Vanguard's Alpha and Morningstar's Gamma

A Brief Discussion of Vanguard’s Alpha and Morningstar’s Gamma

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This paper was written for educational purposes only. It must not be construed as the rendering of investment, tax, retirement, estate or risk planning advice. Please do not take action on anything that you read in any of our whitepapers, or anything that is mentioned in our classes, before first discussing it with your investment, tax, retirement, estate and risk planning advisors. All Rights Reserved.

Vanguard’s Alpha

Vanguard is one of the world’s largest investment organizations. Vanguard works with millions of individual investors plus thousands of fee-only wealth managers. Over the past 18 years, Vanguard has been quantifying the value that clients receive when working with “good wealth managers”. Vanguard uses the term Alpha to describe the additional investment return that wealth managers may create for their clients when they adhere to the Vanguard Framework of Good Wealth Management.

Of course, the increase in a client’s investment return is not guaranteed. Client results will vary based on several factors, including the wealth manager’s expertise and the client’s financial behavior.

Let’s briefly discuss the seven parts of the Vanguard Framework of Good Wealth Management.

1

Asset Allocation

A portfolio’s asset allocation is the amount of money that is invested in different asset classes (stocks, bonds, real estate, etc.) as well as within asset classes (US and foreign stocks, value and growth stocks, large and small stocks, etc.). According to Vanguard, asset allocation is the most important determinate of the risk and return of investment portfolios. Therefore, good wealth managers will work hard to select appropriate asset classes for their client’s portfolios. How much does good asset allocation add to a client’s return? According to Vanguard, the potential value of good asset allocation is “significant but too unique to each investor to be able to properly quantify”.

2

Asset Class Rebalancing

Over time, asset classes produce different returns. As a result, investment portfolios gradually assume asset class characteristics that will be different from the client’s original intention. Good wealth managers strive to maintain their client’s asset allocation through periodic asset class rebalancing. How much does asset class rebalancing potentially add to a client’s return? According to Vanguard, typically about 0.35% a year.

3

Asset Location

The correct location, or placement, of assets in taxable accounts, tax-deferred accounts and tax-free accounts is a significant aspect of good wealth management. How much does good asset location add to a client’s return? According to Vanguard, typically about 0.75% a year.

4

Cost-Effective Investment Implementation

Vanguard’s research has shown that low investment costs are correlated with good investment performance. Good wealth managers first select indexes to capture the returns of their client’s asset classes and then select low-cost funds and ETFs capture the return of their selected indexes. How much does cost-effective investment implementation potentially add to a client’s return? According to Vanguard, typically about 0.40% a year.

5

Account Withdrawal Order

Retirees often own accounts that are taxed in different ways. For example, they may have taxable accounts, tax-deferred accounts (traditional IRAs, etc.) and tax-free accounts (Roth IRAs etc.). When retirees make withdrawals from their accounts, there is usually an optimal account withdrawal order. How much does optimal account order withdrawal potentially add to a client’s return? According to Vanguard, typically about 1.10% a year.

6

Total-Return Investing

In the past, many retirees were able to live on the interest and dividends generated by their investments and invested accordingly. However, according to Vanguard, today most retirees are better served by investing for “total-return”. With total return investing, investments are selected that generate a combination of interest, dividends and capital gains. How much does total return investing add to a client’s return? According to Vanguard, the potential increase in return is “significant but is too unique to each investor to be able properly quantify”

7

Behavioral Financial Coaching

Investing evokes emotional reactions that can lead many clients into making behavioral mistakes (for example, buying high and selling low). Therefore, good wealth managers strive to help their clients maintain a disciplined approach to their investing. How much does effective behavioral financial coaching potentially add to a client’s return? According to Vanguard, typically about 1.50% per year.

Let’s now summarize the typical additional returns that good wealth managers create for their clients when they adhere to the “Vanguard Framework of Good Wealth Management”:

Asset AllocationUncertain ¹
Asset Class Rebalancing0.35%
Asset Location0.75%
Cost-Effective Implementation0.40%
Account Withdrawal Order1.10%
Total Return InvestingUncertain ¹
Behavioral Financial Coaching1.50%
Typical Increase in Annual Returns 33.50%+ ²

¹ According to Vanguard, the additional return generated by this aspect of good wealth management is “significant but too unique to each investor to be able to quantify.”

² The increase in a client’s annual return is not guaranteed. Client results will vary based on several factors, including the wealth manager’s expertise and the client’s financial behavior. In addition, the increase in annual return is not achieved on a straight-line basis i.e. in some years the increase will be more or less than in other years.

Morningstar’s Gamma

Morningstar is the world’s largest provider of financial analytical reports. Morningstar works with millions of individual investors plus thousands of fee-only wealth managers.

Over the past eighteen years, Morningstar has also been quantifying the value that clients receive when working with good wealth managers. While Vanguard concentrated its research on the investment aspects of wealth management, Morningstar concentrated its research on the retirement aspects of wealth management.

Morningstar uses the term Gamma to describe the value that “good wealth managers” may be able to create for their clients. According to Morningstar, good wealth managers who help their clients make “optimal retirement planning decisions” may be able to increase their client’s cumulative lifetime retirement income by 20.00% or more.

Of course, the increase in a client’s cumulative lifetime retirement income is not guaranteed. Client results will vary based on several factors, including the wealth manager’s expertise and the client’s financial behavior.

Let’s now discuss six of the many retirement planning issues that require optimal decisions:

1

Withdrawing Money from Company-Sponsored Retirement Plans

Upon retirement, retirees can often take either a lump-sum distribution of their account balance or a pension annuity that pays them a monthly income.

With a lump sum distribution, retirees usually have three choices:

  1. Take the distribution as a lump-sum and pay ordinary income taxes.
  2. Take the distribution as a lump-sum and make a trustee-to-trustee transfer to an IRA, which defers the payment of ordinary income taxes.
  3. Take the distribution as a lump-sum; apply the Net Unrealized Appreciation tax rules to company stock; and then either pay ordinary income taxes on the balance or make a trustee-to-trustee transfer of the balance to an IRA.

With a pension annuity, retirees usually have multiple choices, including:

  1. Straight life annuity. With this choice, the “annuitant” receives payments for as long as the annuitant lives; upon the annuitant’s death, income payments stop, and any remaining balance is forfeited.
  2. Life and refund certain annuity. With this choice, the annuitant receives payments for as long as the annuitant lives; however, if the annuitant dies before receiving all of their principal, a beneficiary is also paid. Under an “installment refund,” the beneficiary continues to receive payments until the principal is paid back. Under a “cash refund,” a lump sum equal to the balance of the principal is paid to the beneficiary.
  3. Life and period certain. With this choice, the annuitant receives payments for as long as the annuitant lives; however, if the annuitant dies before a specified period, the payments continue to the beneficiary until that period expires.
  4. Joint and survivor life annuity. With this choice, annuitants receive payments as long as one of two people is living. Upon the death of the second person, payments stop. Joint and survivor annuities may be in different versions e.g. joint and 100%, joint and 75%, joint and 50%, etc. Joint and survivor life annuity with period certain. With this choice, annuitants receive payments for as long as one of two individuals is living. However, if both individuals die before the end of a certain period, payments are made to a beneficiary until that period is reached.
  5. Joint and survivor life annuity with refund certain. With this choice, annuitants receive payments as long as one of two individuals is living. However, if both individuals die before receiving the principal that was invested, payments continue to a beneficiary until the principal amount is received.

2

Claiming Social Security Retirement Income Benefits

There are literally dozens of different ways to claim Social Security retirement income benefits. Although most retirees pay very little attention to the “Social Security claiming issue”, an optimal Social Security claiming decision can easily add $150,000 to a retiree’s lifetime income.

3

Determining Retirement Spending

Determining retirement spending is usually easier if it is first broken down into two steps.

In Step One retirees estimate their initial spending:

  1. Replacement Rate Models estimate spending by multiplying the retiree’s total income just before retirement by a “Replacement Rate”, usually from 75% to 85%.
  2. Expense Models estimate spending by analyzing all budget categories. Budget categories are then combined into either one total spending plan or into an “essential spending plan” and a “non-essential” spending plan.

In Step Two, retirees extrapolate spending from their initial spending until their death. These models can be grouped into two categories:

  1. The Constant Spending Model assumes that a retiree’s spending remains constant throughout life adjusted for inflation).
  2. The Stages of Retirement Models divide spending into various stages. For example, the early stage when spending is relatively high due to traveling (often called the “go-go” stage); the middle stage when spending decreases in comparison with the early stage (often called the “slow-go” stage); and, the late stage in which spending often increases in comparison to the middle stage (often called the “no-go” stage).

4

Determining the Amount of Withdrawals from Investment Portfolios

Retirees generally need to withdraw funds from investment portfolios in order to supplement income from pensions and/or their Social Security. Retirees need to determine the amount of their investment withdrawals.

Three commonly used investment portfolio withdrawal options are:

  1. Percentage of Starting Balance: with this option, retirees withdraw money from their portfolios at a set rate throughout their retirement.
  2. Percentage of Starting Balance with Inflation/Deflation Adjustment: With this option, retirees start with a withdrawal rate and then adjust that rate up or down by the amount of inflation or deflation.
  3. Percentage of Starting Balance with Inflation/Deflation Adjustment and Market Adjustment: With this option, retirees start with a withdrawal rate and then first adjust the rate up or down by the amount of inflation or deflation. They then further adjust the amount of their withdrawals whenever their investment portfolio increases or decreases by a pre-determined amount.

5

Taking Required Minimum Distributions (RMDs)

What is the optimal way to take age 70 ½ RMDs? Retirees have several choices, including:

  • The calendar year to use for the initial distribution. The absolute last date for the initial distribution is April 1 of the year following the year that you turn age 70 ½.
  • The table to use for distributions: the Uniform Lifetime Table, the Single Life/Inherited IRA Table, or the Joint/Last Survivor Table.

6

Making IRA Distributions to Surviving Beneficiaries

There is usually an optimal way to distribute IRAs to surviving beneficiaries e.g. spouses and children? The questions to consider include:

  • Should the spouse rollover the deceased’s IRA into his or her own IRA?
  • Should the spouse convert the deceased’s IRA into an Inherited IRA?
  • Should the children convert the deceased’s IRA into an Inherited IRA?
  • Should the children’s IRA inheritance be placed in a Stretch Trust?

Please remember that we have only briefly discussed just six of the many retirement planning issues that require optimal decisions.

Please contact us to learn more.

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