After my last column, “With Or With You,” which ran in Financial Advisor magazine’s April issue and recounted my experience with a do-it-yourself investor, many readers asked how I respond to certain questions and handle various situations. Several wanted a breakdown of the study I cited on the benefits of working with a financial planner. Many were excited that the study might “prove” their value to clients. I’ll address the questions and issues in future columns, but this month I’ll give my impressions about the study, Alpha, Beta, and Now... Gamma, by David Blanchett and Paul Kaplan of Morningstar, which came out in September.

A huge amount of analysis has gone into examining alpha and beta. The quest for positive alpha has been an obsession of the investment world. Whether or not any positive alpha is realized, experienced financial planners often add value to their clients lives in intangible ways. This value is very real even if impossible to precisely quantify.

We know that various actions we take on behalf of our clients should help achieve clients’ goals and some of these should be measurable. Blanchett and Kaplan identified a few of these tactics and coined the measurable value added “gamma,” the next letter in the Greek alphabet after alpha and beta.

The headline result of their examination is that compared with a base case, an additional 29 percent of retirement income, the equivalent of another 1.82 percent in annual return, may be realized by using some specific planning strategies. The base case is basically a retired couple both age 65, employing the oft-cited “4 percent rule.”   

The authors came to these numbers by summing the enhancements from five financial planning decisions or “gamma” factors: total wealth allocation, a dynamic withdrawal strategy, an annuity allocation, asset location and withdrawal sourcing, and liability relative optimization.

Total Wealth Allocation
The authors define this as “using human capital in conjunction with the market portfolio to determine the optimal equity allocation.”  To determine a client’s risk capacity, as opposed to risk tolerance, the client’s potential future savings (human capital) is considered along with the client’s financial capital when creating the asset allocation.

Dynamic Withdrawal Strategy
As a panelist at the Financial Advisor Retirement Symposium in March, I was asked about the infamous “4 percent rule.” As I often do when speaking on retirement issues, I asked if anyone knew anyone who starts retirement spending 4 percent, or any other percentage, of their assets and increases that amount in lock step with inflation for the rest of their lives. As usual, not a single hand went up.

Spending is naturally dynamic because life is dynamic. Jon Guyton is widely cited as the guy that got this discussion going in earnest among planners. The gamma authors utilize a different approach, but it reinforces Guyton’s conclusions – if the client isn’t cemented into a rigid spending pattern, more can be spent than the 4 percent rule of thumb. Blanchett was involved in formalizing a method that determines annual withdrawal amounts based upon the ongoing likelihood of portfolio survivability and longevity.

Annuity Allocation
To what extent does annuitizing 25 percent of a client’s assets add value?

Asset Location And Withdrawal Sequencing
Say that after considerable deliberation, you and your clients decide that a 50/50 split between a diverse variety stocks and bonds is ideal for that client. Making this asset allocation decision is not the end of the portfolio design process.

Should all accounts have the same 50/50 split or should certain asset classes go in certain types of accounts, taxable vs. retirement accounts, for instance, to better manage taxation on the assets? This is an asset location decision.    

Conversely, when withdrawals are needed, how does a decision to withdraw from a certain kind of account -- taxable, tax deferred, or tax-free -- affect portfolio survival?  This is the withdrawal sequencing decision.

Liability Relative Optimization
Pension plans have for decades used their liabilities as the driver of their portfolio structure. Pensions provide retirement income, so it seems logical that it may be beneficial to apply some of these concepts when advising an individual who needs retirement income.

The Results: Getting To 29 percent
The authors ran three different tests to examine the five factors. All five factors increased the income over the base case independently. Total wealth allocation added 6 percent; dynamic withdrawals, 9 percent; an annuity allocation, 4 percent; tax efficiency, 8 percent; and liability relative optimization, 2 percent. Total those together and you get the 29 percent income enhancement mentioned earlier.

I would caution any planner from suggesting that this study shows they will enhance a client’s lifetime income by 29 percent or boost returns by 1.82 percent. The study makes assumptions and compares to a base case based on the 4 percent rule. Unless your client’s circumstances align with the assumptions and spending pattern of the base case, the gamma calculated is not directly applicable.

This does not mean real-world gamma would be lower necessarily. The 4 percent rule assumes a spending and an investment discipline few individuals have, for instance. One could argue that a real-world gamma would be one that compares not to the 4 percent rule but to what the client would do without the advice of a planner. As discussed in my last column, making a meaningful comparison to what another person would do is full of conjecture and extremely difficult.  

I think it reasonable to take a few things out of this study that can be applied to the real world. The gamma factor that added the most was the dynamic withdrawal strategy, and the assumptions that went into the testing were the most duplicable when working with clients.

Planners can run similar simulations that determine a failure rate, incorporate a mortality assumption, and adjust withdrawals when certain parameters are exceeded. The gamma factor with the second-largest impact, asset location and tax efficient withdrawals, also could be implemented as easily.

Most good planners incorporate these ideas today. This is not unexpected, given one purpose of the study was to quantify how helpful the techniques used by planners actual are.
I found the least real-world usefulness with two of the other three gamma factors. The liability relative optimization makes theoretical sense, but I was disappointed to see the minimal impact from using it. The annuity allocation, while a plus, didn’t add enough to entice people to overcome their aversion to annuitization.

The most challenging part of the study is the explanation of how gamma is measured. I am not disputing its validity, just pointing out that it is difficult to follow. You will need a grasp of utility functions. I live on the Space Coast of Florida and am surrounded by real rocket scientists, and my guess is less than 1 percent would understand the calculation. So if you want to get into this with a client, you may come out looking smart or you could just confuse them. I have yet to share the study with clients.