Sources of added value available to everyone

Christian Charest: We are back with Dr. Paul Kaplan, Morningstar Canada's Director of Research, who recently co-authored a paper that introduced a new concept in wealth management called Gamma.

Paul, in our previous video, we outlined what the concept of Gamma is about, a way in which investors can add value by making sound financial planning decisions. And in that video, you mentioned five factors, and I'd like to go back to those and expand a little bit on the five factors and also give some real life examples on how investors can add value by making sound decisions in those areas.

Now let's start with the first one, which is total wealth allocation.

Paul Kaplan: Yes, the idea here is that your portfolio does not only include your financial assets, but also includes what we call, human capital. And the way to think about your human capital is like this; let's suppose you are young, you are just starting your career and your career that's ahead of you is going to be generating income. And for that steam of income you can think of it like a bond. It's a stream of income that's going to get paid, and therefore when you're starting off in your career it's as if you had quite a bit of fixed income.

And your financial portfolio, which for most of us would start off small, and then we hope to grow it over time, therefore, it can be more heavily allocated in equities. And so, what we can do is, over time we can balance our total portfolio which consists of both our financial wealth and our human capital in such a way as to maintain an overall level of equity exposure, overall asset allocation, that we feel comfortable with from a total risk perspective.

Charest: Now the second factor is dynamic withdrawal strategy.

Kaplan: Yes, a lot of times financial planning discussions – when talking about retirement, it starts off with a discussion that says well you have $1 million that you're retiring with, how much would you plan on spending? Let's spend 4% of that a year. So let's spend $40,000 year-in, year-out regardless. And the idea here is to do something more sensible than that. Let's dynamically change the amount that we are withdrawing based upon our circumstances as the years go by.

So, a good example of that is the market. Maybe you're planning on doing a major vacation at the beginning of retirement and then the market crashes, so you don't take the vacation. Be sensible about it. Or maybe the opposite happens and the market is unusually generous, so you might say, you know what? I am going to cash in on that and celebrate and take some additional travelling that I wouldn't do otherwise.

So, by sensibly varying the amount that you spend year-in and year-out depending upon conditions, you can make money – you make your money last longer and do better.

Charest: The third factor is using annuities in your planning.

Kaplan: Annuities give you the opportunity to gain some additional return by the fact that you are entering into a pool of people who at some point are going to pass away. And what happens with annuities is that a certain percentage of people are going to pass away within that pool, meaning that the insurance company can distribute the money to those who survive.

It's kind of like getting a free lunch, as long as the only thing you care about is getting income while you are alive and you don't care about the fact that you are going to lose income after you pass away. It can be a real benefit and so by taking at least some of your savings and instead of putting them all in traditional assets, put some of them in a type of payout annuity and you can increase your income.

Charest: And the fourth one is asset location and withdrawal sourcing.

Kaplan: Yes, this is taking advantage of the tax-deferred savings system. Here in Canada we have RRSPs, which investors should be taking full advantage of during their working years, because they can accumulate assets in RRSPs and they do not have to pay any tax on them until they reach retirement in which case once they're retired they might be in a lower tax bracket. The fact is that over long periods of time there is a real advantage of being able to earn income on a tax-deferred basis compared to having to pay tax year-in and year-out.

So, by taking advantage of that system, you can improve your retirement income and then once you retire what you can do what we call, withdrawal sequencing. For most people that means taking the money out of your taxable account before touching the money in your tax deferred account, because the longer it sits in that tax deferred account, the better tax advantage that it is going to get.

Charest: Finally, the last factor is something you call liability relative optimization.

Kaplan: Here the idea is that when I am managing my assets, I should do so in view of what are my liabilities. And for a person who is retired, those liabilities – all the spending that they are planning on doing when they're retired and what's the primary risk of – what's going to change the value of that spending, a lot of that is going to be related to inflation, particularly unanticipated inflation.

And so that means when you're doing your asset allocation over on the asset side you want to pick assets that are going to be particularly sensitive to inflation, such as inflation-linked bonds rather than ordinary bonds.

Charest: Thank you very much, Paul. And once again, Paul's co-author on this paper, David Blanchett, who is head of retirement research for our Morningstar Investment Management Division, will be speaking on this topic at Morningstar Canada's Investment Conference on June 5 here in Toronto.