The question of what a financial adviser is truly worth has come to the fore recently with the advent of the RDR. To help answer this trickiest of questions, a couple of boffins from Morningstar have had an energetic go at quantifying the ‘real’ value of financial advice.
Over the years I have been asked many times by friends and acquaintances what value advisers add to long-term investing and why they should be used. I imagine it is a question many financial advisers, planners and wealth managers pose to themselves too: ‘How do I quantify for my clients the long-term value of my advice? What difference do I make?’
The boffins, David Blanchett, head of retirement research for Morningstar, and Dr Paul Kaplan, director of research for Morningstar Canada, have tried to answer these questions and came up with what they call the theory of adviser “gamma” – the value that advisers add to the investment process.
Most finance professionals are familiar with investment alpha and beta but perhaps not with gamma. It’s a term to describe the value that making “more intelligent financial decisions” over a long period can provide for investors. It is an attempt to quantify the value that advice and advisers add to the investment process. Gamma represents the variation between DIY investing versus using an adviser.
So far, so good and I understand the usefulness of this comparison, but there are a few caveats to add to the study. Firstly, the Morningstar research was based on the US 401k pensions market, perhaps the equivalent of the UK Sipp market to some degree but not immediately comparable to the UK. The other factor, and this applies to both sides of the Atlantic, is the variation and inconsistency between different advisers and different types of advice. The investing process will vary slightly between each firm of financial advisers and, in addition, while an outstanding adviser will add a great deal to the investment outcome for a client, a poor adviser will cost money and potentially expose the client to unnecessary risk. The move to greater adviser professionalism and shared standards should improve adviser “consistency”, by the way, so these factors should erode over time, perhaps giving gamma more universal relevance.
So what did the Morningstar boffins discover?
They looked at a number of gamma factors, including optimal asset allocations based on total wealth, withdrawal strategy, product allocation (the mix of guaranteed income products versus traditional investment products), tax-efficient allocation and drawdown and liability-relative asset allocation (investing to factor in risks such as inflation).
They created a number of portfolios and income drawdown strategies. (Incidentally, income drawdown in retirement is huge in the US and the purchasing of retirement annuities has dwindled, with the UK set to follow this trend.) They then applied standard financial-planning techniques. They set the scenarios against a base-case scenario and then looked at what a hypothetical pensioner could expect to see in retirement income. They found that the “hypothetical retiree” could expect about 20 per cent more income using a “gamma-efficient” retirement income strategy. In other words, using an adviser can provide a 20 per cent better return, according to the study.
One of their most positive findings for advisers is that the gamma factor is not volatile, unlike alpha, and it can be more or less assured. Investors can add gamma to their portfolio by using a good-quality adviser. Of course, nothing is guaranteed but the findings are already stimulating debate.
One of their most positive findings for advisers is that the gamma factor is not volatile, unlike alpha, and it can be more or less assured.In the UK the value of advice has been submerged beneath arguments about the future direction of the adviser market and the impact of the RDR changes. It has often been forgotten that what matters to clients is getting good advice and for that advice to be good value for money. Clients want to see that the fees they pay for advice are rewarded with better results.
The research shows that picking a good adviser is almost as important as investment return and factors such as tax efficiency and risk avoidance are very important to investment success.
DIY investors may well make some good investment choices, but it is much harder for them to ensure their choices are tax-efficient or avoid unnecessary risk, because they do not have the many years of tax-planning knowledge and experience of a good financial adviser.
The Morningstar research suggests that using an adviser earlier in the investment process can help improve results for investors and avoid bad decision-making. This is not a black-and-white scenario and further research is needed, particularly on the UK adviser market, but it does suggest that good advisers improve investment returns and this “difference” is both quantifiable and worth paying for.
Kevin O’Donnell is a financial writer and journalist
Enquiries in response to Tony Hazell’s column on Sesame’s £6m fine (FA, 20 June)
“If a bank or provider is fined, it is the company (or provider) and not the directors who pay the penalty; they don’t give a damn and hand over a cheque. But when a network or IFA is fined this penalty comes directly out of the adviser’s pocket – so, in this regard, the City regulator is not being fair.”
