Most investors have probably wondered whether it’s worth paying for financial advice. You might believe that no-one has a clue about what the future holds, so why pay for nothing. Or that with a few rules of thumb, you can do as well as anyone. But there are many elements that can impact on your retirement income and lifestyle.
Recent analysis by U.S. research group Morningstar Inc suggests the value of holistic financial advice can be substantial: an extra 1.59% of retirement income per annum.
Rather than focusing on the performance of various assets versus a benchmark, Morningstar quantified how much additional retirement income an investor could generate by making better financial-planning decisions, a value they designated as ‘gamma.’
They concluded that significant gamma can be derived from five sources.
1. Total wealth asset allocation
The first is by analysing the client’s total wealth framework. This obviously includes financial assets such as shares, property, bonds and cash but might also include human capital – e.g. an individual’s ability to earn and save, likely retirement date, the ability to work part-time, social security and pension entitlements. Accumulating a million dollar nest egg by age 65 might not be as important for a people who can keep working on either a full-time or part-time basis into their sixties or seventies.
2. Dynamic withdrawal strategy
Advisers can also add value by examining and tailoring your superannuation withdrawal strategy. As financial markets change, it is important to revisit your pension strategy to make sure that the withdrawal amount is still prudent given likely expected market returns and the projected length of your retirement.
3. Guaranteed income products
A third factor is by assessing how income-guaranteed products like annuities and defined benefit pensions fit into your retirement plan. According to Morningstar, these can be a valuable form of insurance, especially for those in good health with a long life expectancy.
4. Asset structuring
Another value-add is by focusing on tax efficiency. Taxes can obviously be a significant drag on performance and it is important to consider their impact when deciding the holding structure for your wealth, the investments you select and your withdrawal strategy.
5. Liability risk management
The final element is liability risk management. Most financial models define risk as the standard deviation of the portfolio or the return relative to a benchmark. In the real world, risk is the likelihood that you won’t be able to pay for a liability. If you need a minimum return of 4% per annum to achieve this goal, what you need is an asset allocation that delivers a safe margin above this target, not one that could dip below 4% in some years.
Of the five types of gamma, the most important is having a dynamic withdrawal strategy which Morningstar believes can add about 0.70% per annum to your retirement income. Formulating a total wealth asset allocation plan adds 0.45%, tax efficiency yields 0.23%, liability risk optimisation is worth 0.12% and guaranteed income streams can add an extra 0.10%.
Are you really a canny investor?
Vanguard Group Inc has undertaken similar analysis and concludes that an adviser’s alpha (or gamma) is around 3% per annum. One of the key value drivers is from behavioural coaching, which often means stopping investors from relying on their own instincts. In particular, reacting to short-term market fluctuations by rejigging or abandoning a well thought out investment strategy. Left to their own devices, investors tend to make choices that lower their returns and jeopardize their ability to fund their objectives.
|Australian investor returns vs fund returns|
|Fund type||Number of funds||Investor (%pa)||Fund |
|Australian Shares - Large||138||4.2||9.4||-5.2|
|Australian Shares - Mid/Small||35||2.3||10.2||-7.9|
|World Equities - Large||73||3.3||4.8||-1.4|
|World Equities - Mid/Small||8||6.0||7.4||-1.4|
|Source: Vanguard, Ten years ended 31 December 2013.|
Historical studies of managed fund inflows show that investors are swayed by short-term relative out-performance, often with damaging consequences for long-term returns. In the case of multisector funds, such as balanced funds that invest across a range of asset classes, the under-performance of investors who go it alone is around 1.7% per annum.