Could financial advisors who offer comprehensive services be doing a better job? Two recent studies shed a positive light on the potential of the financial planning profession to do right by their clients.
Both studies aim to quantify whether advisors add value by helping clients achieve better financial outcomes, which is defined as the potential to spend more in retirement. Both studies attempt to quantify the value of planners in terms of their ability to increase lifetime consumption, rather than trying to measure investment performance through single-period alpha measures.
Regrettably, our profession has been portrayed in a negative light in prior academic studies. Perhaps most famously in planner circles, a March 2012 study, The Market for Financial Advice: An Audit Study, from the National Bureau of Economic Research (NBER), concluded that financial advisors reinforce behavioral biases and misconceptions in ways that serve the advisors’ interests. But such studies have tended to investigate brokers who could be better characterized as salespeople rather than advisors.
Comprehensive planners vs. salespeople
In a blog post, Michael Kitces of the Pinnacle Advisory Group explains that the painful flaw of the NBER study is that it focuses on how salespeople provide advice to earn more commission income rather than to help customers. By the authors’ own admission, their categorization of advisors included only salespeople working at banks and investment firms. Such “advisors” are subject only to a suitability sales standard for their investment recommendations. They may have little training and no responsibility to provide advice that meets the higher standard of fiduciary care.
The NBER study did not consider advisors who actually work as Registered Investment Advisors subject to SEC oversight and have a fiduciary duty to their clients under the Investment Advisers Act of 1940. It also did not consider whether the advisors in the study were trained to provide financial advice. The study concluded that financial advisors do not provide good advice, without attempting to provide any measure or control over the quality of the financial advisor and without making any effort to include trained advisors in the study.
“The NBER research study could have been an opportunity to demonstrate the difference between a true advisor – one who has responsibility to give quality advice, is regulated as such, and has the training to do so – and a salesperson,” Kitces concluded, “by controlling for the training, education, experience, and regulatory standards across all the advisors and ‘advisors’ (salespeople) studied.”
Now, let’s look at the two recent studies.
Planning for retirement
The ideal study Kitces imagined is a tall order given the limitations of existing data sets, but a recent study, Planning for Retirement, by Terrance Martin and Michael Finke at Texas Tech University, is a valiant effort to investigate the differences in outcomes for clients working with comprehensive advisors and clients working with brokers.
Their conclusion is that comprehensive planners help clients achieve improved financial outcomes.
Martin and Finke were constrained by the limitations of the survey questions asked, but they were able to look at wealth accumulations in retirement savings accounts and increases in wealth between 2004 and 2008. They measured the value of financial advice in terms of the accumulated savings for retirement in qualified and tax-advantaged retirement accounts using a household survey that has followed the same individuals since 1979.
They classified individuals in the survey into one of four categories. Those who said they use an advisor and have calculated their retirement needs were classified as working with a comprehensive financial planner. Those who work with an advisor but do not calculate retirement needs were classified as working with brokers. Those who do not work with an advisor but who have completed a retirement-needs assessment were classified as do-it-yourself investors. Finally, the majority of people (66%) in the sample neither worked with an advisor nor had a retirement plan.
The authors addressed several research questions. Does using an advisor help to increase savings for retirement? Is there a difference between comprehensive advisors (who help to assess retirement needs) and brokers? Finally, is the do-it-yourself approach just as effective in increasing savings for those not working with an advisor?
After controlling for a variety of factors, such as income and education levels, the authors found that those working with comprehensive planners save substantially more for retirement than anyone else across the distribution of wealth outcomes. Those with a do-it-yourself retirement plan also save more than those without any plan. The study confirms that those working with advisors who do not have a retirement plan are not saving any more than those without an advisor or plan.
We have to be careful about reading too much into the results of the study. For instance, those who seek out comprehensive planners may be more organized and forward-looking on their own, such that their improved outcomes could be explained by their own behavior and not by the planners. Planners may also seek out clients who have greater wealth, which could explain why those with comprehensive planners have saved more for retirement. But this problem was partly corrected by also considering how those with comprehensive planners enjoyed greater wealth increases between 2004 and 2008.
We also have to be cautious about how the study divides comprehensive planners from brokers. The division is based on a question about whether someone works with an advisor and whether someone has made a plan for their retirement. Those with self-directed retirement plans who work with brokers are classified as working with comprehensive planners within the study’s framework. Nevertheless, until better data can be obtained, this study demonstrates the importance of distinguishing between advisor types.
Alpha, beta, and now… gamma
A second study, Alpha, Beta, and Now… Gamma, took a different tact. Rather than attempting to measure the influence of actual financial advisors, David Blanchett and Paul Kaplan of Morningstar aimed to quantify the potential value provided by making better financial decisions relative to more naïve rules of thumb. Their study defined a new investment measure – gamma (which follows alpha and beta in the Greek alphabet) – as the value of improved decision making. The study quantifies how making better financial decisions affects the potential of increasing retirement income on a utility-adjusted basis. The utility adjustment penalizes more volatile spending patterns.
Financial planners could use the results of this study to help explain to clients the quantitative value of their services. The study quantified the potential impact of making improved decisions along five dimensions, which I will describe in descending order of their importance.
First, using a dynamic withdrawal strategy provided 8.5% more utility-adjusted income for a retiree than simply spending an inflation-adjusted withdrawal amount (4% of retirement-date assets until financial assets are depleted). The more sophisticated dynamic spending behavior is from another article that David Blanchett co-authored with Maciej Kowara and Peng Chen called Optimal Withdrawal Strategy for Retirement-Income Portfolios. They determine that optimal spending strategies involve using variable withdrawal percentages. This is a dynamic process that involves annually updating the planning age, the asset allocation and the maximum withdrawal percentage for a given target probability of failure. This allows a client to spend more when markets do well and to make cuts to preserve the portfolio when markets do poorly.
Next, incorporating tax efficiency into retirement withdrawal decisions through asset location and withdrawal sequencing can increase income by 8.2%. The naïve investor ignores these issues by keeping the same asset allocation for both tax-deferred and taxable accounts and then withdrawing proportionately from each account in retirement. The more sophisticated approach is to fill tax-deferred accounts with bonds and leave stocks for taxable accounts. Efficient withdrawal sequencing is to first spend down taxable accounts and then spend down tax-deferred accounts.
The third factor is total wealth asset allocation, which can increase income by 6.1%. In this case, asset allocation decisions incorporate human capital and Social Security. Within the framework of their study, the authors chose to increase the stock allocation from 20% to 45%.
Next, adding single-premium immediate annuities (SPIAs) to retirement portfolios provides 3.8% more income. Naïve investors view annuities as a gamble — where one loses if one dies too soon — and ignore them as a retirement income option. In this study, the improved outcome occurs by using 25% of financial assets to purchase a SPIA. Bonds are sold to make this purchase, increasing the stock allocation of the remaining financial portfolio. The asset allocation at retirement is then 45% stocks, 30% bonds and 25% SPIAs.
Finally, by making asset-allocation decisions after incorporating future spending needs, retirees can obtain 2.2% more income. The naïve investor makes allocation decisions without regard to spending goals by focusing on single-period Modern Portfolio Theory concepts. A more sophisticated approach is to incorporate future spending needs as a liability and to allocate assets which will best meet that liability.
By making these improved financial decisions, retirement income can be increased dramatically. On a utility-adjusted basis, more sophisticated planning allows for an increase in retirement income of 29% over the naïve case.
The authors also asked how much all this is worth in terms of traditional alpha measures of portfolio performance. In other words, how much would portfolio returns need to be increased to support 29% more spending? Their answer was that, over a 30-year period, the naïve investor would need to earn 1.82% more per year (the median value in a Monte Carlo simulation) to increase income by this amount. This is the “gamma-equivalent alpha.” An investment advisor charging 1% of assets under management fee would be splitting the gains roughly in half in this example if the client’s alternative was to behave naively. The value provided by planners could be even greater if they help clients make better decisions on when to claim Social Security and if the clients also tend to commit correctable behavioral mistakes such as buying high and selling low.
The bottom line
Comprehensive planners help their clients achieve better outcomes in a variety of ways, including budgeting and saving for the future, making better investment decisions, thinking about tax efficiency and considering total-portfolio and lifetime perspectives. Both of these new studies help to quantify this. These studies serve as a wake-up call to other researchers that studying the investment outcomes of broker-guided portfolios is not a sufficient way to quantify the value provided by the financial planning profession. Hopefully, we will see more studies along these lines in the coming years.
Wade D. Pfau, Ph.D., CFA, will be joining the American College in the spring as a Professor of Retirement Income in their new Ph.D. program on Financial Services and Retirement Planning.He is also an active blogger on retirement research and maintains the educational Retirement Researcher website. See his Google+ profile for more information.
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