Journal of Financial Planning: January 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.
The good news continues. I noted in my July 2013 Journal column that I was encouraged with the quantity of applied research related to the concerns of practitioners; not only does the quantity continue, but so does the quality. I didn’t have to search beyond this year’s Journal to fill this column. However, I couldn’t miss introducing you to an exciting new entry (with the caveat that I serve on the advisory board), Institutional Investor Journals’ The Journal of Retirement, so I’ve included a few entries from it. Although I don’t necessarily agree with every paper’s conclusion, I believe each is worthy of your attention.
“End the Charade: Replacing the Efficient Frontier with the Efficient Range,” by Meir Statman and Joni L. Clark (Journal of Financial Planning, July)
Although Statman is well known for all of his work in behavioral finance he’s also provided many contributions on the issue of optimization, and this one is a winner. Although it has an in-your-face title, the paper introduces a useful concept of replacing an efficient frontier with an efficient range—the bracketing of the traditional efficient frontier to allow the practitioner to incorporate the well-known uncertainties in the input to a mean variance optimizer, as well as customizing solutions that incorporate constraints such as socially conscious investing.
“Using a Simplified Deterministic Model to Estimate Retirement Income Sustainability,” by Gregory W. Kasten (Journal of Financial Planning, July)
In this paper, Kasten reminds practitioners that traditional Monte Carlo simulation results are highly sensitive to small changes in arithmetic return and other related input. As an alternative to third-party capital needs software that he suggests is often difficult to customize, he proposes a simplified deterministic model using standard deviation to convert the arithmetic return to a derived return for each level of confidence. Although his model may be far superior to many of the simplified web-based retirement planning models, I do not believe it will replace quality professional planning software; however, I believe this paper provides practitioners with a useful education regarding the issues that drive a classic capital needs analysis.
“Understanding Unusual Social Security Claiming Strategies,” by Alicia H. Munnell, Alex Golub-Sass, and Nadia S. Karamcheva (Journal of Financial Planning, August)
If you have yet to focus on the potential power of appropriate Social Security claiming strategies for your clients, this is a critically important paper. If you are already familiar with the issue, you will still find this paper of value and possibly a useful piece to share with your clients. Focusing on the strategies of “claim and suspend” and “claim now, claim more later,” the authors point out that only about 27 percent of couples benefit from “claim and suspend,” but more than 80 percent of couples on the verge of retirement have the potential to gain from “claim now, claim more later” strategies. The authors looked at potential cost to the Social Security system and found that in 2006, if couples had utilized the expanded option of “claim now, claim or later” versus simply claiming benefits at their optimal ages, the cost to the system would have been $9.7 billion. Fortunately for the system, actual claiming behavior is not optimal as individuals tend to claim early. Using this comparison, the system saved $23.3 billion. The obvious point is, with good advice from practitioners such as ourselves, in the future that $23.3 billion can accrue to the benefit of our clients.
“A Scenario Based Approach to After-Tax Asset Allocation,” by Andrew L. Berkin, Glenn S. Freed, and Sheryl L. Rowling (Journal of Financial Planning, August)
This paper expands on important concepts raised years ago by William Reichenstein, namely that expected returns and risk of taxable assets should be adjusted for taxes and, for the purpose of asset allocation, the value of investments in tax-deferred accounts should be adjusted to reflect the embedded tax obligation. The authors note that they strongly agree with this overall philosophy but take issue with the implications for practice and they introduce a scenario-based approach to incorporate these issues.
“A Decision Matrix Approach to Retirement Income Portfolio Design,” by H. Jeffrey Spivack and Edward Nelling (Journal of Financial Planning, August)
Although there are many elements in this paper that I disagree with; for example, the use of age-banding segmentation and suggestion that “At higher asset levels changes to guaranteed allocations may be unnecessary because the client’s assets are likely to be sufficient to fund the higher drawdown rate,” I believe that the introduction of the concept of a decision matrix approach and incorporation of annuities and guaranteed income sources are worthy of further consideration.
“Simple Formulas to Implement Complex Withdrawal Strategies,” by David M. Blanchett (Journal of Financial Planning, September)
I am always concerned when I read about a simplified method of planning my client’s financial future; however, when I see the author of the paper is Blanchett, I know I need to take it quite seriously. Blanchett is a member of a small group of authors, including Meir Statman, Rob Arnott, Wade Pfau, Bill Reichenstein, Michael Kitces, and Moshe Milevsky, who regularly contribute to our professional literature and who are always “must reads.” That doesn’t mean I always agree with their conclusions, but I always learn something of value. This paper is no exception. In this case, my disagreement is with the premise that the “dynamic complex approach” to determining sustainable withdrawal (incorporating current portfolio value, expected portfolio returns, and expected mortality) requires a database that needs calculations that are “likely impractical for the vast majority of financial planners … ” However, the logic behind the proposed formulas and the introduction of the concept of the “withdrawal efficiency rate” are intriguing concepts. Better yet, Blanchett has provided an Excel spreadsheet for public use at www.DavidMBlanchett.com/tools. I look forward to comparing the results to some of my own cases, and I encourage you to do the same.
“Is an All Cash Emergency Fund Strategy Appropriate for All Investors?” by Janine Scott, Duncan Williams, John Gilliam, and Jacob P. Sybrowsky (Journal of Financial Planning, September)
This is a particularly important paper for practitioners, because it addresses an issue that we consider for all of our clients—an emergency reserve. It’s one I’m biased in favor of, because most of the authors are good friends and one is a colleague at Texas Tech. Of course, this doesn’t mean I don’t have some disagreement with the conclusion that the opportunity cost of a traditional all cash emergency reserve significantly outweighs its benefits. The authors make a very strong case for their position; however, the results are based on a six-month, not a more common three-month reserve. Although the paper acknowledges that behavioral theory postulates the existence of mental accounting and separate buckets, the conclusion is based on the traditional concept of the rational investor who recognizes that wealth is fungible. As a consequence, rational investors should invest emergency funds similar to the allocation of the retirement account. As a passionate behaviorist, I caution against ignoring what I believe is the reality of irrational behavior. Consequently, although I believe we need to seriously consider the implications of this paper, we need to do so with a bit of caution.
“The Glidepath Illusion ... and Potential Solutions,” by Robert D. Arnott, Katrina F. Sherrerd, and Lillian Wu (The Journal of Retirement, Fall)
In addition to his work being extraordinarily educational, Arnott is not one to mince words, and this paper is no exception. The introduction lays out the authors’ position very clearly. “We believe that the heuristic of buying stocks when young and bonds when mature—a rule of thumb by which many billions are invested—is flawed, and that the typical glide path implementation fails to solve the basic problem facing most investors. Since their inception, conventional glide paths have fallen short of contrarian strategies or ordinary balanced strategies. They offer more, not less, uncertainty about perspective and retirement income.” The paper provides a simple alternative that addresses the “glaring pitfalls” of current strategies.
“Alpha, Beta, and Now ... Gamma,” by David M. Blanchett and Paul Kaplan (The Journal of Retirement, Fall)
Blanchett, along with his Morningstar associate, Kaplan, introduce a concept they call “gamma.” This is a measure of the contribution advisers provide clients by enabling their clients to make more intelligent financial planning decisions. Focusing on a holistic view of a client’s financial life to determine an optimal asset allocation, a dynamic withdrawal strategy including guaranteed income products, tax-efficient allocations, and optimization that includes unique client constraints, the authors conclude that this advice would equate to an annual return increase in retirement income of 1.59 percent. You might consider using this approach to evaluate the value added by your firm and discussing it with your clients.
“Applying a Stochastic Financial Planning System to an Individual: Immediate or Deferred Life Annuities?” by Agnieszka Karolina Konicz and John M. Mulvey (The Journal of Retirement, Fall)
Addressing immediate and deferred life annuities and confirming earlier studies, the authors conclude that “most individuals would benefit from purchasing deferred annuity contracts and should purchase them as early as possible.” In percentage terms, based on the client’s degree of risk aversion and bequest motives, the allocations range from 20 to 70 percent of savings.
I hope these reviews introduce you to concepts that will enable you to provide your clients even more value in 2014.