More On Tax Planningfrom The Advisor's Professional Library
- IRAs: In General Individual Retirement Accounts are highly popular tools for contributing funds that grow on a tax deferred basis. Depending on the type of IRA, the accumulation can be tax free.
- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
You know about alpha and beta, but you should know about gamma, which provides advisors with the foundation to help their clients generate more retirement income
In an environment of low yields and higher taxes, as ongoing volatility remains a factor and Americans live longer, advisors must manage multiple challenges to help their clients generate lasting retirement income.
Traditionally, fixed income has been the core of most retirees’ portfolios. After the financial crisis, many Americans saw it as a safe haven from the volatile stock market. But in today’s low yield environment, advisors cannot rely on fixed income alone to meet their client’s income needs.
To help improve clients’ chances of generating more income for more years, many advisors seek to maintain a significantly higher allocation of equities in clients’ retirement income portfolios. But a higher allocation to equities comes with higher risks, making proactive strategies for risk management an increasing imperative.
Research shows that most Americans still need to accumulate more assets to generate sufficient income in retirement, and outliving their assets in retirement has become their number one concern. Studies also indicate that even high-net-worth investors face serious risks to their retirement income—including rising healthcare costs, the threat of inflation and the impact of prolonged periods of increased tax rates on their investments.
Facing this triple threat of a low yield environment, maintaining adequate equity exposure and managing volatility, advisors are turning to tax-optimized tactics to increase Gamma. According to Jefferson National's latest survey of over 400 advisors, 85% say tax deferral is one of the most important solutions to maximize accumulation and generate more retirement income.
What Is Gamma?
The concepts of Alpha and Beta are well known and regularly used by financial advisors to discuss investment strategies with their clients. However, these are not the sole factors that produce more retirement income.
Last year, David Blanchett and Paul Kaplan of Morningstar introduced an intriguing new approach to measuring Gamma in their published research, “Alpha, Beta, and Now…Gamma.” This new approach to Gamma was developed "to quantify the additional value that can be achieved by an individual investor from making more intelligent financial planning decisions." According to the research, Gamma, when used in the context of generating more retirement income, is created from five factors:
1) asset location and withdrawal sourcing
2) total wealth asset allocation
3) annuity allocation
4) dynamic withdrawal strategy
5) liability-relative optimization.
As clients are primarily concerned with outliving their retirement savings, we believe Gamma helps fill a gap in the discussion that advisors are having with their clients about their investment decisions.
While all five factors play an important part to achieve Gamma and generate more retirement income, the factor of tax-optimized investing through asset location and withdrawal sourcing is becoming increasingly important for advisors and their clients, especially HNW clients who experience the highest burden when taxes rise. According to the research, there is measurable value in the asset location component of Gamma, which may add as much as 320 basis points (bps) of additional retirement income to client portfolios every year.
As advisors work with their clients to maximize their investment performance while ensuring income in their Golden Years, boosting Gamma through tax-advantaged investing should be a key strategy. Specifically, advisors can look to a concept known as the "Tax-Efficient Frontier," which is simply locating assets based on their tax treatment to increase returns—without increasing risk. In fact, 88% of advisors surveyed leverage tax deferral by using asset location to help minimize the impact of taxes and enhance after-tax returns.
Optimizing Portfolios Through Asset Location
The Tax-Efficient Frontier begins with asset location, which is typically defined as placing assets in the most tax-advantageous account type. This decision should begin by considering the tax characteristics of asset classes, turnover rates, the time horizon for their clients’ investments and breakeven points.
Advisors should not only evaluate their clients' portfolios by asset class or risk, but also by tax characteristics: identify the tax-efficient assets and tax-inefficient assets. Tax-efficient assets, such as index funds, funds with low turnover and passively managed investments generate long-term capital gains and dividends, currently taxed at a maximum of 20%. Tax-inefficient assets, such as bonds, REITs and many hedge-like funds, generate ordinary income or short-term capital gains, currently taxed as high as 39.6 percent. Moreover, actively managed investments can suffer the biggest hit: short-term capital gains tax plus the added cost of multiple transaction fees.
To further evaluate tax efficiency we can look at breakeven points, which is the point in time when tax-deferral will help assets yield a better after-tax return. Tax-efficient assets typically have longer breakeven points and should be located in taxable vehicles, unless individuals plan on holding these assets for a time horizon of several decades. Conversely, tax-inefficient assets can have breakeven points of one year or less and should almost always be located in tax-deferred vehicles.
Tax-Advantaged Solution to the Retirement Income Challenge
Once the tax efficiency of assets has been determined, the next step is to evaluate which assets in the portfolio should be located in taxable vehicles and which should be located in tax-deferred vehicles such as IRAs, 401(k)s and next-generation variable annuities. This will minimize the impact of taxes on accumulation and maximize after-tax returns.
Placing tax-inefficient bonds, REITs, and investments that generate dividends in tax-deferred vehicles allows income to continue compounding for years without paying taxes until assets are distributed. This approach can be particularly attractive for clients who are close to or in retirement and who may still rely on bonds and dividends to provide conservative but predictable income.
A tax-deferred vehicle provides additional benefits for advisors using tactical management , liquid alternatives or high turnover strategies, allowing them to reallocate as the market requires, to capture more upside, minimize the downside, while cutting costs and compounding the gains for years. In this way, tax-deferred vehicles help advisors control how much their clients pay in taxes and also when they pay taxes.
When using tax-deferred vehicles, it is first important to maximize contributions to qualified plans, such as an individual retirement account (IRA) or 401(k). However, high-net-worth individuals can easily max out the IRS' low contribution limits of qualified plans and will need additional vehicles and strategies to grow their portfolio while minimizing taxes. Specifically, the IRS' deferral limits for 401(k) plans is $17,500, which can be easily met by those who have higher incomes.
One tax-deferred vehicle advisors can use is low-cost variable annuities. Many advisors are reluctant to use traditional variable annuities because of their high asset-based insurance fees, limited investment options, steep commissions, surrender fees and complex insurance guarantees. According to the survey, 52% of advisors who use traditional variable annuities are not satisfied with them and 54% of their clients express concerns about these products.
However, a new generation of variable annuities has been designed to provide a low-cost tax-advantaged investing solution. For example, with a flat-fee variable annuity, advisors can help clients earn higher returns and build more long-term wealth while eliminating asset-based insurance fees altogether. Instead of complex insurance guarantees, flat-fee variable annuities offer a broad range of investment options, including liquid alternatives with unique strategies for managing volatility and funds designed for active trading with no transaction fees.
Even clients who have already accumulated enough assets to reach their retirement goal are still looking to their advisors for sophisticated planning to ensure that they will have enough income to last a lifetime. Blanchett and Kaplan's unique approach to using Gamma provides financial advisors with the foundation to help their clients generate more retirement income and achieve a secure financial future.
For investors who rely on fixed income, for those who use tax-inefficient strategies to manage volatility and for high-net-worth individuals who face rising tax rates, the impact of Gamma can be especially helpful as it alleviates taxes while generating more wealth for more years.