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Why a New Type of Alpha Should Be Retirement Portfolios' True Goal

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It’s a bit of a surprise that a term like alpha, described as excess return, has such wide appeal among financial advisors given its relatively technical origins.

Alpha is the intercept in a regression and its early use in the investment industry originates from research exploring whether actively managed mutual funds outperform on a risk-adjusted basis (the risk-adjustment part is the beta).

Investment alpha is portfolio-related actions, such as fund selection, asset class weights, tactical market-timing decisions, etc. that can result in investment outperformance.

Investment alpha is fundamental to the value proposition of most advisors (i.e., “I will build a portfolio that beats the benchmark”), which makes sense in an industry where compensation largely is tied to assets under management.

Clients want to feel like their advisor is adding value through professional management and doing better than the client could do on his or her (or their) own.

The thing about investment alpha, though, is that it’s pretty much a zero-sum game. For every winner out there, there has to be a loser, and that’s before considering fees.

This doesn’t stop many financial advisors from seeking investment alpha, and investment alpha from being the cornerstone of the value proposition.

Since alpha is often characterized as adding value, or at least the attempt to do so, the concept can be extended into other domains.

Tax alpha is one example and generally refers to strategies that increase the client’s after-tax rate of return or after-tax wealth. Another example is longevity alpha, which focuses on helping clients achieve sustainable lifetime income during retirement.

Longevity Alpha

Because longevity alpha is focused on accomplishing a goal, it can include other types of alpha. Since improving portfolio returns would have an obvious positive impact on sustainability, longevity alpha would include concepts like investment alpha and tax alpha.

In other words, these alphas aren’t necessarily mutually exclusive.

There are strategies related to longevity alpha that aren’t related to investments. One example would be delaying claiming Social Security retirement benefits. This is perhaps one of the most widely recognized ways to increase the longevity of retirement assets today.

Another way to generate longevity alpha is to purchase an annuity. I know what you might be thinking — what does an annuity have to do with alpha?

That’s part of the general problem and one reason why so many advisors ignore annuities: because annuities are financial products and not investments despite many having investment-like attributes.

Sure, there are issues around compensation, licensing, product quality, etc., but insurance (i.e., annuities) just doesn’t seem to have the same pizazz as investing (and concepts like the efficient frontier).

If we assume the primary goal of most retirees is portfolio longevity (longevity alpha), though, and not just portfolio outperformance (investment alpha), the retirement income strategy and the underlying products that are considered and used, need to evolve. That means revisiting the potential value of annuities as a way to generate guaranteed lifetime income.

As a financial product, annuities have been around for thousands of years. You cannot guarantee a certain level of lifetime income from a portfolio, but you can with an annuity. Annuities provide coverage against one of the hardest risks to plan for: longevity risk.

When it comes to maximizing longevity alpha, it’s inevitable that certain strategies are going to bump heads. While you can technically generate some longevity alpha by solely using either investments or an annuity, the most efficient strategies will likely incorporate both.

You may be thinking that “longevity alpha” is just a marketing term — and to some extent you’d be right.

But how you help clients accomplish an objective doesn’t necessarily change based on the words used to describe the approach.

However, by explicitly combining the idea of longevity protection and investment alpha into a single term, hopefully some advisors will realize that the goal of the optimal retirement income strategy can’t be “solved” through efficient portfolios (i.e., investments) alone.

While investment alpha is obviously important, helping clients accomplish financial goals is the primary purpose of advisors. Therefore, we need to move beyond investment alpha as the primary objective and focus on what it takes to generate sustainable retirement income: longevity alpha.

David M. Blanchett, Ph.D, CFA, CFP, is head of retirement research for Morningstar’s Investment Management Group.


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