Introducing fpPathfinder: Flowcharts And Checklists For Diligent Financial Planners

Introducing fpPathfinder: Flowcharts And Checklists For Diligent Financial Planners


Financial planning is full of complex decisions. From handling the nuances of Social Security planning (e.g., whether part-time income may trigger the Earnings Test, or whether past non-FICA earnings could trigger the Windfall Elimination Provision), to navigating the complex set of rules tied to retirement accounts (e.g., how to delay RMDs from a traditional IRA, or the rules for when and how to make a backdoor Roth contribution), the reality is that it can be challenging to remember how all of the many different components of financial planning might interact with each other when making recommendations to clients. Yet managing this complexity is crucial for financial advisors, as the failure to do so can lead to both omissions (e.g., a key rule that gets missed) and errors (e.g., failing to recognize the full breadth of issues that had to be considered in the first place).

Fortunately, checklists are a proven method for helping professionals manage such complexity. As highlighted in his famous book “The Checklist Manifesto”, author (and doctor) Atul Gawande illustrates that one of the easiest ways to handle the daunting complexity that face professionals today is simply to create a checklist of the key steps thatmust be taken, or the key factors that must be considered. In fact, checklists have been widely adopted and demonstrated to be successful in avoiding errors in many professions, including both airline pilots and surgeons. One limitation of checklists is that many people prefer to learn visually, though, which in turn has led to the adoption of flowcharts in professions such as computer programming, where the purpose of the flowchart is largely similar to a checklist (e.g., to help ensure quality control for complex processes that require consistent outcomes), but to do so more visually than a bullet-point checklist.

Yet despite the effectiveness of both checklists and flowcharts, the reality is that one of the biggest barriers to adopting the use of such tools is creating the tools themselves, as it is both time consuming, and can take considerable knowledge to develop these tools in the first place. To address the challenge, we’re excited to announce the launch of fpPathfinder, a new business specifically created to provide checklists and flowcharts for financial advisors, to use either internally in their own practices when evaluating client scenarios and formulating recommendations with clients, or directly with clients as a way to illustrate and explain key financial planning concepts and decisions.

As a starting point, fpPathfinder is offering a “Retirement Planning Essentials” package of visual flowcharts that can be used to cover key retirement planning issues, from eligibility to make tax-deductible IRA contributions and take tax-free Roth distributions, to the specialized claiming rules for Social Security benefits for divorcees or surviving spouses, the rules for delaying RMDs from a traditional IRA, and the rules for when and how to make a backdoor Roth contribution. Over time, fpPathfinder plans to launch additional flowcharts covering both retirement planning and other topics, as well as a complementary set of checklists for common planning scenarios, a voting system for members to express interest in what flowcharts to create next, and the opportunity for advisors to white-label the flowcharts with their own name and brand. Ultimately, fpPathfinder hopes to be a valuable resource for helping financial advisors adopt the checklist and flowchart processes common among other professions – as a means to both help advisors avoid errors and omissions, and to elevate the value of services that advisors provide to their clients!


Professional Complexity And Minimizing Errors & Omissions

Financial planning, like most professions that provide some kind of advice to clients, is complex. Not only is there a sheerly immense amount of information to learn in order to craft technically accurate and appropriate advice recommendations to clients in the first place – the CFP Board lists 72 different Principal Knowledge Topics to be mastered in order to fulfill the education requirement for CFP certification – but it’s even more challenging to remember how all these different components might interact with each other as a part of someone’s financial world.

For instance, when it comes to Social Security alone, it’s straightforward toidentify the client’s projected benefits (on their Social Security statement), and there are many calculator tools to help evaluate the prospective benefits of delaying Social Security. But how often does the advisor alsoremember to verify that the client doesn’t have too much in part-time earnings in retirement to trigger the Earnings Test for those under full retirement age? Or remember to ask the client if they were previously married to a spouse for at least 10 years, such that there could be an ex-spouse’s spousal or survival benefit? Or ask if the client had a prior (or current) job where he/she did not participate in the Social Security system (which can trigger the Windfall Elimination Provision)? Or consider the sequence of return risk impact on the portfolio by taking higher withdrawals in the early years while delaying Social Security?

These challenges – writ large across a wide range of financial planning scenarios for clients – lead to two types of core concerns. The first is that, in the process of trying to consider all the issues, there’s an omission: a key rule that gets missed, perhaps something that is uncommon and only comes up rarely, but happened to matter in this particular client scenario. The second is that the advisor simply makes an error, as the sheer amount of complexity causes some particular interaction effect to be missed, by failing to recognize the full breadth of issues that had to be considered in the first place. We have the knowledge, but fail to apply it correctly.

Thus why most professionals (including financial advisors) end up buyingErrors and Omissions insurance, specifically to help insure against the consequences of those mistakes, whether driven by ignorance or ineptitude.

Ideally, the advisor is simply diligent enough to have studied and learned all the relevant issues, the potential interaction effects, and has the skillset to readily recall all of the key information at the exact time it’s needed.

Unfortunately, though, the reality is that few professionals are perfect all the time. In one study conducted in Australia, 400 mystery shoppers met and became clients of financial advisors, and in the process evaluated seven different client-experience categories (communication, compliance, quality of advice, understanding / needs analysis, referability, emotive reaction, the environment).  The “Understanding” scores were relatively high (ranging from 75.2 to 85.4) suggesting that the advisors consistently did a good job understanding the client needs. But the advisors’ ability to satisfy the need with a quality solution or strategy scored between 58.5 – 72.2. In other words, the advisors came up with a substantial range of different (and varying quality) solutions and recommendations to the exact same client situation and needs.

And beyond the range of mastery of the relevant financial planning knowledge from one professional to the next, the reality is that sometimes we get tired, or distracted, or clients don’t present all of the relevant information we needed to know (and we don’t realize the unasked question that needed to be asked)… or we simply forget an esoteric rule in a situation that doesn’t often come up.

As a result, while studying extensively and gaining experience as a professional – e.g., by earning CFP certification – is a crucial first step in becoming professionally diligent to minimize the risk of errors or omissions for clients, it’s rarely sufficient to prevent all the potential errors and omissions and lead to consistent quality advice.

Financial Planning Checklists And Flowcharts To Ensure Diligent Advice

As highlighted in his famous book “The Checklist Manifesto”, author (and doctor) Atul Gawande illustrates that one of the easiest ways to handle the daunting complexity that face professionals today is simply to create a checklist of the key steps that must be taken, or the key factors that mustbe considered.

One of the first groups of professionals to employ checklists were airline pilots. Because, as the pilots discovered when testing “next generation” bombers in the years leading up to World War II, airplanes had already become so much more complex than the first generation of simple gliders and propeller planes flown by the Wright brothers, that even experienced pilots couldn’t always remember the proper steps to take, especially in the heat of the moment – leading the first test of the Boeing B-17 bomber to result in a fiery crash due to pilot error(where the pilot was the Air Corps’ highly experienced Chief of Flight Testing!). Yet ultimately, a subsequent 1.8 million flight miles occurred in the B-17 bomber without a single crash… once a series of simple checklists (no more than a dozen or two items at a time for the pilot and co-pilot to review together) were created for takeoff, flight, landing, and taxiing.

Similarly, an experiment with checklists in the medical context was conducted at Johns Hopkins in 2001, and later expanded into an even larger multi-hospital experiment, where Dr. Peter Pronovost created a simple checklist to help reduce the frequency of infections when inserting a central line (a large 12-inch catheter inserted into the jugular vein in the neck to administer major medical interventions like chemotherapy, kidney dialysis, or long-term antibiotics). Pronovost created a simple 5-item checklist for the doctors: 1) wash hands with soap; 2) clean patient’s skin; 3) place sterile drapes; 4) wear sterile mask/hat/gown/gloves; and 5) put a sterile dressing over the site once the catheter is inserted. All were steps that doctors already knew, and had long since been trained to do. Nonetheless, once the initiative was rolled out, and anyone/everyone on the team was endowed with the authority to ensure the checklist was followed (and call out the doctors for not following it), the 3-month infection rate fell literally to zero. Just by having a simple checklist to ensurethe key items were always, consistently followed.

The key point is that checklists don’t need to be terribly complex to reduce the frequency of adverse outcomes in complex situations. They’re not necessarily intended to cover every possible situation – as the edges of complexity are still where professional expertise reigns – but instead to ensure that the core essential steps that at least cover the overwhelming majority of cases are applied consistently. And the professional is at leastprompted to spot where there may be an issue that in turn merits further diligence.

On the other hand, one key challenge of checklists is simply thatapproximately 65% of the population are visual learners, who need to seewhat they’re learning or are supposed to do in order to fully assimilate the information. As the saying goes, “a picture is worth 1,000 words”.

Accordingly, in professions like engineering and computer programming, it is more common to use flowcharts as a way to sort through and evaluate the key information in a process. The basic concept remains the same – the flowchart serves as a means to ensure that all the steps of a process are properly considered and followed, in the proper sequence, without skipping any key steps that could lead to the wrong outcome. And can be especially effective because the visual nature of the flowcharts allows small, lesser known rules to place just as much “weight” as the other rules, since it clearly shows all the relevant options to consider at each decision point. In fact, one of the earliest uses of flowcharts was specifically to help ensure quality control for complex processes that required consistent outcomes.

Introducing fpPathfinder For Financial Planning Flowcharts and Checklists

Several years ago on this blog, I made the case that it was time for financial planners to adopt checklist as a way to improve the consistency (and therefore the overall quality) of financial planning advice. The more comprehensive financial planning becomes, the more complex it also becomes, and the greater the risk that even a well-trained and well-intentioned advisor fails to identify and spot every possible planning issue, opportunity, or concern from memory alone. And as Gawande illustrates in his book, checklists (and flowcharts) help to reduce this risk and better ensure a consistently diligent planning process.

Notably, though, such tools aren’t just a means to have simpler navigation of complex processes, and as a way to ensure that a financial planning situation is thoroughly researched and considered from all angles. Instead, financial planning flowcharts and checklists have a number of important uses, including:

  • Client educational tool:  Clients can benefit from checklists, and especially visual flowcharts, just as much as a planner.  Much of what individuals hear and learn from the mass media related to financial planning is incomplete, and does not fully capture the complexity of the financial planning process. It can be overwhelming for clients, leading them to make a bad decision because they did not invest the time or energy to learn everything they needed to about the issue.  Flowcharts in particular provide an alternative method of presenting that information, in a way that allows the client to quickly and easily understand the scope of the issue, and the advisor can walk them step by step through the key decisions that must be made along the way.
  • Respond to client questions faster:  Some of the best opportunities to create value for clients comes from quickly addressing their challenges in times of need – the unscheduled client call with what “should” be a simple and straightforward planning question that has important consequences.  But if the planner is preoccupied or distracted, he/she may not give the most thorough answer, or not remember to ask the appropriate probing questions.  At best, this could lead to the planner needing to do more research before calling back with answers (which takes a lot of time). At worst, the planner could give improper advice off the cuff that could actually harm the client (either through error or omission). Checklists or flowcharts readily available as a desk reference for the planner ensures that all the major decision points and issues have been addressed right there on the spot, saving time for the advisor, and getting the client the answer they wanted quickly.
  • Show actual complexity: Sometimes clients may be unaware of the extent of how complicated financial planning decisions can really be.  Flowcharts in particular can be used to more effectively frame the depth and complexity of a conversation.  A good example deals withthe issues related to eligibility and timing for claiming Social Security.  It is especially important to show and consider the number of less-common-but-extremely-important rules and exceptions that must be considered before claiming, such as the Earnings Test, deemed filings, the Windfall Elimination Provision, and the Government Pension Offset rules.  From a client’s perspective, this can give them confidence knowing that their planner is thoroughly covering all the issues.
  • Uncover more planning opportunities. There are times when planners may not connect the dots between two seemingly separate planning issues.  In reality, many planning issues are interconnected, and advice in one area can open advice discussions in other areas. For example, a planner could use a flowchart as a guide to rememberpossible IRMAA penalties before doing a Roth conversion, and a discussion about the taxability of Social Security benefits could lead to a discussion about changing a municipal bond portfolio because its income is still included in Social Security provisional income for tax purposes.
  • Quick introduction to a new concept.  Using a checklist or flowchart prior to doing research on a financial planning issue is akin to providing a 10,000 foot overview. It doesn’t provide all the detailed knowledge, but it quickly gets the planner to hone in on the major issues that affect the client issue they are working on.  From there, the planner can jump into other resources to clarify or deepen his/her understanding.
  • Avoid careless errors. In some cases, planners run the risk of making a mistake.  They may misremember one of the steps in a Roth conversion, or don’t think through a Backdoor Roth contribution correctly, leading to a slew of subsequent problems for the client. Perhaps it could be as simple as a careless error, or perhaps it’s caused by a planner who was unqualified to give the advice on a specific topic and didn’t take enough time to (re-)research the issue first.  While no tool can prevent those problems from happening 100% of the time, a series of easy to use checklists can drastically reduce the likelihood of those mistakes happening.
  • Remember old / odd rules:  There are many cases when financial planners are simply rusty on certain rules, or the nuances associated with those rules.  Rules around IRA contribution amounts and contribution limits are often a sticking point for many planners, because the numbers change (i.e., are inflation-adjusted) almost every year.
  • Multi-Advisor Quality Control.  In his “Checklist Manifesto” book, Gawande references a finding that doctors and nurses make a mistake 1% of the time.  But what’s surprising is that doctors and nurses do somuch every day, that a 1% error rate translates to about 2 mistakes per day, with potentially fatal consequences for patients.  Applying that finding to financial services, planners can use simple tools like checklists and flowcharts to improve the quality of advice and client outcomes across their entire practice, especially when multiple (especially newer associate) advisors are involved, ensuring that they make fewer mistakes (and making the compliance and legal departments happier!).
  • Study tool:  For students and new planners working toward their CFP certification, checklists and especially visual flowcharts can be useful study tools to help make a concept “stick” and easy to recall.  What makes flowcharts particularly interesting is how the CFP Board exam tends to test not just on the rules, but on the exceptions to the rules (often using “tricky” questions).  In these cases, flowcharts excel due to their ability to illustrate not just the rules, but the nuances and exceptions associated with the rules, in a visual format most conducive to the majority of the population who are visual learners.
  • Quick reference: Instead of cracking open a voluminous reference guide, or trying to verify the most accurate rules online, it can be easy enough to have a series of fast reference checklists or flowcharts within arms reach.

fpPathfinder LogoGiven all these opportunities and uses, we’re excited to announce the launch of fpPathfinder, a new business specifically created to provide checklists and flowcharts for financial advisors, to use either internally in their own practices when evaluating client scenarios and formulating recommendations with clients, or directly with clients as a way to illustrate and explain key concepts, or simply walk through the decision-making process and the key choices and issues to consider with the client.

Can I Make A Backdoor Roth IRA Contribution 2018

As a starting point, we’re offering a “Retirement Planning Essentials” package of visual flowcharts that can be used to cover key retirement planning issues, from eligibility to make tax-deductible IRA contributions or take tax-free Roth distributions, to the specialized claiming rules for Social Security benefits for divorcees or surviving spouses, delaying RMDs from a traditional IRA, or the rules for when and how to make a backdoor Roth contribution.

Over time, we plan to launch an ever-wider range of flowcharts (both within and beyond retirement planning), a complementary set of checklists for common planning scenarios, a voting system for members to choose which flowcharts or checklists they’d like to see next, and the opportunity to white-label the flowcharts and checklists with your own name and your firm’s logo (in a range of color choices).

fpPathfinder LogoBecause again, as the Checklist Manifesto, and the entire history of flowcharts and checklists have shown, even diligent professionals can benefit from simple tools to help ensure they’re giving the right recommendations to the clients they serve! AndfpPathfinder aims to fill that void when it comes to helping financial planners better serve their clients!

 (Disclosure: Michael Kitces is a co-founder of fpPathfinder.)

So what do you think? Do you use checklists or flowcharts in your practice? Can flowcharts help with client education? What flowcharts would you find most useful? Please share your thoughts in the comments below!

SEC Backs Major ETF Rule Change

SEC Backs Major ETF Rule Change

The SEC has voted unanimously to officially propose the so-called “ETF Rule”, which is now open for a 60-day comment period, and if adopted would make it drastically easier for new ETFs to be launched. Specifically, proposed SEC Rule 6c-11 would allow ETF issuers to launch both new ETFs structured as an open-ended fund (both active and passive version, but not UITs) without being required to first obtain “exemptive relief” (a workaround that allows the ETF to be issued without violating  the Investment Company Act of 1940, particularly around the requirement that shares of an open-ended fund must be redeemable on any day at the request of the shareholder, whereas ETFs can only be deemed by authorized participants). Currently, exemptive relief for an ETF must be applied for and ruled on one new ETF at a time, which dramatically increases the legal/regulatory costs (and the timeline) to launch an ETF, and some allege it has caused an “uneven” playing field because each ETF issuer has its own exemptive relief provisions that are not necessarily consistent with others (as what the SEC has been willing to allow has itself changed and evolved over time as ETFs have matured and gained adoption). The rule would also expand the ability for custom creation/redemption baskets to be made available for all ETFs, which is important to allow particularly active ETFs the ability to swap which securities are used in creation versus redemption transactions in an attempt to minimize capital gains events. Ironically, though, the growth of the ETF market has already led to various white-label issuers stepping in to support ETF creation, such that what took a year and $1M to get approved a decade ago, is now just a few months and tens of thousands of dollars instead (though it’s not clear how those white-label providers will evolve now that expedited exemptive relief will no longer be necessary in most cases). Notably, the SEC’s proposed ETF rule would also increase transparency requirements for ETF providers, including a requirement for issuers to disclose historical premiums and discounts and their typical bid/ask spreads directly on their own websites, and to publish their creation baskets at the beginning of each business day.

Here Come New No-Load Insurance Policies

Here Come New No-Load Insurance Policies

The growth of ETFs and index funds hasn’t just signified a notable shift in the use of active versus active investment vehicles over the past 20 years; it’s also signaled the rise in “buying power” that no-commission fee-based financial advisors can command with their clients. Yet despite the meteoric growth of various no-commission/no-load investment options, the insurance and annuity marketplace has remained stubbornly hooked to commission-based (and commission-only) products and distribution models. As with loaded mutual funds, the significance is not just a difference in how the advisor is paid and charges for services, but the simple fact that once commissions don’t have to be priced internally into the product, the internal costs are often much lower; for instance, amongst the (admittedly small) subset of variable annuities available on a no-load basis, the typical cost is just 20-30 basis points, compared to an average of 135 basis points for commission-based variable annuities. In addition, for most insurance and annuity products, the surrender charge exists primarily to help ensure that the company can recover the upfront commissions paid via those higher expense ratios (or the surrender charge itself if the contract is cancelled early)… which means if the product is no-load, there is usually no need for any surrender charges, either. The caveat, though, is that early experiments with no-load annuity products in particular have gained only limited traction at best, due in part to the simple fact that even if the products are no-load and thus can fit an RIA’s business model, they lack the integrations to fit the RIA’s existing technology and business processes. And to the extent that no-load products are being launched at all, they have primarily been on the annuity side of the business, and not life insurance. Nonetheless, with both a regulatory (i.e., fiduciary) push that is anticipated to lead inevitably to more fee-based business and less commission-based business, and companies like DPL Financial Partners working to build the bridge between insurance/annuity carriers and the RIA market, the pace of no-load insurance and annuity product launches (and integration capabilities) is anticipated to expand rapidly in the coming years.

SigFig Raises $50M Series E To Expand Capacity As The B2B2C Robo Model Accelerates.

SigFig Raises $50M Series E To Expand Capacity As The B2B2C Robo Model Accelerates.

This month, robo-advisor-for-advisors SigFig announced a whopping $50M Series E round (bringing their total capital to $117M), funded by late-stage venture capital firm General Atlantic (also known for investing in Facebook, Alibaba, and AirBNB). The influx of capital is a huge confidence boost to the B2B2C “robo-advisor-for-advisors” model that SigFig (and many others) pivoted to in 2016 when itpartnered with (and took funding from) wirehouse UBS, and later expanded to work with Wells Fargo and Citizens Bank as well. In fact, General Atlantic reportedly had decided to wait and not invest in early B2C robo-advisors that were struggling in the war for costly client acquisition and facing slowing growth rates, and instead view SigFig as more of a large-financial-services-firm technology infrastructure play as SigFig increasingly integrates to and overhauls the wirehouses’ existing technology. AndSigFig CEO Mike Sha himself reports that the entire venture round will go towards engineers and product managers, and not client acquisition. Not to say that SigFig isn’t powering actual client results; it’s the core of the UBS Wealth Advice Center, which for 75 bps provides the SigFig dashboard of portfolio diagnostics, goal tracking features, and a UBS managed account solution. Instead, the momentum for SigFig appears to be driven in part byrecognizing that “robo” tools are really a back-office operations and infrastructure play and not a direct path to (young) clients, while large firms like UBS that already have retail distribution capabilities are the ones that can best put it to use (while most independent advisors can’t). The bottom line, though, is that General Atlantic’s big investment into SigFig is the strongest signal yet that the overhaul of legacy financial services technology systems into modern “robo”-style tools is still only in its nascent stages, as robo automation technology finally finds its proper home powering back-office and middle-office systems (and not just as a direct-to-consumer niche solution).

Understanding FIRE: A Philosophy For Financial Independence And Retiring Early

Understanding FIRE: A Philosophy For Financial Independence And Retiring Early

The acronym “FIRE” is short for “Financial Independence, Retire Early”, a movement born largely online with a focus on spending less, saving more, and harnessing the power of compounding to retire early. But as Hy notes, the FIRE movement (as embodied by the massive nearly-400,000 participants in its active sub-reddit) arguably goes even further, embodying a broader life philosophy that combines personal finance with “a DIY work ethic, opportunistic side hustles, life hacking, and the tenets of anti-consumerism” (i.e., spending less by not buying into tradition consumer buying trends). As those who pursue the FIRE movement typically try to save extreme percentages of income (e.g., more than 50%/year) to accelerate the path of achieving financial independence, which notably comes from not only trying to reduce spending (often by living a deliberately “simplified” more frugal lifestyle, from biking to work to save on commuting expenses and learning to cook to save on eating out, which also have personal health and family bonding benefits), but also increasing income (through a primary job or side hustles) to generate excess dollars that can be saved. Many members of the FIRE community then go even further to “hack” the consumerist world, such as proactively rotating credit cards to capture bonuses (but only hitting the minimum spend requirement and then cancelling before the annual fee must be paid), and leveraging credit cards points systems to save aggressively on travel expenses as well. The ultimate goal is to save enough to reach 25X annual spending (which correlates to a 4% safe withdrawal rate), albeit while recognizing that the actual amount of savings that will entail varies greatly by geographic location (with city-dwellers aiming to “FatFIRE” with $2M+ in cities like New York, while others “leanFIRE” in low cost of living areas where less than $40,000/year may be completely viable in the long run).

Vanguard Declares War Against Custodial Platform Shelf-Space Distribution Agreements

Vanguard Declares War Against Custodial Platform Shelf-Space Distribution Agreements


Earlier this week, Vanguard announced that in August it will begin offering commission-free ETF trading through its online brokerage platform on a whopping 1,800 ETFs… which includes not just its own ETFs, which were available commission-free already, but virtually all ETFs, including those from all their major competitors like Blackrock, State Street, and Schwab (on top of the 2,500+ mutual funds already available through Vanguard without trading fees). Yet while the media immediately jumped on the announcement as a new stage of the price wars on ETF trading costs, as Vanguard’s platform will offer nearly 5X – 10X the breadth of ETFs as their largest competitors… the real significance of Vanguard’s announcement is much bigger.

In this week’s discussion, we discuss why the real impact of Vanguards announcement is a potentially fatal disruption to the nature of no-transaction-fee (NTF) ETF platforms themselves, undermining existing pay-to-play distribution agreements to the most popular NTF ETF platforms today, and potentially pushing RIA custodial platforms instead to charge advisors (or investors) a more transparent and less conflicted basis point fee directly for the clearing, custodial, and other services they provide.

Some historical perspective on the use of shelf-space and revenue-sharing distribution agreements for fund providers may be helpful to understand why Vanguard’s announcement is so disruptive. The first “no transaction fee” (NTF) online brokerage platforms got going in the 1990s, pioneered by companies like Schwab with their OneSource program, establishing a giant online supermarket of mutual funds that were made available (and funded by) 12b-1 shareholder servicing fees and sub-TA fees instead of charging “traditional” transaction fees to purchase a fund. But then along came ETFs, which “felt” like mutual funds to many consumers who wanted to be able to buy them without transaction fees as well… except, ETFs don’t have a 12b-1 fee or a sub-TA fees! As a result, when the online brokerage platforms wanted to offer ETFs under a no-transaction-fee platform, they needed a new way to get paid. What emerged was brokerage platforms negotiating “distribution” agreements directly with the ETF providers that effectively said, “If you want to be listed in our NTF platform, you need to pay us directly”, taking the form of other a revenue-sharing agreement (paying basis points for assets on the platform) or “shelf-space” agreements (which are typically negotiated flat fees and not set as basis point directly, though they are still effectively loose basis point equivalents based on total assets). The key point: one way or another, fund providers had to pay to be on the NTF platform, which is why most NTF ETF platforms have a limited lineup (or only those providers willing to pay).

And, mostly out of necessity for distribution opportunities, many fund providers have paid to be on these platforms. The bold exception to this trend was fund companies like Vanguard and DFA, which were notorious for not paying dollars under the table to get onto these NTF platforms. Early on when many NTF ETF platforms were being built out, Vanguard still wasn’t nearly as dominant in the ETF space as they are today, so many companies allowed Vanguard onto their platforms as a way to validate their platform (with Vanguard’s name recognition) in the hopes of attracting clients who might also use some of the other NTF funds (that do pay to be listed). But as Vanguard has continued its meteoric rise over the past several years, Vanguard attracted so much in assets onto these platforms that it was adversely impacting the profitability of the entire platforms… leading companies to swap Vanguard out for other ETF providers that were more willing to pay to participate.

And that is why it’s such a big deal that Vanguard made the announcement this week that it’s going to make virtually all ETFs available on its own online brokerage platform. The significance is that they’re offering a no-transaction-fee platform without requiring the same back-end shelf space payments that all the other brokerage and custodial platforms require. In other words, the latest move by Vanguard isn’t a price war against ETF trading fees; instead, it’s declaring war on the entire model of asset managers being forced to pay back-end revenue-sharing and shelf-space agreements to get onto those platforms in the first place, by offering their own and not charging the asset managers what everyone else charges!

How will this potentially play out from here? ETFs that currently pay NTF platform fees are compelled to increase their expense ratios to cover the cost (because the money has to come from somewhere to pay)… except now ETF providers have a problem: their ETF expense ratios are boosted higher to compete on NTF platforms at companies like Schwab, Fidelity, and TD Ameritrade, but the higher expense ratios to cover the distribution costs on those platforms will reduce their competitiveness on the new mega Vanguard platform! As a result, ETF providers may be compelled to start creating a new series of their popular ETFs, with those additional distribution costs stripped out, creating a lower-cost “clean ETF” that can better compete in a true NTF environment. Yet once this happens, since the ETFs will be available elsewhere as well (just with a transaction cost instead) it will recreate the multiple-share-class effect we have now in mutual funds, where there’s a higher cost version of the mutual fund in the NTF platform – because it’s pushed up by the 12b-1 and sub-TA fees – and then there’s a lower cost version of the same mutual fund you can buy directly. Which ultimately will lead to consumers (and advisors) adopting whichever fund is cheaper in their situation, putting further pressure on custodians to offer less conflicted models where investors (or advisors) are simply charged a transparent basis point fee for the clearing and custodial services provided instead.

But ultimately, the key point is to acknowledge that the real news is not that Vanguard is simply offering a larger NTF platform than other providers. The real news is that this may be a fatal disruption to NTF platforms themselves, and a step towards a more transparent model of custodial services over the more conflicted models of back-end distribution agreements that currently exist!

Shelf-Space And Revenue-Sharing Agreements For NTF ETF Platforms

So, a little bit of historical context here. The first no-transaction-fee online brokerage platforms really got going in the 1990s. Pioneered by companies like Schwab, with their OneSource program, that basically built this giant online supermarket of mutual funds. Now, of course, brokerage firms still have to make money, but the key insight at the time was that, rather than charging transaction fees to purchase funds, which they realized actually wasn’t going to be a good deal for mutual funds anyways because they tend to be bought and held and not actively traded the way that stocks and bonds are, Schwab’s OneSource program took this 12b-1 shareholder servicing fee for the funds instead, with a plan to make money over time on the servicing fee for buy-and-hold investors instead of making it up on the trading volume.

And this was further bolstered by what are called sub-transfer agent or sub-TA fees, which were paid by the mutual funds to the brokerage platforms for all the handling that they were doing around fund record-keeping, tracking purchases and sales, calculating dividends and gains distributions, and so forth. So the mutual fund NTF platforms made no money on the upfront trading fees because they made their money on the ongoing 12b-1 and sub-TA fees instead, which works well when you’ve got long-term investors.

Then ETF showed up. And from the investor perspective, an ETF felt like a mutual fund. Sure, it traded intraday instead of just once a day at the end and there were some differences in tax treatment, but it was a pooled investment fund like other pooled investment funds like mutual funds. And so, even though ETFs traded intraday like stocks, investors increasingly wanted to buy them like mutual funds, and without the transaction fees.

And the problem is that ETFs don’t have 12b-1 fees or sub-TA fees to pay the brokerage platform. So when online brokerage platforms wanted to offer ETFs under a no-transaction-fee platform, they needed a way to get paid. And the way they got paid was they simply negotiated direct distribution agreements with the ETF providers and said, “Look, if you want to be listed on our NTF platform, you’ve got to pony up, you’ve got to pay, either as a revenue-sharing agreement, if you want to be on our platform, you have to pay 10 or 20 or 30 basis points for all the assets on our platform,” or what were effectively shelf space agreements, where the ETF providers didn’t pay basis points, but everyone did the math. If the ETF provider had $1 billion in the NTF platform, the brokerage firm said, “If you want to continue accessing the platform, you’ve got to pay us 1 million bucks.” And 1 million bucks was 10 basis points and $1 billion in the platform. So it was a shelf space agreement and not a basis point agreement, but it was really calculated to be equivalent to basis points.

So this way, brokerage platforms could continue to make their basis points or basis point equivalent providing no-transaction-fee ETFs the same way they did with their transaction fee mutual funds. And while the ETF doesn’t literally have a 12b-1 fee or a sub-TA fee, functionally, the end result is the same. The fund company has to pay to distribute the ETF, which increases the expense ratio of the ETF, because the money has to come from somewhere. And so for most consumers, it was really a distinction without a difference. You could buy a mutual fund that paid an NTF platform through 12b-1 and sub-TA fees, or you could buy an ETF that paid the NTF platform fee through a revenue-sharing distribution agreement. End result, though, was that the expense ratio of the fund was lifted up for the consumer so that the custodial platform could make their dollars.

And then Vanguard came along.

How Vanguard (And DFA) Bucked The Trend Of Paying For Distribution

Because, the unique thing about Vanguard relative to virtually the entire remainder of the ETF marketplace, is that they’re notorious for not paying dollars under the table to get onto these NTF platforms. They just don’t pay the way that everybody else does. Now, 5 to 10 years ago when a lot of these platforms were being built, Vanguard was still not nearly as dominant in the ETF space as they are today. They were popular, and so a lot of companies allowed Vanguard in because it was good name recognition, it helped to validate the platform to say they offered Vanguard funds, but there was always tension because technically, every investor or advisor that actually chose the Vanguard ETFs in the NTF platform was sticking it to the custodian or brokerage firm because they weren’t actually getting paid on those assets.

But as Vanguard continued its meteoric rise over the past several years, that phenomenon has shifted from, “Sure, we’ll include some Vanguard funds as part of our ETF lineup to give it more credibility, and we’ll just hope that most investors use a lot of other funds that pay us as well,” to something that’s more like, “Oh, crap, Vanguard is attracting so much in assets to our NTF ETF platform that it’s killing the profitability of our platform, we’ve got to swap them out for other ETF providers who will pony up and pay.” And that’s why last year you saw the big announcement when TD Ameritrade completely redesigned their NTF platform, which they billed as a great expansion of their NTF options, but reality was structured to kick Vanguard out, because Vanguard wouldn’t pay on the back end, and they had to substitute in other ETF providers who were willing to pay to play.

And it’s a phenomenon that’s been happening with Vanguard mutual funds for a long time as well. This is why most RIA custodial platforms charge more to trade Vanguard mutual funds than any other, because Vanguard doesn’t give them the 12b-1 and sub-TA fees that the others do. DFA is also known for not paying on the back end, which is why they are more expensive to trade. And this is even why you saw the big announcement last year that Morgan Stanley decided to kick Vanguard mutual funds off their platform entirely because Vanguard wouldn’t give them the back-end payments.

Now, most fund companies that refuse to pay to play distribution game end up suffering. This is why it is so entrenched. Because they just don’t have any other way to get their funds out there. So they’re stuck mired in obscurity. Or even if they can get known a little, it’s so hard for most fund companies to become so known and so popular that consumers will choose to take that upfront transaction fee slap to the face just to have a chance to own that fund.

That’s where Vanguard is somewhat unique in being able to get away with this because the Vanguard brand is so strong. And in part, because they really do make it up for the consumer by making their mutual funds and ETFs cheaper, and passing along that savings of what they’re not paying in distribution payments to the consumer. So, you know, we as the advisor and the investor say, “Well, I’m willing to pay a little bit of a trading fee for Vanguard funds because I know I’m going to make it up in the long run on the lower ongoing costs. And, you know, it sucks to have to pay the upfront fee, but I can see it’s a good deal in the long run.”

Vanguard Declares War On Shelf Space Distribution Agreements

And this is why it’s such a big deal that Vanguard made the announcement this week that it’s going to make virtually all ETFs available on its online brokerage platform. Because the real significance is not just that they’re offering no transaction fees on 1,000 more ETFs than any other NTF platform, the significance is that they’re offering a no-transaction-fee platform without requiring the same back-end shelf space agreements that all the other brokerage and custodial platforms require.

In other words, the latest move by Vanguard isn’t a price war on ETF trading fees, it’s declaring war on the entire model of asset managers being forced to pay back-end revenue-sharing and shelf space agreements to get onto the platforms in the first place. And Vanguard is doing it by saying, “Fine, we’ll just make our own and not charge the asset managers what everybody else charges.” That helps to explain why they got 1,800 ETFs onto the platform. It’s pretty easy for an asset manager to say yes to that.

So in the near term, the headline is, “Vanguard is offering 1,800 ETFs with no transaction fees”, which means I’m sure sometime in the next few weeks, Schwab or Fidelity or TD Ameritrade, or several of them will cut some more deals with ETFs or new ETF providers and send out a press release that says, ‘Hey, we’re expanding our lineup by another 100 or 200 or 300 ETFs as well, and we’ll now provide opportunities for more than 98% of the investable marketplace with our free-to-trade ETF lineup.’” Because it misses the point.

The real significance here is not the breadth of the Vanguard lineup of no-trading-fee ETFs, because it doesn’t take that many to get broad exposure in the market in the first place. We don’t need 1,800 different ETFs to make a well-diversified portfolio. The significance is that they’ve created a platform to do it without layering in the same depth of back-end fees that the other platforms are charging to the asset managers in the first place.

And I want you to think for a moment about how this plays out from here. ETFs that pay these platform fees are compelled to increase their expense ratios to cover the cost, because the money has to come from somewhere. Except now if you’re an ETF provider, you have a problem. Your ETF expense ratio is boosted artificially higher to compete on NTF platforms like Schwab and Fidelity and TD Ameritrade, but the higher expense ratio to cover the distribution cost on those platforms is reducing your competitiveness on the new mega-Vanguard platform, where Vanguard itself is probably going to kick your butt on the expense ratio because their expense ratios are not elevated for the back-end payments you’re paying on the other platforms.

So what do you do as an ETF provider? My guess, you’re going to see ETF providers start creating new series for their popular ETFs with those distribution costs stripped out. A new lower-cost version of their ETF specifically to go on platforms like Vanguard’s no-transaction-fee platform, because they need the lower cost to be competitive, especially on a platform like Vanguard, which is known for its cost competitiveness.

But this causes a bifurcation in ETFs. Because what we’re going to end out with are the equivalent of two share classes of ETFs: higher-cost share class ETFs that go into NTF platforms that require back-end or shelf space agreements, and lower-cost versions of the same ETFs that go to platforms like Vanguard’s, or even any other platform where if you’re just willing to pay a few bucks for an upfront trading fee, you get the lower-cost share class of the ETF.

Basically, it’s going to recreate the multiple share class effect we now have in mutual funds, where there’s a higher-cost version of mutual fund that get some distribution agreements in the NTF platforms, pushed up by 12b-1 and sub-TA fees, and then there’s another lower-cost version of the same mutual fund that you can buy directly. All mutual fund share classes at the end of the day are derived from different payment distribution agreements to platforms.

And now the same thing is coming to ETFs, spurred by what Vanguard has done. And it creates an opportunity for us to choose whichever one is the lower cost in the long run. The NTF version for small clients where trading fee is prohibitive and we want to get that NTF platform, and then buying the lower-cost version directly, where the trading fee is smaller than paying the ongoing higher expense ratio. Which over time is really going to turn NTF platforms from free no-transaction-fee platforms into what’s really just a fee-based wrap account where the transaction fees are wrapped into the ongoing basis points you pay on the platform. You can either pay directly as wrap fee or indirectly through the expense ratio or the mutual fund or ETF. But if you want the cheaper version, you’ll be able to get it and separate out those distribution costs.

How Vanguard Profits In The War Against NTF Platforms

In the meantime, you may be wondering how Vanguard itself can afford to do all this without actually earning the money that the other platforms earn, because obviously, Vanguard does need to run an economically viable business itself. But think about it for a moment from Vanguard’s perspective. Vanguard gets more opportunities to consolidate a household’s entire base of assets onto the platform at Vanguard in ETFs where they’re already the market leader. I mean, how long do you think it is before investors consolidate their assets into Vanguard’s offering of 1,800 no-transaction-fee ETFs and then decide that, “Hey, there’s a Vanguard option version of what I’ve already got that’s a little cheaper, why don’t I just switch to the Vanguard version?”

In fact, Vanguard will essentially get to use this as on-platform market research. All they have to do is literally look into their own accounts, see what investors hold that Vanguard thinks they can replicate at a lower cost. And if there’s enough of the asset opportunity, roll out a competing fund at a lower cost, communicate to all the investors on their platform, “Hey, we’ve just offered a lower-cost version of what you already own, would you like to make the switch? Click here.” And it’s a huge asset growth opportunity for Vanguard.

On top of that, Vanguard has Personal Advisor Services, their advisor platform where they give access to human CFP certificant to provide additional financial advice for a cost of 30 basis points. So even if Vanguard makes nothing on the ETFs that their clients hold from competitors that aren’t Vanguard, they can make money on the Vanguard advice offering.

Which is just what I predicted last year, that eventually someone would break the existing paradigm by saying, “We’ll give the investments away for free and just charge for the advice.” And that’s exactly what happens if Vanguard starts to gather assets on its no-transaction-fee platform. It doesn’t make money on the back-end payments because they just upsell to Vanguard Advisor Services instead. So they’ll make zero on the investments and 30 bps on the advice. Which is actually even better for them because at the end of the day 30 basis points on advice is way more revenue than 3 to 5 basis points that they charge on a lot of their ETFs anyways. And of course, there’s still the opportunity that Vanguard advisor works with the investor, and then helps them to discover that there are some cheaper Vanguard alternatives for the things that they already own. It’s a win-win-win opportunity for Vanguard even without making all those back-end dollars.

Implications For RIA Custodians And Financial Advisors

So what are the implications on this for us as advisors? The bad news, I guess if you can call it that if you’re in search of lower-cost solutions for your clients, is Vanguard does not have a full-scale custodial offering for RIA. So, as far as I’m aware, we will not have any way to directly access this kind of, you know, true no-transaction-fee platform for our clients unless we send them directly to Vanguard retail. And while we’ll see if ultimately Vanguard makes a harder shift into the financial advisor business by actually offering custody and clearing services for RIAs, at this point, they seem content to have their funds distributed through other RIA custodians to reach advisors, and focusing their services on serving consumers directly, including financial advice directly for those who want to buy it from Vanguard Personal Advisor Services.

But even if Vanguard isn’t going to become an RIA custodian any time soon, the ripple effects that are going to come from them basically declaring war on NTF platforms and all these hidden back-end shelf space agreements that are out there, it’s a really big deal. In retrospect, I think this explains why just two weeks ago, E-Trade announced that they were adding 32 Vanguard ETFs to their own NTF platform. Because Vanguard probably told them, “Not only are we going to not pay you basis points to put Vanguard ETFs on your E-Trade platform, but we’re going to open our own competing NTF platform. So if you don’t allow us in the mix with your ETFs, we’ll just take your customer and allow them to full mix of ETFs on our platform instead.”

Similarly, I think this is really a slap in the face to TD Ameritrade that kicked Vanguard out of its NTF platform last fall, right before the Scottrade acquisition, and now instead of just losing money on Vanguard ETFs in the TD Ameritrade NTF platform, now TD Ameritrade is going to have to compete directly against Vanguard’s own solution. I think they may have slightly underestimated the size of the hornet’s nest they were kicking when they decided to kick Vanguard out.

And again, because the reality is that the expense ratios of so many ETFs are artificially inflated by all of these platform shelf space and revenue-sharing agreements that happen and all the ways that brokerage firms try to extract money from asset managers behind the scenes, if Vanguard’s new NTF platform gets any traction, there’s going to be immense pressure on asset managers to launch new versions of their ETFs that are lower-cost alternatives to strip out all these back-end payments, which will then become lower-cost ETFs that all of us can buy for advisors as well, even if Vanguard doesn’t offer us the platform directly. Because once the ETFs are launched, they’re out there, and that ever-decreasing ETF trading cost, you know, $9.95, $6.95, $4.95, as they go lower and lower, this just becomes a better deal for all of us to serve our clients as well.

And frankly, will pull even more assets away from NTF platforms because every advisor is going to do a map and figure out, “Is it cheaper to pay the upfront trading fee into the lower-cost fund, or to avoid the trading fee and just pay the higher-cost ETF instead?” You know, in essence, we’resystematically wired to dismantle the profits of our custodians as cost savings for our clients, and now the game is on.

You know, even as Karin Risi said, who’s Vanguard’s own managing director of retail, you know, the way they frame this is, “Vanguard is driving down the cost of investing in ETFs.” Not the cost to trade ETFs, the cost to invest in them, because this is actually about the back-end payments, not the upfront payments. And if it doesn’t work, well, it’ll be interesting to see if Vanguard does decide to take the process one step further and actually launch some kind of more full-service RIA custodial platform and expand this kind of less conflicted version of the NTF platform more directly to the advisor community.

Now, I do think it’s important to notice, as we wrap up, that RIA custodians and brokerage platforms do provide a service and they do deserve to get paid. I am not at all advocating that we should be getting everything for free here. But the nature of NTF platforms with their hidden back-end payments that I’m not even sure all advisors and investors realize are there, presents real conflicts of interest between RIA custodians and their advisors, which we see play on situations like TD Ameritrade yanking Vanguard funds out of their NTF platform and causing an advisor uproar in the process.

In fact, my guess is that this new shot fired from Vanguard back at the back-end payments for NTF platforms will hasten us towards what I think is theinevitable conclusion that eventually, RIA custodians are going to have to charge their own basis point fee for custody services instead, rather than trying to squeeze all these back-end payments. So if a custodian says, “Look, we need to make 5 basis points or 10 basis points or 20 basis points,” whatever it is on investor assets on the platform, rather than I think this quagmire of back-end payments and the whack-a-mole game that as advisors we play to try to game the system to bring the cost down for our clients, just let the RIA custodians charge that exact same custody fee directly for the real value they’re providing, from trading and record-keeping, the technology and support services, it won’t necessarily be more or less expensive. In fact, the custody fee could be restructured to deliberately match whatever the average basis points are that custodians already earn on advisor assets.

But by realigning the model, they can be in alignment with advisors and our clients, and actually focus for once on giving the best solutions because they’re already getting paid, rather than trying to drive us or game us into higher-cost solutions to make their hidden but not really hidden fees. That’s why most RIA custodians sweep client cash to proprietary money market and related bank entities that pay 0.5% or 0.1% or some literally zero, and Vanguard’s online brokerage platform is going to sweep to a Vanguard money market fund that yields 1.82%. It’s amazing what happens when companies reduce the conflicts between their own business model and the advisors and investors they serve.

But the bottom line here is just to recognize that the real news of the announcement is not that Vanguard is going to be offering 1,800 ETFs with no transaction fees while their competitors only offer 100 or 200 or 300. The real news is that Vanguard is fighting back hard against the industry practice of trying to extract back-end revenue-sharing and other shelf space distribution agreements by launching their own competing platform and focusing on other ways that they can make money that’s more aligned to the consumer.

But in the process, I think is causing what ultimately may be a fatal disruption to the nature of the NTF ETF platforms that at the least are probably going to see a bifurcation of higher-cost and lower-cost ETF share classes and bring on a new wave of lower-cost ETFs. And at best will still slow the flows to higher-cost NTF platforms or still undermine the model that firms have to switch to a more transparent version of just charging the advisor or investor a basis point fee for custody and clearing and wrap and all the other services, and make themselves independent of all the conflicts that come from these back-end distribution agreements. I mean, wouldn’t it be nice to have an RIA custodial platform where they actually have an incentive to offer the best solutions to us independent of what they’re paying on the back end?

In fact, I think it’s likely no coincidence at all that even though Vanguard’s new platform won’t launch until next month, until August, they chose this month, they chose this week, the week of July 4th to make the announcement, right? Because what better way to make an announcement about driving greater platform independence for investors than to announce it just in time for Independence Day? So, well done Vanguard, message received loud and clear.

This is Office Hours with Ellis Associates, Inc. Normally 1 p.m. East Coast time on Tuesdays, but we’re a little late today due to meetings I had this morning. Thanks for joining us, everyone, and have a great day.

So what do you think? Is Vanguard’s new NTF platform a bigger deal than has been reported in the media? Will their new NTF platform lead other ETF providers to offer lower cost ETFs that don’t pay traditional fees to be on an NTF platform? Will this all ultimately lead to custodians charging advisors basis point fees for the services they provide instead? Please share your thoughts in the comments below!


Advisors To Receive Guidance For Meeting New CFP Standards

Advisors To Receive Guidance For Meeting New CFP Standards

This week, the CFP Board announced the formation of a new “Standards Resource Commission”, a blue-ribbon panel of 13 experts who will be tasked with creating resources, such as fact sheets, FAQs, videos, webinars, and more, to provide further guidance to CFP professionals about what they must do to meet the new Code of Ethics and Standards of Conduct scheduled to go into effect next October 1st of 2019. As while the high-level duty of CFP professionals under the new standards is straightforward – to act in the best interests of the client at all times when providing financial advice – the nuances of determining when, exactly, the advisor has taken “reasonable” steps to meet that requirement is less clear (highlighted by the fact that the CFP Board’s new Standards use ‘reasonableness’ in 28 different instances!). In fact, CFP Board CEO Kevin Keller noted that in talking to CFP certificants directly during the CFP Board’s Town Halls, there was a clear desire for more concrete and specific guidance about what, exactly, CFP certificants are expected to do in order to comply with the new rules, in areas ranging from required disclosures to clients and upfront planning agreements, determining the depth of due diligence that’s necessary to prove a “best interests” recommendation, to interpreting various compensation situations and whether the advisor can permissibly hold out as “fee-only” or not. Accordingly, the Standards Resource Commission was created, in a similar vein to the Commission on Standards that CFP Board created in 2015 to establish the latest version of the new standards themselves, and will include both independent practitioners like Linda Leitz and Bill Prewitt and Randy Gardner, large-firm representatives from Fidelity, Northwestern Mutual, Schwab, and Raymond James, fiduciary experts Blaine Aikin and Fred Reish, and consumer advocacy representatives including Pamela Bank of Consumer Reports and Lori Trawinski of the AARP Public Policy Institute.