Journal of Financial Planning: July 2014
Harold Evensky, CFP®, AIF®, is chairman of Evensky & Katz in Coral Gables, Florida. He is an internationally recognized speaker on investment and financial planning issues and is the author of Wealth Management and co-editor of The Investment Think Tank: Theory, Strategy, and Practice for Advisers.
I have a problem. There are so many papers I believe are worth your attention, I can’t figure out how to include all of them along with my pithy comments. So, because I’ve concluded that introducing you to the papers is far more important than my musings, I will forgo my usual commentary and provide you with a few bullet points and salient observations on each, in the hope that you’ll be intrigued enough to read the papers in their entirety; they all deserve your time. So with that introduction, here’s my take on papers worth your attention so far in 2014.
The Fiduciary Debate
“The Fiduciary Obligations of Financial Advisers under the Law of Agency,” by Robert Sitkoff (Journal of Financial Planning, February).
- Although an adviser may not be a fiduciary under federal law, because the state agency fiduciary law is not coterminous with federal law, he or she may be a fiduciary under state law.
- “A financial adviser who ignores the possibility of fiduciary status under state agency law acts at his peril.”
“Suitability Versus Fiduciary Standard: The Perceived Impacts of Changing one’s Standard of Care,” by Joseph Goetz, Swarn Chatterjee, and Brenda Cude (Journal of Financial Planning, February).
By now it should be no secret that there is a raging debate regarding the possible expansion of a fiduciary standard to incorporate many activities of a traditional broker. This article is a brief summary of the results of a survey designed and administered by faculty from the University of Georgia Department of Financial Planning, Housing, and Consumer Economics.
- Although 67 percent of registered representatives do not expect their advice to be different under a fiduciary standard, 16 percent expect the advice might be different, and 17 percent do not know.
- Eighty-three percent of registered representatives recommend a larger percentage of actively managed mutual funds and passive alternatives compared to 43 percent for investment advisers.
- Only 35 percent of registered representatives reported meeting with a new client an average of four more times before recommending an investment, compared to 86 percent for investment advisers.
- Fifty-five percent of registered representatives said they meet with new clients once on average before making an investment recommendation, and 10 percent reported they did not have a single meeting.
Education
“Beyond Normal: Understanding Skewness and Kurtosis,” by Paul Kaplan (Morningstar Magazine, April/May).
Although not a research journal, Morningstar Magazine publishes so many academically oriented papers I thought it would be useful to introduce it to readers who may be unfamiliar with the publication. This particular contribution by the director of research with Morningstar Canada, is an excellent example.
- “The statistics characterize the markets extreme returns not predicted by normal distribution.”
“Dividend Indexes and Value Indexes,” by Konrad Sippel (Journal of Indexes, March/April).
- An examination of the different characteristics by value and dividend schemes is provided.
- Because the dividend methodology selects a much smaller number of stocks than the value methodology, there is more opportunity to avoid less desirable components.
- Factor analysis finds a 28 percent value factor exposure for the value index versus only 10 percent for the dividend index.
- Both provide significant negative exposure to the growth factor (–23.4 percent for the value index and –29.3 percent for the dividend index).
- Over a longer term, both concepts provide more conservative approaches to portfolio selection than market-cap-weighted indexes.
- “Investors looking for pure value exposure fare better with a value-based selection method; however, if the focus is on lower volatility exposure, a dividend-based selection method may provide a strong alternative.”
Fixed Income
“Low Bond Yields and Efficient Retirement Income Portfolios,” by David Blanchett (The Journal of Retirement, Winter).
As always, Blanchett provides a contribution well worth reading.
- The traditional approach of developing simulation models based on long-term historical averages may be less useful when there is a significant and sustained deviation from those historical averages.
- Today, the yield on 10-year government bonds is more than 2 percent below historical long-term averages.
- This paper incorporates current bond yields and five potential investment options (cash, bonds, stocks, immediate fixed annuities, and a variable annuity with a guaranteed lifetime withdrawal benefit rider [GLWB]).
- “The probability of success of a 4 percent initial withdrawal rate using the forecasted returns model is significantly lower than the historical returns model … The probability of success for a hypothetical 40 percent equity portfolio is 93 percent using the historical returns model, versus 49 percent using the forecasted returns model.”
- “Both forms of annuities [GLWB and immediate fixed] effectively crowd out the allocation to cash and bonds, suggesting that annuities likely offer a more efficient ‘fixed’ exposure for retirees, given today’s low-yield environment.”
“Target Maturity Bond Funds as Retirement Income Tools?” by Matthew Patterson and Darrin DeCosta (Journal of Indexes, March/April).
Although perhaps a bit biased, as Patterson and DeCosta are principles of the firm that designed the primary target maturity bond funds, their paper raises a number of important issues and introduces the reader to a fixed-income product that might play a role in client portfolios.
- The creation of a diversified target maturity bond fund depends on the existence of broad credit markets. The NASDAQ BulletShares USD Corporate Bond indexes include no fewer than 153 unique issuers in any single maturity year 2014 through 2022.
- Round-trip spreads on established target maturity bond ETFs are generally less than 15 basis points and rarely exceed 50 basis points. For retail investors, round-trip spreads on individual bonds range from 90 to 160 basis points.
- “The perpetual nature of traditional bond funds renders them ill-suited for investors requiring distributions in excess of the income-generating potential of their portfolio.”
- “Target maturity bond funds allow for the creation of highly customized fixed-income portfolios that address the specific future cash flow needs of each investor … Such funds give investors more control over their interest-rate risk and a better liability match than traditional bond funds.”
Sustainable Withdrawal
For both practitioners and our clients, the issue of sustainable withdrawals is obviously the elephant in the room. The good news is there is an increasing amount of research focused on it; the bad news is many of the conclusions are contradictory. The following are what I consider among the best of these papers. I will leave it up you to parse between the contradictions.
“Strategies for Mitigating the Risk of Outliving Retirement Wealth,” by Vickie Bajtelsmit, LeAndra Ottem Foster, and Anna Rappaport (Financial Services Review, Winter 2013).
Unquestionably the most academic of the articles included in this month’s contribution, this paper provides a resounding confirmation of conclusions obvious to experienced practitioners, including:
- A combined strategy of delayed retirement and Social Security claiming, reduced discretionary spending, and LTC insurance is found to greatly improve retirement outcomes for typical retiree households.
- Individuals and their advisers should be wary of relying on averages and estimating retirement resource adequacy.
- A major implication and concern for all stakeholders is that many individuals are reaching traditional retirement ages without adequate assets.
“Asset Valuations and Safe Portfolio Withdrawal Rates,” by David Blanchett, Michael Finke, and Wade Pfau (The Retirement Management Journal, Spring).
This is one of three contributions I selected from this journal, a must-read for any practitioner interested in retirement planning. It’s also written by three authors on my must-read list (no surprise given the frequency you will see their names pop up in my columns). This paper is a follow-up to the authors’ June 2013 Journal of Financial Planning paper, “The 4 Percent Rule Is Not Safe in a Low-Yield World,” which received the Journal’s 2014 Montgomery-Warschauer Award.
- “Traditional Monte Carlo simulation approaches generally do not incorporate market valuations in their analysis. To simulate how retirees will fare in a low-return environment for both stocks and bonds, we incorporate the predictive ability of current valuations to simulate impact on retirement portfolios.”
- “Assuming that future real returns on assets will equal the real returns experienced by investors in the past ignores current-state information.”
- “Not only are bond yields well below historical averages, but today’s CAPE [cyclically adjusted price-to-earnings] ratio is well above the historical average. This is therefore not a great time for investors in light of history.”
- “We find the probability of success for a 40 percent equity allocation with a 4 percent initial withdrawal rate over a 30-year period is approximately 48 percent. The success rate is materially lower than past studies and has sobering implications on the likelihood of success for retirees today, as well as how much those near retirement may need to save to ensure a successful retirement.
- The paper includes two valuable tables showing:
- the probability of success for a 4 percent initial withdrawal rate over 30 years for different equity allocations, initial bond yields, and initial CAPE values
- initial withdrawal rates for various equity allocations and probability of success assuming an initial bond yield of 2 percent and a CAPE of 22
“The Cost of Guaranteed Income: Demystifying the Value Proposition of Variable Annuities with Guaranteed Lifetime Withdrawal Benefit Riders,” by Rosita Chang, Jack DeJong, Qianqui Liu, John Robinson, and Jack Suyderhoud (The Retirement Management Journal, Spring).
- This research articulates and quantifies the consumer opportunity cost of VA rider guarantees.
- “… one of the most important concepts for consumers to understand is that the constant withdrawal guarantees offered under most GLWB riders are not equivalent to the inflation-adjusted withdrawal rates discussed in most sustainability studies or in the popular press.”
- “… this analysis suggests that such contracts’ [those with a GLWB] greatest value proposition may be in helping consumers maximize income after 10 years accumulation. On this score, a counterintuitive finding is that the most robust and most expensive guarantee riders seem to produce the highest guaranteed cash flows … .”
- “… this paper is generally consistent with past research in concluding that VA contracts may be a rational choice for risk-averse consumers with long anticipated distribution horizons and little bequest motive.”
“The True Impact of Immediate Annuities on Retirement Sustainability: A Total Wealth Perspective,” by Michael Kitces and Wade Pfau (The Retirement Management Journal, Spring).
This continues the theme of their controversial paper “Reducing Retirement Risk with a Rising Equity Glide Path,” published in the January 2014 issue of the Journal of Financial Planning.
- “… the primary scenarios where SPIAs should be used are specifically those where the intent is to hedge significant longevity risk beyond life expectancy, where the benefit of mortality credits begin to dominate; in the remaining scenarios for most retirees, though, retirement outcomes can be improved by simply implementing the rising equity glide path that bucketed SPIA strategies indirectly create, without the annuity contract itself.”
- The results of the research suggests that most prior studies that indicated a benefit of partially annuitizing a retiree’s portfolio were actually showing the benefit of a bucketed liquidation strategy that spends down fixed assets first and allows the household equity allocation to rise, not to the benefit of the SPIA itself.
- “This doesn’t necessarily mean that retirees should not use SPIAs at all, but to recognize that the benefit shown in prior studies were primarily due to a glide path effect that can be achieved without the use of the SPIA contract.”
“Lifetime Expected Income Breakeven Comparisons Between SPIAs and Managed Portfolios,” by Larry Frank, John Mitchell, and Wade Pfau (Journal of Financial Planning, April).
I saved the best for last. This paper includes an appendix that provides detailed instructions on how a practitioner, using Excel, can apply the authors’ analytic framework using the practitioner’s own assumptions.
- The paper provides comparisons of expected lifetime cash flows between SPIAs and managed portfolios.
- “… the SPIA only begins to come into play for those who have a tendency to outlive their cohort and only at advanced ages when they no longer have a long remaining lifespan over which to generate market returns.”
- To justify self-managing her portfolio, the retiree needs to have a comfort level with the equity allocation required to do better than a SPIA, and a sense of not likely being in the group of long-lived cohort.
- The current low interest rate environment suggests that encouraging the purchase of SPIAs prior to age 80 may be misplaced.
I had quite a few more papers to share, but I see I’ve already exceeded my word limit, so I hope you find enough food for thought to keep you busy until next time.