thought that comes to mind is often how it will support their lifestyle through their remaining years. Moving beyond their own expenses, they might also consider whether they want to leave legacy bequests to their children or others. But typically, thinking about the future financial security of their great-great-great grandchildren is not at the top of their minds.

While most clients might not have the wealth to think several generations into the future, doing so has become increasingly popular among the ultra-wealthy (defined here as families with a net worth of at least $30 million). Of course, doing so comes with challenges, whether it is supporting an increasingly large extended family, preventing heirs from becoming spoiled, or finding estate planning tools to prevent taxes from taking too large of a bite out of the wealth as it is passed down the generations. In addition, investing can look different for the ultra-wealthy, who often have a much longer time horizon (well beyond the original owners’ lifetimes) for their investments and access to investment vehicles that are either unavailable or less useful for those with less wealth (e.g., private placement life insurance).

The key point is that while advisors working in family offices might be used to the needs and wishes of the ultra-wealthy, advisors working in a firm serving a broader range of clients will want to understand how these individuals and families think differently if they are approached by a prospect with significant wealth. Because these clients might not just be planning for their own retirements, but also for the financial security of descendants who might not have yet been born!

(Monevator)

Many Americans seek to become wealthy one day. While the amount of money it takes to feel wealthy can vary widely, having wealth is often seen as a way to live your life to the fullest. Whether it is having more control over your time (because you no longer have to work), being able to live in the nicest house, flying first class to exotic locations (though you don’t need to be rich to do so), or being able to donate money as you see fit, there are several clear benefits to having significant wealth.

But wealth can come with downsides as well. First, for those whose primary goal in life was to become wealthy, when they finally reach whatever wealth target they set, they will need to find a new goal, or else they might feel purposeless. Relatedly, those who have built wealth have to resist the urge to compare themselves to those who are wealthier, as they might otherwise find themselves unhappy due to their relative ‘lack’ of wealth. Significant wealth can also bring unwanted attention from scammers looking to get a piece of the wealth and can lead to tough decisions if family members ask for money. In addition, those who make large purchases such as luxury homes or boats often find that the costs to maintain these forms of property can eat away at their wealth.

In the end, while having wealth can open many avenues to a more fulfilling life, the actions and attitudes of the wealthy individual will ultimately drive whether their wealth brings them lasting joy or fleeting pleasure. And financial advisors can play an important role for these individuals, not just in managing wealthy clients’ assets, but helping them discover how they can use their wealth to generate durable happiness in their lives.

(Maddie Burton | Flow Financial Planning)

Many prospective financial planning clients come into their financial advisors’ offices with a major goal in mind. Perhaps they are on the cusp of retirement and want to know if they can afford to leave their jobs within the next year, or maybe they want to save enough to pay for their children’s college educations. But many prospects don’t have specific goals in mind and feel content with how their lives are going.

But advisors can play a key role in helping these individuals discover what’s important to them, whether it is considering their values, goals, or dreams. Because even if they don’t know where they want to be in 10 years (and research shows that they might not have a very good idea of what their life will be like then anyway), an advisor can help them get on a path that gives them the flexibility and optionality. Whether it is saving up an emergency fund (to have the peace of mind that they will be able to handle any unexpected expenses that come their way), to setting aside money for an “opportunity fund” for goals that might pop up beyond the next few years, advisors can help clients position themselves financially to both handle whatever comes their way (e.g., a new child or a bout of unemployment) and take advantage of opportunities that present themselves (e.g., a month-long hiking expedition with friends or an entrepreneurial venture).

Notably, this framework can apply to advisors as well, as some might be pleased with the current state of their businesses and don’t have distinct growth goals for the future. Instead of focusing their attention on a lofty business goal, these advisors can position their firms (and their lifestyles) to be able to take advantage of opportunities if they do want to pursue a different course in the future, whether that is shifting into high-growth mode or perhaps focusing on a non-revenue metric, whether it is taking off a certain number of days during the year or just spending more time with family!

(Jason Fried | Hey.com)

From a young age, individuals are taught about the importance of setting goals. Whether they are educational, professional, or financial, setting goals (and achieving them) is often framed as the key to prosperity, and those without goals are often viewed as unambitious. But is setting goals really required to be successful in business and in life in general?

For example, Fried has found professional success as the co-founder of Basecamp and Hey, but cannot remember ever having set an actual goal. Instead, he looks to do, build, and try different things, making progress along the way. Rather than seeing success as hitting a series of goals, he views it as a continuous process, starting from his very first job to his businesses today. By doing the work that he wants to pursue today, he often finds that it leads him to unexpected ventures and successes in the future.

Financial advisors have many goals they can set, from a certain amount of revenue, AUM, or take-home income (and there are plenty of benchmarking studies available to help compare their firms to others!). But achieving these targets can leave one wondering what’s next. Ultimately, given that people are typically bad at predicting what their lives will be like in the future (and advisors are people too), perhaps it could be better to have a sense of direction for your business and lifestyle rather than firm goals?

(Maggie Zhou | Refinery29)

When people set goals, they are usually aspirational targets, whether it is a person looking to retire by a certain age or an advisor working toward a revenue target. But in addition to these ‘positive’ goals, individuals might also want to avoid certain things, perhaps having to work 60 hours per week or living in a city far away from family. These ‘anti-goals’ can help individuals focus on what they don’t want and how they can work to avoid those scenarios.

This idea of ‘anti-goals’ is related to the concept of inversion, the idea that problems are often best solved when they are reversed, which can be summed up by the quote from famous investor Charlie Munger, “Tell me where I’m going to die, so I’ll never go there”. In the world of financial planning, while a ‘normal’ client goal might be to amass a certain net worth by retirement (with the underlying assumption that this nest egg will support them in their later years), an ‘anti-goal’ might be to not run out of money during their lifetime. Using this anti-goal, the advisor and client can craft a retirement income plan that reduces the chances that the client runs out of assets during their remaining years.

‘Anti-goals’ can also apply for advisors running their own practices. While an advisor’s goal might be to earn $200,000 of take-home pay, if the advisor’s top priority is to spend time with their kids, an ‘anti-goal’ could be to never have to work after 5:00 pm during the week (and then figure out how to make that happen). Ultimately, the key point is that while goals can help a person focus on the things they want to achieve, ‘anti-goals’ can help them avoid an undesired outcome along the way!

We hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think we should highlight in a future column!

In the meantime, if you’re interested in more news and information regarding advisor technology, we’d highly recommend checking out Craig Iskowitz’s “Wealth Management Today” blog, as well as Gavin Spitzner’s “Wealth Management Weekly” blog.