September 20, 2012

Efficient Investing Results in 29% More Income: Morningstar

Increase equal to 1.82% more per year

In its search for ways advisors can help clients improve retirement outcomes, in a report released Wednesday, Morningstar put a number to how much more income a person can generate by being a better investor: 29%. Referring to this extra income as “gamma,” Morningstar noted that this increase is equivalent to 1.82% bump in annual returns.

“Investors arguably put a lot of time and effort into selecting investment funds or managers they hope will outperform the market—the so called ‘Alpha’ decision,” David Blanchett, head of retirement research for the Morningstar Investment Management division, said in a statement.

The report, “Alpha, Beta and Now … Gamma,” focused on five factors that affect the success of a retirement plan: optimal total wealth asset allocation, dynamic withdrawal strategy, guaranteed income products, tax-efficient allocation decisions and portfolio optimization.

The report determined investors could earn an extra 29% on their portfolios through gamma-efficient investing by running a series of tests that analyzed the effects of total wealth asset allocation, annuity allocation and dynamic withdrawal strategy; liability-relative optimization; and tax efficiency of assets.

“The increase in utility-adjusted income (i.e., Gamma) could be multiplicative, additive or neither and is something we leave for future research,” the report noted. “Here, for simplicity purposes, we assume the improved income that could be generated are additive across the three tests since each of the tests are relatively independent.”

In the first test, Morningstar estimated the gamma for the total wealth asset allocation, annuity allocation and withdrawal strategy. The report found total wealth asset allocation had a gamma value of 6.06% and annuity allocation added 3.79%. A dynamic withdrawal strategy added the most gamma at 8.53%.

In the second test, Morningstar estimated the impact of tax-efficient investing strategies. The difference between the most inefficient tax strategy, which Morningstar found was inefficient asset location and withdrawing from a 401(k) first, and the most efficient strategy, which included efficient asset location and making taxable withdrawals first, was 19.09%. Portfolios with tax-efficient assets and where taxable withdrawals were made first earned an additional 8.23% of income, while a portfolio with less tax-efficient assets earned 4.95% more. In a portfolio where withdrawals were made from the 401(k) first but had tax-efficient assets, extra income was less than 1%. When assets were not tax-efficient, income fell by over 10%.

Morningstar asserts that there is a better strategy than allocating assets to get the most out of a client’s investments for a given level of risk because such a scenario doesn’t plan for the ongoing liability that will be the client’s retirement income. In the third test, which estimated the return on a portfolio optimized for liabilities, Morningstar built three retirement portfolios with a target return of 6%: one had a liability-driven optimization, one had an asset-driven optimization and one used what Morningstar called a “naïve” asset allocation of 80% bonds and 20% equities.

To study inflation’s effect on the portfolios, Morningstar ran a Monte Carlo simulation and found the liability-driven portfolio had the lowest returns when inflation was at its lowest level. The asset-only portfolio exceeded the liability-driven portfolio in returns when inflation was low, but the liability-driven portfolio fared better in the high-inflation scenario.

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