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Apr 09, 2019 Rick Pfeil,CFP,CPWA® | Member of Baird Retirement Management;Photo by pexels.com

“Gamma”: Are You Getting What You Think You Are Paying For?

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The wealth management industry is going through a process of streamlining accounts into a fee-based model. Most firms now have some type of fee-based platform. The reasoning for this shift is up for debate, but more and more clients are investing in these accounts at the direction of their financial advisors. According to a PriceMetrix study, “The State of Retail Wealth Management,” published in May of 2018, assets in fee-based relationships were up 48% at the end of 2017 versus the end of 2014, from 31% to 46% (Table 1, Mckinsey.com). Because this trend, in the authors’ opinion, does not show signs of stopping, it is very important to understand how much you are actually paying, and more importantly, what your fee should be paying for.

Table 1 (Mckinsey.com)

 

2014

2015

2016

2017

Fee- Based revenue

46%

49%

54%

63%

Fee- Based Assets

31%

33%

37%

46%

Percentage of Households with Fee Accounts

29%

31%

36%

46%

The PriceMetrix report compiled data from 20 major investment firms, 12 million retail investors and over $6 trillion in assets under management. The study found that the average fee for a client household with investable assets between $1 million and $1.5 million was 1.08%, which probably does not sound too high to the average investor who has heard of a fee-based arrangement. The rule of thumb has always been “around 1%” in the authors’ experience. So what should a client receive for this fee?

Many investors understand these two common measurements of investing:

Alpha: the added value found in selection of “good” investment funds and fund managers.

Beta: the added value found in the allocation of these funds into a portfolio.

Few investors understand how to measure the added value of hiring a financial advisor to help the investor make more intelligent financial planning decisions over the course of their retirement. This brings us to the concept of “Gamma.”

Blanchett and Kaplan’s 2013 study dives deep into the concept of “Gamma,” which is meant to be a portfolio measurement for the value of making intelligent financial decisions (Blanchett, Kaplan). Their calculation for Gamma has many different components, such as asset location and withdrawal sourcing, total wealth asset allocation, annuity allocation, dynamic withdrawal strategy and liability-relative optimization. Their conclusion is that a proper application of these factors in a retirement strategy might generate 22.6% more “certainty-equivalent” income and provide an increase of 1.59% in annual arithmetic return. They found that this +1% Gamma can be achieved by anyone following an efficient financial planning strategy.

The concept of Gamma could make hiring a fee-based planner attractive. A client is charged 1%, and the portfolio should benefit by more than that because of the intelligent financial decisions made. However, two key questions arise: Is the fee the actual all-in cost, and is that fee actually reasonable?

A 2017 report based on a survey conducted by Bob Veres suggests that the actual total costs of a fee-based relationship can be almost double the stated fee because of underlying expenses of investments in the portfolio as well as additional miscellaneous investment costs (Veres). For example, the study found the median fee level for a $1 million to $2 million portfolio is .85%, with median underlying additional costs of the portfolios of .65%, which many in the industry would deem reasonable. The report not only found total portfolio costs with a median of  1.5% for this $1 million to $2 million cross-section of investors, but increasingly higher costs up to 4% in a few of the outlier cases. With an industry-standard 4% withdrawal rate, this 1.5% median total cost represents 37.5% of the income withdrawn from the portfolio.

It is easy to assume that most fee-based planners are providing the basic services that would fall in the seemingly liberal definition of an “efficient financial planning strategy,” but that is not necessarily the case. Many planners depend heavily on off-the-shelf financial planning software and portfolios. Many of today’s financial advisors have little more to contribute to the relationship than selecting “good” investment funds and fund managers. Instead of getting their retirement and income boost as promised by the attractive concept of Gamma, many fee-based investors are instead getting a 1.5% guaranteed drag on their  alpha. That is a guaranteed 150 basis point reduction of yield, and thus, total return on the investments chosen by their financial planners.

In the next article in our series focused on Gamma, we will circle back on some of the information discussed here, as well as look at industry trends that have opened the door for an advisor to charge a fee without the corresponding service.   

Past performance is not a guarantee of future results and no investment strategy or plan is guaranteed to be successful.



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