How intelligent planning decisions can add value for investors
by David Lau
Mr. Lau is Chief Operating Officer of Jefferson National, innovator of the industry’s first flat- fee variable annuity with the largest selection of underlying funds. Connect with him by e-mail: dlau@jeffnat.com. For more information, please visit www.jeffnat.com.The concepts of alpha and beta are well known in the investment world and regularly used by financial advisors to discuss investment strategies with their clients. Alpha allows a financial advisor to measure how a security or a portfolio can outperform a benchmark, and beta is a measure of the volatility or systematic risk of a security or a portfolio compared to the market as a whole. But these are not the sole factors that impact the ultimate success of a retirement portfolio.
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.” Their new approach to using Gamma has been 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; and 5) liability-relative optimization.
In our view, this provides a new framework and language that fills a gap in the discussion that every advisor is having with their clients about their investment decisions, particularly as they face the challenge of planning for a retirement that could last thirty years or more.
While all five factors are critical to create more 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 the high net worth who experience the highest burden in this time of rising taxes. According to the research, there is real and 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-optimized investing should be a key strategy. Specifically, using tax deferral can potentially increase returns—without increasing risk—by simply locating assets based on their tax treatment, a concept known as the “Tax-Efficient Frontier.”
Achieving Gamma through Tax Optimization
Attaining 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, turn-over rates, the time horizon for their clients’ investments and breakeven points.
Advisors should start by evaluating their clients’ portfolios – not just 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 percent. Tax-inefficient assets, such as bond funds, 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 usually 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.
Below is a chart that provides general guidelines for optimal asset location based on these breakeven points.
A Tax-Advantaged Investing Solution
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 variable annuities. This will minimize the impact of taxes on accumulation and maximize after-tax returns.
Placing tax-inefficient bonds and REITs 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 the more conservative portfolios of clients who are close to or in retirement. For advisors who use tactical management, liquid alternatives and other high turnover strategies to manage risk, a tax-deferred vehicle provides additional benefits. It allows them to reallocate as needed, 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. 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.
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 high net worth individuals who face rising tax rates, the impact of Gamma can be very beneficial to their retirement accounts, especially if there is a strategy that focuses on asset location and tax deferral.
