More On Tax Planningfrom The Advisor's Professional Library
- Health Insurance: Health and Medical Savings Accounts A Health Savings Account is a trust created exclusively for the purpose of paying qualified medical expenses of an account beneficiary. Although they are popular, they are not without their pitfalls and the regulations can be complicated. Learn more about how to avoid federal taxation on the accumulation and distributions of HSA.
- Charitable Giving Charitable giving can reduce your clients’ tax liabilities. However, the general and verification rules for the deduction of charitable gifts must be understood in order to take full tax advantage of such gifts.
Possibly the most valuable content at the Morningstar Investment Conference is a rather technical session on the subject of “gamma” whose applications have immediate take-home value for financial advisors.
Morningstar’s David Blanchett delivered the talk. He, along with his Morningstar colleague Paul Kaplan, is the mastermind of gamma, a nifty Greek letter that comes after alpha and beta in the Greek alphabet but, as it does alphabetically, goes beyond those two in terms of adding value.
While alpha investors are looking to add that 100 basis points in total return and beta investors are seeking to match the market while minimizing risk, Blanchett and Kaplan estimate that gamma enables advisors to enhance the welfare of their clients to the tune of 29% more income, which equates to 1.82% in added alpha.
Better still, alpha is a zero-sum game—your win as a buyer is another investor’s loss as a seller. With gamma, however, every advisor and every client can win.
In practical terms, financial advisors often face a skeptical public that questions whether they are worth the fees they charge. If clients perceive that the key value the advisor adds is fund selection, many will cut out the middleman and buy the funds themselves, using consumer ratings.
What Blanchett and Kaplan have attempted to do is quantify all the ways an advisor adds value.
In a Thursday session at Morningstar’s Chicago conference, Blanchett divided an advisor’s value into five key areas: total wealth allocation; dynamic withdrawal strategy; annuity allocation; tax-efficient asset location; and retirement portfolio construction.
Tax-efficient asset location may provide the simplest example of a service advisors provide that increases client wealth.
Do-it-yourself investors may make excellent investment selections, theoretically, but limit the benefits of those investments by leaving “tax alpha” on the table.
A classic example is bonds. Because their realized income is taxed at ordinary income rates, they are highly inefficient from a tax standpoint.
Stocks, on the other hand, are far more tax-efficient, incurring a 15% capital gains rate.
So an advisor, because he understands the client may be paying a 35% tax on an investment whose historical average has been just 5% (and is possibly in secular decline), will recommend the client keep the bonds he needs in a nontaxed traditional IRA or 401(k), for example.
Blanchett says a good advisor will first determine the appropriate allocation for the client’s unique circumstances, and only then determine where to locate the assets across accounts.
Another illustration of advisors adding gamma is in the area of retirement income, where their ability to frame the decisions and tailor them for clients with different outlooks is key.
It is common for people to see portfolio withdrawal strategies as sexy and annuities as somehow grotesque, Blanchett says.
But what is really at issue are two key decisions—what impact retirement income will have on your accumulated wealth and how afraid you are of outliving your wealth.
Blanchett cites a study by Allianz asking whether people were in greater fear of dying or outliving their income, and more people feared the latter.
Yet people don’t like the idea of handing their wealth over to an insurance company. Advisors can point out that people hand over their money to their home insurance company wthout any expectation they will make money on the deal.
Another way to frame things: would you rather have a low-cost annuity from Vanguard or a portfolio withdrawal strategy based on active managers charging 300 basis points?
Ultimately, Blanchett says, “If you really care about your wealth, you don’t want an annuity. But if you’re afraid, you don’t want income risk. For each person, preference factors and perception of risk differs.”
Either way, advisors help their clients plan for an uncertain future. Most “black swan” events, Blanchett says, are really “black turkeys”—events that are foreseeable if unlikely. Looking at whether you smoke and other factors, it is reasonably possible a person will live to 105. Not having an annuity, yet planning to live to an old age, may unduly prevent a person from consuming enough income.