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Adding value to retirement plans

Making money and good investments concept

By Kyle Tetting

In a field obsessed with performance and with no shortage of tools to measure it, financial advisors have struggled to quantify the value they themselves can add to individuals’ retirement success.

In addition to helping investors realize meaningful risk-adjusted returns, financial advisors can help individuals identify and achieve a successful retirement. New research is starting to identify ways to quantify the impact of good financial advice.

A focus on performance alone ignores a myriad of ways that a good financial advisor helps clients succeed. A research team at Morningstar Investment Management has suggested ways to measure the additional value added by making more intelligent financial planning decisions – the sorts of decisions that can be led by good investment advisors.

Morningstar, a global leader in independent investment research, has identified a set of decisions that, when properly planned, can add significant value to an investor’s retirement income. The findings suggest that advisors can begin to measure how their planning can contribute to retirees’ success.

Unlike discussions about the markets or asset allocations, Morningstar’s set of decisions gets to the core of an individual investor’s situation. Among the factors considered:

  • Holding assets in the most tax-efficient accounts. Less tax-efficient assets generally belong in retirement accounts.
  • Withdrawing assets in the most tax-efficient way. Taxable accounts should generally be drawn down first, preserving the preferential tax treatment of retirement accounts.
  • Maximizing the benefits of Social Security, pensions and annuities. Consider the benefits and risks of multiple retirement income sources and align withdrawal strategies with other considerations.
  • Matching asset allocations to objectives and capacity for risk, not just risk tolerances. Consider all income sources and allocate risk based on a need for risk as much as a desire for risk.
  • Using a dynamic withdrawal strategy. Consider taking a little more when the markets are doing well and a little less when they are doing poorly. Prepay big-ticket items in the good years to reduce future expenses in the lean years.
  • Incorporating liabilities into asset allocation. Take potential risks, such as inflation, and incorporate them into asset allocation to better hedge those risks.

A focus on just a few key decisions can play a significant role in increasing retirement income. Just how significant is difficult to quantify in the abstract, but the research team at Morningstar suggests that proper financial planning could add as much as 22.6% more income than a focus solely on asset allocation.

Among the professional tools to gauge investment performance are:

  • Alpha: The returns in excess of the risk of the portfolio, as measured by beta
  • Beta: A measure of the volatility of a portfolio relative to a standard benchmark, most typically the Standard & Poor’s 500 stock index

Researchers at Morningstar Investment Management have named their measurement of the value of financial decision making after the third letter of the Greek alphabet: Gamma.

Please click here to read the Morningstar research report “Alpha, Beta, and Now…Gamma.”

According to the research, getting the key things right could add income equivalent to an additional 1.59% annual return on a retiree’s portfolio.

The research illustrates the power of intelligent financial planning by beginning to quantify the added value of key financial decisions. Given the significance for investors, a solid financial plan should include more than discussions about the markets and asset allocation.

To achieve success, investors and their advisors need to consider the complex set of decisions that impact retirement income. The results may not show up as total returns on a quarterly statement, but it should help to secure a more favorable outcome in retirement.

Asset allocation remains crucial to the performance of retirement portfolios, but now we’re gaining a clearer and quantifiable sense of how other decisions not directly related to the portfolio can make a significant difference to retirement goals.

Kyle Tetting is director of research at Landaas & Company.

(initially posted Dec. 19, 2013)

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