Investors have long wondered about whether it’s worth paying someone to mastermind a financial plan.
After all, it’s tough to see how much a proper asset-allocation plan or the right withdrawal strategy really adds to performance.
Now, new research from investment researcher Morningstar Inc. gives investors an idea of the added value of financial planning:
An extra 1.82% per year.
That’s not some random amount, but rather the results of a groundbreaking study that Morningstar released last week, one that is likely to have the financial-services community — and their clients — buzzing.
Functionally, Morningstar quantified how much additional retirement income investors can generate by making better financial-planning decisions.
The effect of ‘Gamma’
Morningstar calls the measure “Gamma,” and the concept is worth looking at for anyone who has an adviser or might want one.
Historically, investors have focused on choosing the “best” money-managers or mutual funds, the ones who “add value,” which is the financial world’s way of saying they beat their benchmark consistently.
The specific investments, however, typically are less important than many of the other portfolio-building decisions.
Gamma, as defined by Morningstar, is “the extra income an investor can earn by making better financial decisions.” Put another way, it is the potential value that could be added by someone who feels they can’t do this on their own and must hire an adviser for counsel.
“Most financial planners and investment advisers focus on investment decisions, picking the next best fund,” said David Blanchett, co-author of the study and head of retirement research for Morningstar Investment Management.
“Other things that you do have a very important impact on your financial well-being, so good financial-planning decisions are very important to success,” he added. “It’s hard to quantify the benefit someone receives from someone who gives good financial advice. … Gamma is the idea that there is more to just helping someone than picking good funds.”
In the research paper, Morningstar researchers zeroed in on five key financial-planning decisions — though Blanchett noted that it actually applies to virtually everything advisers do.
What the research showed is that the ability to deliver extra income — unlike the ability to beat the market — is completely predictable. Take certain steps — what Morningstar calls “following an efficient financial planning strategy” — and you achieve excess returns.
The five key decisions boil down to asset allocation, withdrawal strategy, tax-efficiency, product allocation (the use of traditional investment products versus guaranteed-income products), and “liability-driven investing” (which is investing with an eye toward an investor’s specific goals, needs and timeline).
Through simulations, Morningstar’s researchers found that a hypothetical retiree could generate nearly 30% more income using a Gamma-efficient retirement-income strategy.
That’s equal to kicking up the annual arithmetic return by 1.82% compared to the average person making those same decisions.
Here’s how consumers can put this information to work:
If advisers in an ideal world can add 1.82% by making all the right moves, then they have to make most of those moves in order to justify their salary.
Say an adviser charges 1% of assets under management to run a portfolio; they would need to deliver at least 1% in Gamma — extra income — to cover their services. The more an adviser charges, the more Gamma they need to deliver.
Truthfully, most consumers will never have a clue of just how much value their adviser adds to the process. In my experience — having written two books on the subject of hiring and working with financial counselors — consumers typically say they are seeking help because they want assistance on key financial decisions, but they dismiss advisers when investment returns fall short.
“It’s hard for the individual to figure out how much value is being added by doing the services,” Blanchett said in an interview on my radio show. “But, honestly, to me the big question is ‘Are they being talked about in the first place?’ Is whoever is giving you advice, who is helping you figure out how to map your financial future, thinking about these things and incorporating these things in your financial plan.”
For example, conventional wisdom since the early 1990s has been that asset allocation is the most important factor in determining potential return.
When it comes to an adviser boosting income for a lifetime, however, Morningstar found that a “dynamic withdrawal strategy,” which Blanchett described as “going in once a year and, based upon market performance and market strategy, figuring out what is a sustainable withdrawal for that portfolio.” The second-most important decision involved making sure that allocation decisions were tax-efficient.
An investor who pays a financial adviser to pick mutual funds either misses the point of planning or has a bad adviser. In fact, Blanchett said that the thing that surprised him the most about the research was the value of annual meetings, where clients and advisers tweak strategies, particularly as the consumers is entering or in retirement; both advisors and clients tend to focus on market results more than the benefits they get from having that sit-down.
“There’s a significant benefit for retirees or investors in general to having someone make the right decisions,” Blanchett said. “Gamma is something that everyone can do that adds the most value; we call them financial planners or advisers, we don’t call them mutual-fund pickers. … It really is worth it to pay someone 1% a year to help me figure out how to do this stuff because [the 1.8%] is significant value that any [adviser] can achieve.”
Chuck Jaffe is a senior MarketWatch columnist. His work appears in many U.S. newspapers.