The Value of Sound Financial Decisions: From Alpha to Gamma
Note: Last summer, I published an article entitled, “The Value of Financial Advice.” I have since revised and updated that column and here I present to you part two of the new version. Part one can be found here.
David Blanchett and Paul Kaplan at Morningstar created a similar study about the value of good decision making. Their results and approach are different from those of Vanguard, but the goal is the same: to quantify the costs of poor and good decision making. Naturally, many assumptions must be made regarding good financial decisions and the impact of poor financial decisions.
The Morningstar research is more directly focused on how retirees can achieve higher income, which they call “gamma.” They left out issues like behavioral coaching and included other matters like dynamic retirement spending. Full details can be found in their article, “Alpha, Beta, and Now… Gamma,” published in the Fall 2013 issue of the Journal of Retirement.
The dimensions for improving financial decisions considered in their article are broken down into several issues, along with consideration of how a naïve investor might approach each issue and how an improved outcome could be achieved with improved knowledge and education, or the help of a professional.
(1) Total Wealth Asset Allocation
The issue: Making asset allocation decisions after considering total wealth including lifetime human capital (future employment earnings)
Naïve investor: Makes asset allocation decisions without considering the role of lifetime human capital.
Improved Outcome: Calculate the present discounted value of lifetime earnings to be saved. Determine the characteristics of lifetime income in terms of whether it is more bond-like or stock-like. Consider this as an asset in your portfolio and then figure out the asset allocation for the financial portfolio in order to obtain the final overall desired asset allocation for wealth.
(2) Dynamic Withdrawal Strategy
The issue: Making withdrawal decisions using a variable spending strategy that updates spending to keep a similar probability of failure for the remaining time horizon in retirement.
Naïve investor: Uses the 4% rule: takes out 4% at retirement, then increases that amount by inflation in subsequent years for as long as possible until wealth is depleted.
Improved outcome: Make dynamic decisions based on a circular process. Every year, determine retirement horizon, asset allocation, and maximum withdrawal percentage for a given target probability of failure. Repeat annually to determine spending.
(3) Annuity Allocation
The issue: Using product allocation to devote some financial assets to purchasing guaranteed income products may improve outcomes
Naïve investor: Views annuities as a gamble on dying too soon and ignores them as a retirement income option.
Improved outcome: View annuities as insurance against outliving one’s wealth by relying on the guaranteed income for life. Allocate part of the financial portfolio to an income annuity at retirement, while also keeping the same overall amount invested in stocks. In other words, part of the allocation to bonds in the retirement portfolio is transitioned into an income annuity.
(4) Tax Efficiency Through Asset Location and Withdrawal Sequencing
The issue: Maximizing tax efficiency by locating assets in the most tax efficient places and withdrawing assets in a more tax efficient manner.
Naïve investor: Ignores these issues by keeping the same asset allocation for both tax-deferred and taxable accounts, and then withdraws proportionately from each account in retirement.
Improved outcome: Use efficient asset location by filling tax-deferred accounts with bonds, while stocks would be used in taxable accounts as much as possible. Couple that with efficient withdrawal sequencing, which first spends down taxable accounts, and then moves on to tax-deferred accounts.
(5) Liability Relative Optimization
The issue: The true risk for a retirement portfolio is not the annual volatility of the asset portfolio, nor is it the performance of the asset portfolio relative to a benchmark. Rather, it is the risk that you won’t be able to meet your spending goals.
Naïve investor: Makes asset allocation decisions with no regard for spending goals, focusing instead solely on single-period Modern Portfolio Theory concepts.Improved outcome: Make investment decisions specifically with spending liabilities in mind. This could result in a portfolio with a lower expected return and/or higher volatility than a more traditional one, but it might do a better job meeting lifetime spending needs. Adding a liability creates a different efficient frontier with portfolios that would have previously seemed suboptimal. For instance, TIPS might not play a role in an assets-only optimization problem, but it might do a better overall job of meeting spending needs, especially in high inflation environments.
(6) Social Security Claiming
The issue: Social Security retirement benefits may be claimed between ages sixty-two to seventy, with credits provided for those who delay, yet Americans frequently claim Social Security early.
Naïve investor: Claims Social Security retirement benefits at age sixty-two, as do nearly half of Americans.
Improved outcome: Make joint Social Security claiming decisions based on the potential insurance value of Social Security to provide the most possible lifetime .
By making these improved financial decisions, retirement income can be increased dramatically. Exhibit 1 shows that on a risk-adjusted basis, retirement income is 31.8% higher for the individual making good financial planning decisions relative to someone making naïve planning decisions. How much is this worth in alpha terms? In other words, how much would portfolio returns need to be increased to support a 31.8% larger spending level?
Over a thirty-year period, those starting with a 4% withdrawal rate would need to earn 2.34% more per year as alpha (in the median case)—a difficult task indeed—to increase their income by this amount. This is the “gamma-equivalent alpha.” For someone who would otherwise make naïve planning decisions, a 1% advisory fee is worthwhile if that advisor helps the individual make these improved decisions. The net gain to the individual would still be an additional 1.34% in annual market returns, according to the Morningstar research.
Exhibit 1: Components of Morningstar’s Gamma
|Financial Behavior||Additional Income Generated||Gamma Equivalent Alpha|
|1||Dynamic Withdrawal Strategy:||9.88%||0.70%|
|2||Total Wealth Asset Allocation:||6.43%||0.45%|
|4||Liability Relative Optimization:||1.65%||0.12%|
|6||Social Security Claiming||9.15%||0.74%|
|Good Financial Decision Making:||31.78%||2.34%|
|Source: Journal of Retirement (Fall 2013) – Factors 1-5; Journal of Personal Finance(Fall 2012) – Factor 6|
Though I use the term “naïve” to describe decisions made without enough attention to good financial planning strategies, it is important to emphasize that many well-informed individuals may fall prey to these decisions. Two things might hold you back: inertia and behavioral finance.
It takes quite a bit of discipline to continually make the little adjustments needed to maintain the integrity of the portfolio and subsequent goals. And if you are busy with life, you are probably not going to stay up late on a Wednesday night, for instance, to review/reassess your withdrawal sequencing and asset location. Life can get in the way.
It is easy to be an armchair advisor and think you will not succumb to the naïve decisions because the answers are obvious, but when you are in the field that is not always the case. Please keep this in mind.