Journal of Financial Planning: August 2016
We all recognize that the Department of Labor’s Conflict of Interest Final Rule—the fiduciary rule—will greatly impact the financial services industry and how financial advisers interact with clients. Just as successful advisers prepare clients for the certainty of uncertainty regarding their financial decisions and lives, this article serves to prepare advisers for the certainty of uncertainty under the new DOL ruling and other market realities.
The final DOL fiduciary rule aims to ensure that advice is in the retirement investors’ best interest, thereby rooting out questionable fee structures and substandard performance otherwise attributable to advisers’ conflicts. The main objectives of the rule are to develop and enforce a fiduciary standard; raise investment advice standards for retirement accounts; and reign in conflicts of interest for financial advisers working with 401(k)s and IRAs.
Moral philosopher Adam Smith might have agreed that advisers who act in a client’s best interest serve their own self-interest in the long run. This is not a revolutionary concept. It is the right thing to do now; it was the right thing to do several years ago. And, when we reflect on it years from now, it will be the right thing to have done. I believe that financial planners who personally accept the obligation to act in the best interest of their clients will be doing a greater service for their clients and themselves.
With the commoditization of products and the compression of product-related fees, many advisers have already moved to best-interest practices by charging separately for planning and advice. For financial advisers still operating under transaction-based advice or fee-based advice (where fees are based on assets under management), the new rule provides the opportunity to improve their value proposition and their business model. Instead of just “bolting-on” new compliance-focused policies and procedures, these advisers may wish to seize the opportunity to transform their business model into a holistic, advice-based approach where fees are based on the advice, not on AUM.
The Value of an Adviser
The role of a financial adviser has evolved from a technical investment manager to a financial planner, and the role is morphing again into more of a behavioral coach with financial planning acumen. Some have been offering this approach for a while, but the value to investors is being acknowledged now more than ever.
A 2014 Vanguard study on the value of a financial adviser concluded that on average, over time, an adviser added 3 percent net of fees in value for a client annually. Half of this value came from behavioral coaching the adviser provided to the client, up to 70 bps were correlated to the spending strategy (also behavioral in focus), and the rest was attributed to the asset location (not allocation).
Another study by DALBAR, called the Quantitative Analysis of Investor Behavior, has pointed out that investments work better than investors. Over the last 22 years, these annual reports yielded similar results. The 2016 report illustrated that the 30-year average return earned by investors in equity funds was just 3.66 percent, compared to 10.35 percent for the S&P 500—meaning that the average investor earned just 35 percent of what the market provided over this period. The reason for this difference, as indicated by DALBAR, is investor behavior. Imagine how much more money a client could have accumulated if the adviser helped, even slightly, to close the gap between investment performance and investor performance.
Over any measurable period of time (one year, three years, five years, 10 years, etc.), looking at how investors did versus how investments did, investors didn’t do as well, commonly a result of investors acting in a manner inconsistent with stated goals. At times, the financial industry is guilty of selling products that are emotionally easy to get investors to buy—which is often the wrong thing for them in the long term. If clients are prepared for uncertainty, they are less in need of emotionally soothing products that do not serve their best interests.
How Planners Can Prepare
In order to prepare, skilled advisers must:
Help clients behave appropriately and reduce their financial stress by preparing them for the certainty of uncertainty. No one knows what the future holds. Uncertainty includes the length of life, health status while alive, as well as navigating market and economic conditions. Helping clients manage their behavior in a way that prepares them for inevitable uncertainty increases the probability that they won’t run out of money before they run out of life. This is based on think2perform’s Smart Money Philosophy, meaning that whenever the client needs money, there will be a smart place to get it. This is the best thing an adviser can do for a client. It fully serves the best interest of the client and encompasses the scope of financial planning under a holistic, advice-based fee model.
Know that your value is advice, not products. Clients value advice that discourages otherwise smart people from doing dumb things with their money. These advisers effectively influence client behavior by helping clients understand that the single greatest determinant of future value in a retirement account is not the rate of return, product selection, or asset allocation, it’s how much is put into the account. Without understanding this, most advisers spend their time inverse to value. They focus on product selection first and asset allocation second, spending minimal time influencing an investor’s investment behavior, which is actually the most important component.
Know that demographic factors support the move to a holistic, advice-based fees approach as a preferred economic model for assets under distribution (AUD). In the United States 10,000 people per day are turning 65. These same people will begin using at least some of their retirement accounts for income. Helping investors spend their retirement dollars wisely will be an increasingly important element of the adviser’s value proposition. Therefore, it only makes sense that the adviser’s economic model is consistent with their clients’ needs. If an adviser’s business model is priced solely on assets, there will be a decline in revenue and a possible temptation to provide advice that ultimately serves the adviser’s interest, not the client’s desire to enjoy the retirement lifestyle they’ve earned. However, using an advice-based fees model, the adviser is valued and rewarded for unraveling the complexity of converting money from retirement accounts into retirement income.
Moving to a holistic approach may also attract baby boomers’ children, many of whom do not continue working with their parents’ financial adviser. InvestmentNews data shows that two-thirds of heirs terminate the relationship with their parents’ financial adviser upon inheritance. This younger generation of investors is not interested in a financial adviser who offers an irrelevant value proposition and business model. They want transparency, they value loyalty, and if they don’t already have a relationship with their parent’s adviser, they won’t feel a need for loyalty.
Know that holistic, advice-based financial planning for a client includes more than asset management. Many advisers are familiar with and adopt the CFP Board’s practice standards. This planning process greatly assists financial advisers transitioning to an advice-based fees model. It involves six steps, best remembered by the mnemonic, “mirage,” backward: engage, gather, analyze, recommend, implement, and monitor. Although it takes work to set up, this repeatable process can provide exceptional value to the client and the adviser. It not only helps clients through the process, giving them the right advice at the right time to face the certainty of uncertainty, but each step of the process has an output and an audit trail of the advice provided. For financial advisers, this level of documentation is even more important under the new ruling.
Look for ways to systemize the predictable in order to make more time for holistic financial planning. Examples of this might be outsourcing asset management by using robo-advising for certain asset classes or incorporating off-the-shelf technologies into the practice. Systemizing the predictable allows advisers to humanize the exceptional, thus solidly reinforcing the value of their financial and behavioral advice.
It is likely the fiduciary rule on qualified retirement assets is only the beginning, and the next evolution will be on remaining client assets. If an adviser merely complies with the new rule, he or she may find it difficult to be a fiduciary on just qualified assets and not on the client’s entire portfolio.
In addition, when you consider the DOL fiduciary rule and potential rules to follow amid the landscape of increasing product commoditization, future expectation of pricing compression, and rapid innovation in financial technology solutions, moving to a holistic, advice-based fees business model is one of the best ways advisers can prepare for the certainty of uncertainty in the financial planning profession.
Doug Lennick, CFP®, CEO of think2perform, is known for his innovative approaches to developing high performance in individuals and organizations, and is an expert at developing practical applications of the art and science of human behavior.