Financial Advisers: How to Counsel Clients in a Hot IPO Market

cfa_logoLauren Foster of the CFA Institute has an excellent article up at Enterprising Investor about IPO investing. That I’m quoted is an added bonus. My friends Carl Richards and Michael Kitces show up too.

“For those who are convinced that any particular IPO will be ‘the one’ (after all, it might be), I encourage them to understand both the risks and the odds before they buy, and that they only buy with money they can afford to lose,” Seawright says. “It’s like going to Vegas. The lavishness of the casinos demonstrates that the odds favor the house. But, if you only play with money you can lose (perhaps out of your entertainment budget), it’s not quite so bad.”

I encourage you to read the entire article. 

Financial Advisers: How to Counsel Clients in a Hot IPO Market

The U.S. Retirement Crisis: Essential Reading and Resources

CFALauren Foster of the CFA Institute asked Wade Pfau, Michael Kitces, David Blanchett and I to suggest some resources for advisors dealing with retirement.  What we suggested and a lot of other good stuff are available here.  I think it’s well worth your reading.

The U.S. Retirement Crisis: Essential Reading and Resources

Top Ten Benefits Of Financial Advisors, Besides Investment Returns

Thank YouAs I have noted here many times, I am a big fan of Michael Kitces and his blog, Nerd’s Eye View.  If you aren’t a regular reader of it, you should be.  Michael is my “go to” guy for financial planning issues and concerns.  He is as talented and knowledgeable as they come.  That’s why I was so pleased that he asked me (unlike yesterday) to allow him to use my Financial Advice: A Top Ten List as a guest blog post.  I was honored and (of course) agreed.  The link is below.  Thank you Michael.

Top Ten Benefits Of Financial Advisors, Besides Investment Returns

Financial Advice: A Top Ten List

Dilbert - Index FundsYesterday, while I was otherwise engaged, Josh Brown threw some fuel on the active v. passive fire:

“Active investors, in the meantime, really can’t say anything. There isn’t a single empirical datapoint backing up the idea that an investor is financially better off paying someone to pick their stocks for them. There are other considerations in favor of active managers – mostly emotional ones involving elbow-rubbing, fancy lunches and alerts – but we’ll leave those aside for now.”

Putting aside the actual substantive argument (my views, including why I advocate some active management, are here and here), advisors routinely tell me that if they used index funds, their clients wouldn’t need their services, consistent with the Dilbert cartoon above.  I disagree vehemently.  Here’s my top ten list of reasons why. Continue reading

Struggling With Clients

Cover Apr_0413.inddMy newest column is now available from Research magazine. Here’s a taste.

As [The Wall Street Journal's Jason] Zweig emphasized, we are all social animals. It is natural and inevitable for most people to measure their success and status against their peers, and advisors are people, too. Yet the advisor who loses business to the competitor proposing an unrealistic approach and envies him “has already lost the battle. [Warren] Buffett likes to say that companies get the shareholders they deserve. Ultimately, every advisor has to be reconciled to the perennial truth that you get the clients you deserve.”

Surely the best advisors will need to listen more carefully, to provide excellent advice and recommendations based upon the most thoughtful research, and to make their points in a way that resonates with clients both intellectually and emotionally. That’s far easier said than done, of course. Long-term financial and retirement planning is difficult business. As Dana Anspach sagely added, “It is hard to plan for something when you don’t want it to happen.” Indeed it is.  

Struggling With Clients

Edge: Michael Kitces

At a high level, I actually think the thing that’s getting the least attention that we SHOULD be worrying about is a good old-fashioned bear market in stocks. Everyone is SO fixated on the bear market in bonds, and either suggesting that stocks are a place to run (which I’ve expressed concern about here) or at the least ignoring that stocks aren’t exactly in a great position either (overbullish, overbought, slowing economy, yadda yadda). Continue reading

Establishing Your Top 10 Investment Default Settings

I pay a lot of attention to the investment process.  In that regard, every investor — personal or professional — ought to have a clear investment plan based upon appropriate personal considerations, goals and outlooks and every investor ought to stick to that plan unless and until something significant changes. But there is a crucial component of the investment process that gets surprisingly little attention:  our investment default settings.  We can use them when we aren’t sure what to do, when we’re deciding what to do, when our circumstances have changed but our plan hasn’t (yet), or when we’re just starting out. 

The idea here is that we all have default settings — known and unknown, acknowledged and unacknowledged — and that those defaults greatly influence how successful we are and become.  Having the right default setting in defined contribution plans make a big difference (more here). I would examine and apply my default settings across and throughout the entire investment process and even suggest that we need to look at our default settings as carefully as we look at anything else.

What follows are my suggested default settings.  Your mileage may vary. Continue reading

Five Good Questions for Moshe Milevsky

Moshe A. Milevsky in an Associate Professor of Finance at the Schulich School of Business and a member of the Graduate Faculty in the Department of Mathematics and Statistics, at York University in Toronto. He has an M.A. (1992) in Mathematics and a Ph.D. (1996) in Finance, both from York University. He is currently the executive director of the non-profit IFID Centre at the Fields Institute, and has published 10 books and over 60 peer-reviewed articles on all aspects of retirement planning and the valuation of mortality-contingent claims. He is currently working on his next book manuscript entitled: TONTINES for the 21st CENTURY: The Fascinating Past and Future of a Product that Can Help Save Retirement. 

But that’s only the more formal biography.  As my friend Wade Pfau quips, when it comes to retirement planning research, “Moshe Milevsky has already done everything.”  He is, without question, “the world’s leading researcher and authority on retirement income strategies.” So, without further ado, let’s get started with what I hope are Five Good Questions for Moshe Milevsky. 

1.       How do you think the “annuity puzzle” can best be solved? 

I think the consensus at this point is that there really isn’t an annuity puzzle anymore. The puzzle is solved. Economists fully understand why people aren’t buying annuities. There is a long list of reasons that have been proposed over the last two decades to help explain the low levels of voluntary annuitization relative to the (famous) Yaari Theorem. Honestly. Very few researchers are running-around trying to find the answer to the annuity puzzle as if it was the Higgs Boson. I think the issue of the day is how to get more retirees to see the value of annuities and overcome some of their legitimate objections. This is especially important for those with 401(k) plans, or those who lack a DB pension. This is not a puzzle — in the traditional economic sense — as much as a challenge. Note the difference between: “Why do people eat unhealthily?” vs. “How do we get people to eat more healthily?” To me the answer to this challenge is a combination of education, product design, accommodating regulations and proper incentives. A week doesn’t go by without another policy-oriented paper that crosses my desk on “how to encourage” this business.

2.       What is your view about the continuation and pricing of retirement income/annuity products going forward, especially in light of the current interest rate environment and QE3? 

At these very low levels of long-term interest rates, the present value of any future cash-flow increases in value which means that retirement guarantees are becoming much more expensive than ever before. If this persists — and it looks like it will for the next few years — insurance companies will be hard pressed to offer new and innovative products. In fact, even the VA products that some companies are still offering these days are pushing-it in terms of pricing. If consumers and advisors were to smarten-up and “optimize” their utilization and allocation strategies, current pricing wouldn’t be sustainable. Here is the bottom line. Enjoy the irrational behavior of the masses — which allows you to get a good deal — while it lasts.

3.       How should advisors position annuity products (deferred and immediate) with consumers and the media? 

The behavioral economics literature is teaching us (old classical folks) that framing and language have a much bigger impact than we previously thought. These complex products have to be explained in terms of what they can do for a retiree’s spending power and standard of living, as opposed to being positioned as an investment product with IRR and yields. I think the concept of mortality (or longevity) credits has to be better explained by the industry, first to the media and then advisors. This is a very unique source of “alpha” that is only available to older individuals, etc. My next book is about the TONTINE Products and I’m hoping that it helps generate a debate about the economics, ethics and regulation of mortality credits.

4.       Your thought on GLWBs has generally moved from “anti” to “pro.”  Why? 

I was never really “anti” and I’m not currently “pro.” Rather, the best way to summarize my “Road to Damascus” conversion is that I can understand the value and role of guaranteed WITHDRAWAL benefits, more than guaranteed DEATH benefits. The existence and role of the GLWB in the optimal portfolio can be justified within a classical life-cycle model, but is more difficult to do with a GMDB, especially when you consider the historical pricing of both riders. Of course, you can probably find a behavioral story to justify almost any insurance product — EIA with a GLWB, anyone? — but you have to be able to spin quite the yarn. Here is the bottom line. Today I own a VA and I paid extra for a GLWB. I didn’t pay for any extra GMDB. Hopefully my grandkids won’t complain.

5.       It makes sense that we decrease spending as we age due to decreasing survival probabilities, but most people seem to reject that notion.  Why? 

This whole area has become quite jumbled. Normative economics — how should people behave? — is being confused with positive economics, which is concerned with how people actually behave. To make things more confusing, there are discretionary expenses vs. required expenses vs. medical expenses, which have completely different dynamics over time and as we age. Everyone is talking across each other here. The point I’m trying to make about longevity risk aversion (LoRA) is quite simple, really. For a new retiree, there is a 5% chance he will reach 100, and there is a 95% chance he will reach 70. Think of it as a roulette wheel that your genes — God? — will be spinning. Well. How much money do you want to put on the 100 slot vs. the 70 slot? Remember. You have a limited nest-egg budget! Well, I would rather put more chips on the 70 vs. the 100. Enjoy it while I’m younger and likely to be alive, because I am longevity risk tolerant. I know there is a 5% chance I’ll become a centenarian, and I’m willing to take a chance and reduce my standard living. Ergo, my spending will decline if-and-when I hit 100, because I didn’t rationally put many chips on that roulette slot. Of course, taking the leap from my simple longevity roulette wheel to actual real-life behavior is a big stretch. But, it should make you stop and think. Do I really want a constant real standard of living for the rest of my entire life? What is your — or your client’s — longevity risk aversion?


The Five Good Questions series: 

This article is also available at AdvisorOne.

Reckoning with Risk (8): Risk Capacity, Appetite, Tolerance and Perception

A major concern of every investor relates to taking on risk.  We generally want to avoid it (in the sense of losing money) but we’re also ticked off when a risk-averse strategy underperforms.  What we’re really talking about is risk capacity, which (as I have noted before) is largely a joining of risk appetite and risk tolerance.  Unfortunately, the theoretical and the practical are often disconnected at precisely this point.

Risk appetite is about the pursuit of risk (in the probabilistic sense rather than in the sense of losing money). If I am at or near retirement and have saved what I need for it, my risk appetite should be small.  If I am 22 and likely have a long investment life ahead of me, it should be far larger.  Every investor should regularly and routinely ask what success will look like and then go about figuring out how best to get there.  That process will necessarily include a careful analysis of risk appetite (or need).  It begins with the neglected art/science of estimating expected returns for prospective portfolios.

Risk Tolerance relates to the degree of uncertainty that an investor can handle with respect to a negative change in the value of his or her portfolio.  Sadly, it seems as though our risk tolerance is highest when things are going best and lowest when things are at their worst.  I don’t need liquidity (until I do).  Ascertaining risk capacity requires an analysis and a merger of appetite and tolerance.  It is a function of capability (how much – as objectively as possible – you can carry) and maturity (your ability to cope with risk).  This maturity relates to emotions (will you panic and sell at the wrong time?) but also to control (how do you deal with uncertain outcomes?).

However, it seems obvious that these determinations are anything but static.  Every financial professional has had clients love a lower risk approach when they are afraid but decide it’s horrific when the market is hot (even for relatively brief periods) and the lower risk strategy underperforms.  Similarly, an extremely aggressive investor can suddenly decide that the aggressive strategy wasn’t right after all when the market heads south.  Clients will even look at individual securities or strategies within a diversified whole and criticize specific losses despite the overall portfolio’s solid performance in line with reasonable expectations.

But wait a minute.

As Michael Kitces has pointed out, a recent study using FinaMetrica data joins a growing body of research suggesting that client risk tolerance  is actually remarkably stable, and that what’s changing through the market cycle is not risk tolerance, but instead risk perception. This research discovered – with a large class of investors examined both before and after the 2008-09 financial crisis and carefully controlled to eliminate other factors – that only a very small number of investors reduce their risk tolerances during crisis.  That result is consistent with other research and FinaMetrica’s own analysis showing that despite much volatility within the world markets over the past 12 years, average risk tolerance has remained remarkably stable. The most significant implication of this research is that financial professionals struggling with unstable client investment behaviors should focus more on managing risk perception, rather than blaming changing client risk tolerances.  In other words, something constructive can be done about the problem.

Kitces argues that investor behavior is driven by two primary factors:  risk tolerance and risk perception. As he sees it, risk tolerance determines whether one is willing to take a specified risk in pursuit of a potential reward while risk perception is one’s subjective evaluation of whether a particular investment is consistent with that risk tolerance. 

On account of recency bias, we tend to focus excessively on what has happened recently to the exclusion of the broader context and to project the recent into the indefinite future.  Thus an investor who has suffered a significant drawdown (but one that ought to be within the expressed risk tolerance) will look to bail not because his or her risk tolerance has changed, but because s/he sees (via risk perception) the experienced drawdown as the beginning of an intolerable loss.

As Kitces argues (very persuasively), this will be a distinction without a difference to investors who have not carefully, comprehensively and objectively measured their risk tolerance.  Otherwise, it will be all but impossible to tell if the problem is that the risk tolerance was poorly assessed or that risk perception is the problem.  For advisors, managing risk perception means providing the ongoing communication (lots of it) necessary to allow the client correctly to perceive his or her investment risk and thus fight the natural tendency to over- and under-estimate the risks throughout the market cycle.  It must begin with realistic expectations before and as the portfolio strategy is undertaken and must continue throughout the management (both portfolio and client management) process. 

Nobody is happy about losing money.  But if expectations are in line with the portfolios created, drawdowns will be much more tolerable.  The key for financial professionals is to communicate, communicate and communicate some more about goals, objectives, risks, rewards and expectations.

Five Good Questions for Michael Kitces

Michael Kitces, MSFS, MTAX, CFP, CLU, ChFC, is the director of research for Pinnacle Advisory Group, a private wealth management firm located in Columbia, Maryland that oversees approximately $1 billion of client assets. He is the publisher of the e-newsletter The Kitces Report and the blog Nerd’s Eye View through his website Kitces is also one of the 2010 recipients of the Financial Planning Association’s “Heart of Financial Planning” awards for his dedication to advancing the financial planning profession. Follow Kitces on Twitter at @MichaelKitces.  Today I ask (in bold) and Michael answers what I hope are Five Good Questions.

 1.  In your view, what are the difference and the significance, if any, in terms like wealth manager, investment manager and financial planner?

While the exact meaning of these terms is somewhat debated, I do believe that they describe substantively different services, and require different knowledge and skills to execute effectively. And while some of it is semantics, I believe the distinctions are important – how we describe ourselves and hold ourselves out to the public matters.

I would characterize an investment manager as someone who is focused solely on investment management – the service delivered is managing the pot (or pots) of money, and the expectation is to create value in the investment management process.

A financial planner and a wealth manager, however, provide a broader range of services, typically incorporating advice regarding a broad range of financial issues, which may or may not include the hands-on investment management aspects as a part. As I wrote recently on my blog, the emerging factor that is distinguishing a financial planner from a wealth manager is the wealth level of the target client. This is more than just using lofty terms; the reality is that the body of knowledge needed to serve the ultra high net worth market – as a private wealth manager – is different than the knowledge needed to serve the rest of the public. Over time, I expect that we will increasingly differentiate between the two; an early glimpse of this is the curriculum being developed by IMCA (Investment Management Consultants Association) for their new CPWA (Certified Private Wealth Advisor) certification, which has only a limited overlap to the CFP certification curriculum.

2.  Is the “4 percent rule” still an appropriate rule of thumb?

I find the “4 percent rule” continues to remain relevant today. The reality, as I recently wrote, is that such safe withdrawal rates are based not on average returns, but the worst return sequences we’ve seen in history – environments where balanced portfolios don’t even generate 1% real returns for 15 years (the entire first half of retirement!). Accordingly, if real returns on bonds stay low and the S&P 500 merely makes it back to its old high by the middle of next decade – truly a horrible return environment – we’re merely looking at results that are similar to the exact returns the 4% rule is based upon in the first place.

Ultimately, I am a little skeptical about whether those who retired in the year 2000 will ultimately violate the 4% rule, as market valuations back then truly reached levels of distortion never seen in our market history, even leading into the Crash of 1929 and the Great Depression. However, today’s market environment, while still overvalued, looks relatively similar to numerous other overvalued market environments throughout history, so while  the year 2000 retiree may be at risk (although recent follow-up research by Bill Bengen has shown that actually the year 2000 is still reasonably on track!), this does not raise the same concerns for today’s retirees, as market valuations today are far less egregious. On the other hand, market valuations are still high on a long-term basis, so I wouldn’t necessarily recommend clients significantly raise spending above that benchmark, unless they have a higher tolerance for risk and a potential need to reduce spending in the future.

3.  Do you think the barriers to entry to and/or the education and training components of our profession are too low?

I do believe that the educational and training requirements for financial planning need to rise, for it to become a bona fide true profession – and I don’t believe financial planning has reached the status of true profession yet, because of this. It should require more than what is essentially “just” half a dozen undergraduate-level courses in personal finance, and should have a more formalized training process than just unleashing newly educated practitioners on the public to earn their experience without necessarily being supervised (and coached and trained) in the advice being delivered. Although it will be a long time before we get there, I expect financial planning in the future, as a profession, to have both a deeper body of knowledge, and also a great deal of additional focus in trust, communication, and how to help clients actually change their behavior (to implement the advice).

Ultimately, significant training and educational requirements do effectively become a barrier to entry as well, which some have been critical of, but that’s part of the natural progression in the development of a profession. If the public doesn’t have a clear way to distinguish between the trained and untrained professional practitioner, it’s not a profession, and more importantly you can’t protect the public.

4.  Appropriate regulation (whether by the SEC, the states or FINRA) is actively being questioned and considered today (obviously).  How would you set things up if you were in charge?

In my ideal world, no one would be allowed to hold themselves out as a financial planner, advisor, consultant, or analogous term, unless he/she actually had the education, training, and experience to serve as a professional advisor. A national regulatory body would oversee this (although in reality state regulation may be the most likely solution), ensuring that only those meeting the appropriate minimum standards can represent themselves as advisors to the public. Anyone who delivers advice would be subject to a fiduciary standard, as almost by definition there’s no such thing as advice that isn’t delivered in the interests of the person receiving the advice! Notably, this is also why the public continues to be confused by our discussion of fiduciary and non-fiduciary standards for advice – because in the eyes of the public, there simply is no such thing as non-fiduciary advice.

That being said, I continue to see a role for people who sell and help clients to implement specific financial services product solutions. I don’t believe we need to eliminate the suitability standard or the existence of commission-based salespeople. However, such individuals should be required to hold themselves out to the public as salespeople, with a return to the labels “stockbroker” and “insurance agent” that were once used in the past. If that individual gives any advice to the client, that person becomes subject to a (fiduciary) advice standard. While I understand the origins of the exemption from the fiduciary standard for brokers and dealers who give advice that is “solely incidental” to their services as a broker/dealer, the reality in today’s world is that the exemption has become far too wide. As a result, there is significant confusion for the public as people routinely provide extensive advice while claiming they shouldn’t be subject to advisor regulation or standards and that the advice is “solely incidental” when it clearly is not.

The bottom line is that the real choice for the public shouldn’t be between fiduciary and suitability standards at all; it’s about the choice between being sold a product from a salesperson, or getting advice from an advisor. That is a valid choice for consumers – as long as the people on each side of the line are held to appropriate standards, and use titles and provide services that make it clear where the line is.

5.  A recent study from the National Bureau of Economic Research found that nearly half of all Americans die with virtually no financial assets. Clearly, many people are not getting good financial advice.  How can we go about improving the quality of financial advice being given overall and making it more available to those without the assets to make them attractive clients?

I think the first key to improving the financial circumstances of the average American is to understand that this is not merely a “financial literacy” problem, as though people would make the right and best decision for themselves if only they had a little more education. Yes, education helps – you certainly can’t make the right decisions if you have no idea what’s best in the first place – but it is only a necessary condition for success, not a sufficient one. If knowledge alone were sufficient, we would long since have conquered our country’s obesity problem, as there’s no lack of information regarding the harmful effects of obesity, and how “easy” it is to avoid it by simply eating less (and healthier), and exercising more. Instead, the reality is that improving financial health, like improving physical health, is about behavior change, and taking the steps necessary to help people change habits and implement changes in their lives.

Thus, to me the starting point is actually better education and training for advisors about how to effectively help clients find real success – and understand that it’s about more than just giving them information and having the technically accurate answers (although that’s also necessary). The greater the positive impact we have on changing people’s behavior and leading them to a sustained improvement in their lives, the more people understand the value of financial planning and seek it out, and the easier it is to serve a wider base of people.

In the end, the real reason that financial planners fail to serve the majority of Americans is simply that the public in the aggregate does not yet see enough value in what we do to demand our services en masse, and consequently firms and advisors seeking to serve the average American struggle with the marketing necessary to sustain enough clients for the business to be successful. To some extent, the lack of demand is simply because we haven’t done a very good job communicating the value of financial planning, so people don’t understand what we bring to the table; but I think the reality is that we could also get better at delivering real results for the average American that would make us more relevant and sought after, too.


The Five Good Questions series: