Gamma, Gamma Go Gamma

Last article, under our journal heading The Gratifying Harvest (Eeny meeny….), I promised to discuss in the future, five important factors that have the greatest impact on retirement portfolios.  Earlier this year I wrote about some key terms used in finance (It’s All Greek to Me), Alpha and Beta. Well the future is here and it is time for a new common term denoted by the greek letter Gamma. (This is somewhat confusing because Gamma is in many glossaries as a descriptive for pricing of options. Gamma indicates how quickly your exposure to the price movement of the underlying security changes as the price of the underlying security varies.  Other times it is used as the variable denoting the investor’s degree of risk aversion.)

In September 2012, Morningstar, a very large service provider to the investment community,  published a research paper authored by David Blanchett, CFA, CFP, Head of Retirement Research, Morningstar Investment Management and Paul Kaplan, Ph.D., CFA, Director of Research, Morningstar Canada titled Alpha, Beta, and Now…Gamma.  This paper proposed that it is not investment/manager selection that has the greatest impact on retirement portfolios; rather it is making more intelligent financial planning decisions.  At Efficient Wealth Management, we have been promoting the exact same five ideas for over ten years with a passion and are very pleased to share with you the conclusions of such an authoritative source.   In a departure from the usual for me, I am simply going to let you read their well summarized abstract and then I will clarify in street terms, the decisions and techniques.

Abstract….

“When it comes to generating retirement income, investors arguably spend the most time and effort on selecting ‘good’ investment funds/managers—the so called alpha decision—as well as the asset allocation, or beta, decision. However, alpha and beta are just two elements of a myriad of important financial planning decisions, many of which can have a far more significant impact on retirement income.

We introduce a new concept called “Gamma” designed to quantify the additional expected retirement income achieved by an individual investor from making more intelligent financial planning decisions. Gamma will vary for different types of investors, but in this article we focus on five fundamental financial planning decisions/techniques: a total wealth framework to determine the optimal asset allocation, a dynamic withdrawal strategy, incorporating guaranteed income products (i.e., annuities), tax-efficient decisions, and liability-relative asset allocation optimization.

We estimate a retiree can expect to generate 29% more income on a “utility-adjusted” basis using a Gamma-efficient retirement income strategy when compared to our base scenario, which assumes a 4% constant real withdrawal and a 20% equity allocation portfolio. This additional income is equivalent to an annual arithmetic return increase of +1.82% (i.e., Gamma equivalent alpha), which represents a significant improvement in portfolio efficiency for a retiree. Unlike traditional alpha, which can be hard to predict, we find that Gamma (and Gamma equivalent alpha) can be achieved by anyone following an efficient financial planning strategy.”

Wheh!  …and read that last half sentence again “….can be achieved by anyone following an efficient financial planning strategy.”  So let’s start.

1)     A Total Wealth Framework To Determine the Optimal Asset Allocation

Your current advisor or bank asks you to answer an investment questionnaire and then discusses it with you.  This is an attempt to establish risk tolerance and risk preference (i.e., an investor’s aversion to or comfort with risk).  This however ignores your risk capacity (i.e., an investor’s ability to assume risk).   Asset allocation should be based on a combination of risk preference and risk capacity, and primarily risk capacity.  The only way to establish risk capacity is through a thorough examination of your total financial picture. A review of assets, liabilities, current spending and future spending expectations, income sources both now and in the future, etc.  In other words, a full financial review of the persons involved.  Commonly called a financial plan.

2)     A Dynamic Withdrawal Strategy

You probably are contemplating a static withdrawal strategy.  An amount based on 4% of assets adjusted for inflation each year is very common.  The future will not be steady and unwavering, so why should the withdrawals.  Your withdrawal plan should be adjustable to the future realities, not the past plans.

3)     Incorporating Guaranteed Income Products (i.e., annuities)

The key here is risk shifting or hedging your risk.  Annuities and other guaranteed products (such as long term GICs) place the future performance worries onto the provider of the product and remove the risk from you.

4)     Tax-Efficient Decisions

You should hold assets in the accounts that are the most tax wise for those types of investments.   Ensure that your withdrawal strategy is also generating income in the most beneficial manner.  It is not just about this year.  A good goal is to lower your lifetime total tax bill to the lowest possible amount.  Access to a skilled tax consultant is essential.

5)     Liability-Relative Asset Allocation Optimization

The risk associated with currencies, inflation and timing of withdrawals as they relate to the future are an important part of establishing the optimal portfolio allocation.

In the words of the authors, “From a more holistic perspective, each of these Gamma concepts can be thought of as actions and services provided by financial planners not investment managers.  Is it time to rethink your own approach?”