Morningstar Advisor - December 2012/January 2013 - (Page 61)

experiences based on optimal financial decision-making. In calculating Gamma, we focus on five important financial-planning decisions and techniques: a total wealth framework to determine the optimal asset allocation, a dynamic withdrawal strategy, the incorporation of guaranteed income products, taxefficient allocation decisions, and a portfolio optimization that includes liabilities. Each of these five Gamma components creates value for retirees, and when combined, they can be expected to generate 29% more income on a utility-adjusted basis when compared with a simplistic static withdrawal strategy, according to our analysis. This additional income is equivalent to an arithmetic “alpha” (the Gamma equivalent alpha) of 1.82% and thereby represents the potential of a significant increase in portfolio efficiency (and retirement income) for retirees. Alpha and Beta: Defining Value A financial advisor could invest a client’s money in very expensive mutual funds that underperform but still provide other valuable services that enable the client to successfully save for retirement. While this advisor may have failed from a pure alpha perspective, the underlying goal was accomplished. This is akin to losing the battle but winning the war. Individual investors invest to achieve goals (typically an inflation-adjusted standard of living). Doing the things that help an investor achieve these goals is a different type of value than that which can be attributed to alpha or beta alone and is in many ways more valuable. Therefore, metrics such as alpha and beta are an incomplete means of measuring retirement-strategy performance. Gamma Factors aggregate asset allocation for each investor (as suggested by the Capital Asset Pricing Model) or build an investor-specific asset allocation that incorporates an investor’s risk preferences. In both approaches, the financial assets are invested to achieve an optimal asset allocation for total wealth. 2 Dynamic Withdrawal Strategy The majority of retirement research has focused on static withdrawal strategies where the annual withdrawal amount during retirement is based on the account balance at retirement and increased annually for inflation. For example, a “4% withdrawal rate” would really mean a retiree can take a 4% withdrawal of the initial portfolio value and continue withdrawing that amount each year, adjusted for inflation. If the initial portfolio value was $1 million and the withdrawal rate was 4%, the retiree would be expected to generate $40,000 in the first year. If inflation during the first year was 3%, the actual cash flow amount in year two (in nominal terms) would be $41,200. We use a different approach. Originally introduced by Blanchett, Kowara, and Chen (2012), our approach determines the withdrawal amount annually based on the likelihood of a portfolio’s survivability (because of market performance) and expected investor longevity. 3 Annuity Allocation Outliving one’s savings is perhaps the greatest risk for retirees. A study by Allianz Life noted that the greatest fear among retirees is not death (39%) but rather outliving one’s resources (61%) (Bhojwani, 2011). Annuities allow a retiree to hedge away this risk and can, therefore, improve the efficiency of a retiree’s portfolio. The benefits, risks, and costs of an annuity in the context of a total portfolio must be considered before determining the appropriate amount and annuity type. 4 Asset Location and Withdrawal Sourcing Tax-efficient investing for a retiree can be thought of in terms of both “asset location” and intelligent withdrawal sequencing from The notions of beta and, in particular, alpha have long fascinated financial advisors and their clients. Alpha allows a financial advisor to demonstrate the excess returns generated in an investment portfolio, which can help justify fees. In contrast, beta helps explain the risk factors of a portfolio relative to the market (that is, the asset allocation). If an advisor is paid solely to manage a portfolio of assets and offers no additional advice regarding anything other than the investment of the client assets, the concepts of alpha and beta should be good measures of the advisor’s value. However, in a more-complex engagement in which the advisor provides financial-planning services to clients, value cannot be defined in such simple terms as alpha and beta because the objective of an individual investor is typically to achieve a goal, and that goal is most likely saving for retirement. In this article, we examine the potential value, or Gamma, that can be obtained from making “intelligent” financial-planning decisions during retirement. A retiree faces a number of risks during retirement, some unique to retirement planning and not concerns during accumulation. We will explore five factors that can provide Gamma to a retiree’s portfolio: 1 Total Wealth Asset Allocation Human capital is a person’s future potential savings. Financial capital is a person’s investment portfolio. Most techniques used to determine the asset allocation for a client focus only on the investment portfolio and are relatively subjective; they focus primarily on “risk preference,” which means an investor’s aversion to risk, rather than “risk capacity,” which is an investor’s ability to assume risk. In practice, however, we believe asset allocation should be based on total wealth (a combination of human and financial capital) and on a combination of risk preference and risk capacity, with an emphasis on risk capacity. We determine an investor’s risk capacity (or target equity allocation) by evaluating his or her total wealth. We can then either use the market portfolio as the target MorningstarAdvisor.com 61 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - December 2012/January 2013

Morningstar Advisor - December2012/January 2013
Contents
Contributors
Letter From the Editor
What Stands Between Me and Stupid
Why Do You Use Dynamic Funds of Funds?
Serving Clients and Community
How to Pick an ETF Managed Portfolio Strategy
Tactical View of Risk
Investments á la Carte
Investment Briefs
Unbundling ETF Managed Portfolios
Risks Loom Over Telecom Industry
Outsourcing Asset Allocation
ETF Managed Portfolios on the Rise
Age-Based Options Take Over 529 Industry
How the Landscape for Advisors Is Changing
Mark Egan Embraces Volatility
Alpha, Beta, and Now … Gamma
Performance Gaps
Gains in Momentum
Companies Where Management Teams Add Value
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Once and Future King

Morningstar Advisor - December 2012/January 2013