Investment performance isn't everything when considering the amount of income retirees can count on.
Rather, making better financial planning decisions could help increase the income stream clients hope to generate once they've stopped working.
A new study by Morningstar Inc. redefines the Greek letter gamma — which typically refers to investors' risk aversion — as the amount of additional retirement income investors can get from improving their financial planning decisions.
“Most advisers think of alpha and beta,” said David Blanchett, head of retirement research at Morningstar Investment Management and co-author of the study. “In reality, retirement is more complex than accumulation.”
Performance isn't the sole metric of an adviser's value, and advisers can do more for clients by taking other steps to raise their income once they've stopped working.
Mr. Blanchett outlined five ways to improve “gamma” for clients:
‰ Dynamic withdrawal strategies: Advisers and clients should step away from withdrawal strategies that adjust only for inflation, and opt instead for ones that consider the portfolio's performance and the expected longevity of the client.
‰ Asset location/withdrawal sourcing: Investors ought to consider the tax ramifications of their holdings and the withdrawals they take from their accounts.
Individual retirement accounts and 401(k)s are hospitable places for bonds that generate their return from coupons or dividends that are taxed as ordinary income. Equities should be held in taxable accounts because most of their return comes from capital gains. When taking withdrawals, clients should pull from taxable accounts first and IRAs and 401(k)s later.
Still, depending on the outcome of the presidential election, the tax code could change dramatically, Mr. Blanchett said.
‰ Total wealth asset allocation: Consider investing in terms of risk capacity — the client's ability to assume risk based on total wealth, including human and financial capital — rather than mere risk aversion. Retirees typically prefer to decrease their equity allocation to as low as 20% but some could benefit from stopping at 40%, Mr. Blanchett said. Further, some income streams, such as a single-premium immediate annuity, are effectively bond allocations allowing clients to dial up some of their risk.
‰ Annuity allocation: Annuities permit retirees to hedge for longevity risk but advisers and clients should think about the benefits, risks and cost before choosing the amount placed into the product.
‰ Liability-relative optimization: Don't just think of asset allocation in terms of domestic bonds and stocks and their performance. Instead, think about accounting for inflation in the future, based on the age of the retiree. That should encourage investors and advisers to think about subcategories of asset classes
One example: Dividing the client's allocation to U.S. bonds among Treasury inflation-protected securities, U.S. bonds and cash. Mr. Blanchett noted that assets in a liability-driven portfolio move in sync with the value of the liability, keeping the ship steadier.
Compared with a portfolio that's 80% bonds and 20% stocks, one that is optimized for the five characteristics above and employing a steady 4% withdrawal strategy, Mr. Blanchett's research showed that there is a 28.8% improvement in income, according to the paper.
“Good advisers should already be considering these methods,” Mr. Blanchett said. “How are you adding value?”
