Christine Benz: Hi, I'm Christine Benz for Morningstar.
Many investors are familiar with alpha and beta, but Morningstar researchers have created a new measure called gamma. Joining me to discuss it is David Blanchett; he is head of retirement research for Morningstar.
David, thank you so much for being here.
David Blanchett: Thank you for having me.
Benz: David, you've written a paper about gamma. Let's talk about what the measure is.
Blanchett: Well, first, you mentioned alpha and beta. Alpha is if you pick a good mutual fund that beats its peers by 1%, that's alpha. Beta is, I'm going to put 60% of my money in stocks, 40% in bonds. Beta is how much you invest in the market. And then gamma is the benefit of making good financial-planning decisions. So, it's all that alpha and beta is not. It's the value you achieve from making intelligent choices about how to manage your money.
Benz: So, you looked at the value that one might add by successfully managing gamma. How impactful can that be in terms of a portfolio's overall results?
Blanchett: We find it was significant. In this research paper, we look at five different things, and there is probably more like 19 different things. We found that you can create 29% more income for a retiree by just doing these gamma-optimized things.
Benz: Okay. So, that's a big number.
Benz: Let's start with one of the first components that you looked at--you called it total wealth allocation. I want to talk about how that's different from the traditional understanding of asset allocation?
Blanchett: Total wealth allocation is the idea that you should think about how all your investments fit in a total portfolio. So, for example, if you have a portfolio that's half stocks and half bonds, and you [also] go out and buy an immediate fixed annuity. That creates very bond-like income. So, with the rest of your money, you can be more aggressive. Think about how all of your components are creating income or how they add value, and then look at that from a holistic perspective.
Benz: And you've got human capital in the mix as well. That's a consideration?
Blanchett: So, for a very young investor, human capital--which is their future earnings--is their most valuable asset. So, as they move through their life expectancy, their lifetime, that gets smaller and smaller and their financial capital gets larger and larger. And so as those offset, it should affect your asset allocation. Same thing in retirement. The different components of your income should drive what you invest in.
Benz: Another component of gamma is what you call dynamic withdrawal strategy. How does that differ from someone using, say, the 4% rule for taking withdrawals from their retirement portfolio?
Blanchett: The 4% rule is an excellent starting place for a couple who is age 65. It doesn't work for someone who is a male who is age 80, a female who is 70, a male who is age 50, or couple who is 50 years old. So, the 4% rule gives you a starting place. The idea behind the dynamic withdrawal strategy is to update that every year. So, once a year, go in and look at, how has my portfolio done? How long am I going to live? What is a smart withdrawal rate given those two things?
Benz: So, if the market has done relatively poorly, you'd want to ratchet your withdrawal rate down a little bit; if it's done better, maybe you could take a little more?
Blanchett: That's right.
Benz: Another thing that you looked at is an investor's annuity allocation. I think a lot of investors hear the word annuity and their hackles go up. They've been thought that annuities can be really costly. But your research shows that looking at annuities as a potential component of a toolkit can be very additive.
Blanchett: Annuities, I guess they are dirty word in some circles--I don't know. But if you want to guarantee lifetime income, you can't do that with a portfolio without an annuity. An annuity is where you hedge risk.
I've seen papers that talk about, you have a low chance of failure if you invest this way or you buy this thing. The only way you can guarantee income for life is through an annuity. They don't work for everyone. I mean, most people actually have a great annuity through Social Security. Social Security is a phenomenal investment for most people, because it guarantees income for life, increased by inflation. So, for most folks, they have social security. And for those that want more guaranteed income, they have to look at an annuity.
Benz: Another thing that you looked at as part of gamma is proper tax management. So, you're really looking at two things there. I want to start with the first thing, asset location--so what types of investments you put in what types of accounts. What are some general rules of thumb you can share on that topic?
Blanchett: So, bonds are very inefficient investments, because with bonds, you realize the income every year as ordinary income. So right now they're taxed at up to 35%. Stocks, on the other hand, are taxed, if they’re held over a year, at the long-term capital gains rate, which is only 15%. So, if you have inefficient investments like bonds, you should hold them in a tax-deferred account like an IRA or 401(k). You should hold stocks in a taxable account to kind of realize the benefits of the taxation between the two different types of accounts.
Benz: Paying attention to what goes where, and also you note that sequencing withdrawals. When it comes time to take distributions from various accounts, paying attention to which accounts you tap first and which you save to last is important. What are some considerations that people should be thinking about there?
Blanchett: So it's kind of the same thing. You want to keep the most efficient accounts you have. A Roth IRA is a very efficient account. There are no RMDs at all. It's got very good estate planning benefits. So if you have a taxable account, a traditional 401(k), and Roth IRA, spend the Roth IRA last. Those taxable monies are good, but every year you have money in that taxable account, you’re paying taxes based upon gains and things, and so thinking about using that Roth piece last, the traditional piece last, will create more income because you have more assets.
Benz: And the taxable piece would go first.
Blanchett: First. You want to have some diversification; I wouldn't recommend that you spend down all of your taxable account. But it is good to think about, what is the most efficient way to invest money, and that’s usually in a Roth or traditional type account.
Benz: And the last thing that you looked at as a component of gamma is having inflation protection or mitigating inflation risk in the portfolio. How should investors think about that specific question?
Blanchett: And this goes back to the other thing we talked about with human capital. So with human capital, for someone that's young, if inflation is material, their wages should increase with inflation, and that should kind of offset things. For a retiree, the risk to their portfolio is creating income for life adjusted by inflation. So you want a portfolio that moves with inflation. So if inflation is high, your portfolio returns well. If it's low, you'd still like to do well, but the goal is income, and so you want to have a portfolio that kind of tracks inflation to create income that better matches your need over time.
Benz: Do you have a thought on what sorts of tools that someone might add for a measure of inflation protection to their portfolio?
Blanchett: Things like TIPS, which are Treasury Inflation-Protected Securities, real-estate, domestic equities. Things that kind of move with inflation are great hedges against inflation.
Benz: Well, David thank you so much for providing an overview of the paper. People who want to learn more can read the entire paper, but thanks for providing a little bit of a shorthand on the research that you’ve done.
Blanchett: Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.