The value of planning? 1.8 percent per year

For decades now, investors have wondered about the value of financial planning, specifically whether it’s “worth it” to pay someone to mastermind a course of action.

After all, it’s tough to see just how much a proper asset- allocation plan, or the right withdrawal strategy really “adds” to performance.

Thanks to new research from Morningstar Inc., however, investors now have an idea of what they can expect from hiring the ideal planner.

It’s an extra 1.82 percent per year.

That’s not some random amount, but rather the results of a groundbreaking study that Morningstar released Thursday, one that is likely to have the financial-services community – and, ultimately, consumers – buzzing.

Functionally, Morningstar quantified how much additional retirement income investors can generate by making better financial- planning decisions.

They are calling the measure “Gamma,” and without getting too nerdy on the subject – or completely lost in the jargon – the concept is worth looking at for anyone who has an adviser or thinks they might someday want one.

Historically, investors have focused the bulk of their time on choosing the “best” money managers or mutual funds, the ones who “add value,” which is the financial world’s way of saying “beat their benchmarks consistently.”

The specific investments, however, typically are less important than many of the other decisions around building an investment portfolio.

Gamma, as defined by Morningstar, is “the extra income an investor can earn by making better financial decisions,” thus it is the potential value that could be added by someone who feels that they can’t do this on their own and must hire an adviser for counsel.

“Most financial planners and investment advisers focus on investment decisions, picking the next best fund,” said David Blanchett, co-author the study and head of retirement research for Morningstar Investment Management, “and other things that you do have a very important impact on your financial well-being, so good financial-planning decisions are very important to success. … It’s hard to quantify the benefit someone receives from someone who gives good financial advice. … Gamma is the idea that there is more to just helping someone than picking good funds.”

In the research paper, Morningstar researchers zeroed in on five key financial-planning decisions – though Blanchett noted that it actually applies to many more decisions, virtually everything advisers do.

What the research showed is that the ability to deliver extra income – unlike the ability to beat the market – is completely predictable. Take certain steps – what Morningstar calls “following an efficient financial planning strategy” – and you achieve excess returns.

The five key decisions boil down to asset allocation, withdrawal strategy, tax-efficiency, product allocation (the use of traditional investment products versus guaranteed-income products), and “liability-driven investing” (which is investing with an eye toward an investor’s specific goals, needs and timeline).

Through simulations, Morningstar’s researchers found that a hypothetical retiree could generate nearly 30 percent more income using a Gamma-efficient retirement-income strategy. That’s equal to kicking up the annual arithmetic return by 1.82 percent compared with the average person making those same decisions. Now comes the part where consumers can put this information to work.

If advisers in an ideal world can add 1.82 percent by making all the right moves, then they have to make most of those moves in order to justify their salary.

Say an adviser charges 1 percent of assets under management to run a portfolio; he or she would need to deliver at least 1 percent in Gamma – extra income – for the services to pay for themselves. The more an adviser charges, the more Gamma he or she had better deliver.

Truthfully, most consumers will never have a clue of just how much value their adviser adds to the process. In my experience – having written two books on the subject of hiring and working with financial counselors – consumers typically say they are seeking help because they want assistance on those key financial decisions and more, but they dismiss advisers when investment returns fall short.

In other words, without knowing any of the Greek or what it really stands for, they hire someone to get Gamma, but fire them for not delivering Alpha.

Let’s get it back to English, because if the average consumer won’t know for sure how this stuff works, they have to take a different approach to benefit from this research.

“It’s hard for the individual to figure out how much value is being added by doing the services,” Blanchett admitted in an interview on my radio show, “but, honestly, to me the big question is ‘Are they being talked about in the first place?’ Is whoever is giving you advice, who is helping you figure out how to map your financial future, thinking about these things and incorporating these things in your financial plan?”

For example, conventional wisdom since the early 1990s has been that asset-allocation is the most important investment decision when it comes to determining returns.

When it comes to an adviser boosting income for a lifetime, however, Morningstar found that a “dynamic withdrawal strategy,” which Blanchett described as “going in once a year and based upon market performance and market strategy figuring out what is a sustainable withdrawal for that portfolio.” The second-most important decision involved making sure that allocation decisions were tax- efficient.

Thus, if investors perceive that they are paying a financial adviser to “pick mutual funds,” they either miss the point of planning or they have a bad adviser. In fact, Blanchett said that the thing that surprised him the most about the research was the value of annual meetings, where clients and advisers tweak strategies, particularly as the consumers is entering or in retirement; most people – on both sides of these relationships – are more focused on market results than on the benefits they get from having that sit-down.

“There’s a significant benefit for retirees or investors in general to having someone make the right decisions,” Blanchett said. “Gamma is something that everyone can do that adds the most value; we call them financial planners or advisers, we don’t call them mutual fund pickers. … It really is worth it to pay someone 1 percent a year to help me figure out how to do this stuff because (the 1.8 percent) is significant value that any (adviser) can achieve.”