As consumers we are constantly asking ourselves if the value of a particular product or service warrants its cost. Some products and services are relatively easy to quantify and others much more difficult to assess.
When considering the engagement of a wealth management firm, how do you determine if the value of an advisor justifies the cost – or if you are better off just handling your own finances?
Until recently, the answer to this question was not always clear. However, in 2013, Morningstar, an independent investment research organization, published a groundbreaking analysis in a white paper entitled Alpha, Beta, and Now…Gamma. The report’s findings? Advisors can add additional income to investor portfolios by helping their clients make better financial decisions in five key areas. The Morningstar study quantified this value at a 29% increase in retirement income, or the equivalent of generating 1.82% of additional return annually.
What may be surprising to some is that the selection of investments is only a portion of the overall value derived from advisors. The five key areas discussed in the Morningstar study are asset allocation, withdrawal strategy, tax efficiency, product selection, and liability investing (or investing toward a specific goal).
By owning a number of different assets that are not highly correlated, investors can reduce risk substantially without dramatically lowering returns. Long thought to be the only meaningful lever of investment return, studies now show asset selection as only one determinant of total portfolio return. The assets used in the Morningstar study included U.S. stocks and bonds as well as foreign stocks and bonds.
In concert with asset allocation, tax efficiency is the proper positioning of assets. For example, it generally makes sense to place high income-producing assets, such a corporate bonds (that pay taxable dividends and will be taxed at ordinary income rates), into IRAs or retirement plans. More efficient assets, such as stocks or real estate (taxed at potentially lower capital gains rates), are placed into taxable accounts.
The utilization of an asset or strategy that guarantees a series of principal payments regardless of how long one lives. In the Morningstar analysis, an immediate annuity was used for a small portion of the overall portfolio. This approach serves to remove the risk of outliving your assets – as payments from the annuity are guaranteed by the insurance company. Other means to accomplish this end could include a ladder of zero coupon bonds that would mature every year for a period well beyond one’s life expectancy.
Dynamic Withdrawal Approach
Historically, people take a set percentage or a dollar amount of income from a portfolio every year. Morningstar used a dynamic approach that adjusted the annual distribution based on the amount of money left in the portfolio and the individual’s life expectancy.
This strategy is the focus on achieving financial goals, including retirement, education, or the purchase of a property, to name a few. If your portfolio temporarily drops 10% in value due to a stock market swoon, how does this impact a goal that is 10 years away? By concentrating on the objective, investors are less likely to make rash judgments by watching their portfolios on a daily basis. Conversely, if you have a very short-term goal, market risk should certainly be taken into consideration.
Morningstar has published a very beneficial report that has been long overdue. As we’ve learned, in order to accurately evaluate the value of an investment management firm, consumers and advisors must better understand the factors that influence financial success.
Mark McClanahan, CFP®, is a Managing Director at RGT Wealth Advisors.