Lifelong planning is your goal

This article was originally published in September 2011.

Make sure their clients don’t run out of money

Investors need help, but the source of help is changing. At a recent exchange-traded fund (ETF) conference, several investment advisors (IAs) complained their main competition was the do-it-yourself investor at home. Information from the Internet and other media has made investing broadly accessible. The benefits of diversification and asset allocation are no longer secrets, and the cost of entry has been slashed by discount and online brokers.

IAs who have relied on information as a barrier to entry now find their value to clients narrowing. Add the potential of ETFs to boost the efficiency and further reduce the cost of investing, and the dilemma of today’s IA is put into sharp focus.

Confusing the consumer

At the root of the decreased value is the investor’s understanding and expectation of the advisor. Proposed fiduciary standards for all financial advisors have created controversy in the U.S. because the business model of a traditional broker-dealer — one who is compensated based on brokerage commissions — is at odds with the duty to put client interests first.

Three of four U.S. investors in a recent survey thought, incorrectly, that financial advisors at brokerage firms were required to put client interests first.

In Canada, investors may suffer the same confusion over labels such as registered representative, financial advisor, investment advisor, investment counsellor and financial planner. What are these people permitted to do? How do their educational standards differ? What is the difference in their duty to clients?

Furthermore, none of these titles are designated registration categories with the Ontario Securities Commission. Whatever happened to stockbroker, mutual fund salesperson and investment counsellor?

A new value proposition

While investors no longer require an advisor to tell them they need a diversified portfolio or a 60:40 asset mix, they still need help managing their household cash flow and how to plan, save and live in retirement.

In the investment world, much time and expense surrounds the elusive pursuit of alpha — a return above the market. The investment industry has convinced itself and the public that alpha is the Holy Grail. What investors really need is the funds to send their kids to university and not run out of money at age 84 in the middle of afternoon tai chi class at the retirement home. What they need is something I call Personal Alpha.

Extended retirement income

By saving a client just 1% per year, an advisor can extend the retirement income of a 40-year-old client by nine years (see chart “Extended retirement income,” right). In this example, nine years represents Personal Alpha.

A 40-year-old with $100,000 contributes $10,000 each year, and receives an 8% return scaling to 6% at retirement when he starts to withdraw $40,000 every year (adjusted for inflation at 2.5%). By saving 1% every year, he can extend retirement spending by nine years.

By using ETFs (0.50% MER) and charging a 1% annual management fee, the investor can save 1% every year when compared with a mutual fund portfolio costing 2.5%. But investment return is only part of the possible solution. Tax savings, budgeting advice and other strategies can contribute and provide additional value.

Personal balance sheet

Source: PÜR Investing

Many advisors cling to active management and the pursuit of outperformance as their raison d’être. They hold themselves out as experts in finding fund managers who will outperform benchmarks. If these IAs are honest with themselves, they know they pick funds that did well in the recent past and their record in predicting future winners is normally distributed.

Advisors who really want to stack the odds in favour of their clients over time have been gravitating towards Personal Alpha, whether they know it or not, by using index funds, transitioning to fee-based practices and by introducing ETFs to client portfolios. These advisors recognize that the most concrete way to add value is to lower costs. But IAs are diversifying their own practices to add value and revenue. The chart “Personal balance sheet” represents a typical lifecycle balance sheet for an individual.

Early cycle needs such as family, mortgage, and college create liabilities to be protected with insurance. Later, as spending diminishes, the opportunity to save through retirement requires tax and estate planning.

Advisors from the insurance industry recognize and appreciate the value of a lifelong planning relationship with their clients. Hoping to play a useful role in the future and in an attempt to increase share-of-wallet, IAs and banks are coming to this same realization.

None of this is revolutionary, but a new way of keeping score clarifies the value in advice and gives advisors a path to a different practice.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.