How Traditional Retirement Models Cost Clients Millions

Putting retirement clients into a similar stock-bond allocation model easily allows advisors to quickly manage these clients’ portfolios and charge their fee on the assets. It’s a business model that is easily scalable. Unfortunately the business model that may be the best fit for the advisor may not be the best fit for the client’s retirement goals.

How the stock-to-bond glide path hurts retirement income goals and long-term wealth

A typical part of a retirement financial plan includes an asset allocation that provides an expectation of success of meeting a goal given a desired level of spending. For example, let’s assume that a client has $5 million in assets at the time of retirement and desires to spend $200,000 per year in retirement (a 4% spending rate). What is the chance of the client meeting that goal in retirement and how much after-tax wealth will the client have left to provide to the client’s beneficiaries at death? These two retirement goals – retirement income and ending after-tax wealth – are thought to be at odds with one another when we limit asset allocation between stocks and bonds. To increase the chance of meeting the retirement goal, the thought is that you need to move away from higher-earning, more volatile stocks towards lower-earning, less volatile bonds. To meet the retirement goal, you are sacrificing long-term wealth – and vice versa. Later we’ll see how this no longer applies when we utilize certain insurance products to provide downside protection and yield in place of bonds.

A key step of a financial plan for retirement is to determine the amount of income that client would need in retirement. The next step is to run a Monte Carlo simulation and determine the chance that the client would be able to meet those retirement income goals using a predefined asset allocation (e.g., 70% stocks/30% bonds or 60% stocks/40% bonds) if the client were to live to a given age (e.g., 95).

The table below shows the chance of a married couple meeting their retirement goals at various asset allocations if the last spouse were to die at age 95. The couple are both 55 now with $2.8 million in assets. They live in California with $200,000/year in expenses. They plan on needing $200,000 per year in retirement (marked to inflation) to cover their expenses and lifestyle.

As the above table shows, while the client’s chance of meeting retirement income goals are similar under all three asset allocation strategies, the amount of after-tax wealth created at age 95 by the 100% stock allocation is more than double the other two asset allocation strategies.

Why higher stock-allocations are better for HNW retirement income goals

As evidenced in the previous table, a HNW couple depicted above has a better chance of meeting those retirement goals and leaving a greater amount of wealth for their beneficiaries with a greater stock allocation. This is primarily because stock gains have higher returns and are more tax-efficient than bond gains. Shifting away from higher earning, tax-efficient stock returns towards lower-yielding, tax-inefficient bond returns hurts individuals in a higher tax-bracket over the long-run.

Many investors will not realize that the bulk of stock returns are due to the price return of the stock, whereas the bulk of bond returns are due to the coupon return of the bond. And bond coupon returns are taxed at significantly higher ordinary income rates than the long-term capital gains rates of price returns. Stock dividends are also often taxed at qualified-dividend rates, which are significantly less than the ordinary income taxation rates of bonds.

Furthermore, the price return of an asset is only taxed when that asset is sold. This means stock investments allow these unrealized price return gains to compound tax-free. If the investment is held until death of the owner, then the owner’s beneficiary will be able to inherit that asset without paying any taxes on the gains of the price differential between the share price that the owner purchased it and the share price at the time the original owner passed away through a provision known as step-up in basis (provided that the value of the original owner’s estate is under the estate tax limits at that time).

This is a huge benefit to buy-and-hold investors who invest in equity assets like the S&P 500 for the long-term. Bond investors won’t benefit through step-up in basis nearly as much over the long-term, buy-and-hold approach since the price return on bond returns over the long-term are small. In the above table, the annualized price return of bonds from 1928-2022 was -0.11%.

People will often live 20 to 30 years post-retirement. The shift away from higher-yielding, tax-efficient stocks to lower-yielding, tax-inefficient bonds has a significant impact on the after-tax wealth high-net-worth individuals leave to their beneficiaries. This is exactly why in the previous table we saw that choosing a 100% stock portfolio left more than double the after-tax wealth to their beneficiaries than the 70/30 or 60/40 portfolios.

In previous articles I’ve written, I’ve talked about how HNW clients should utilize asset location and place tax-inefficient parts of their portfolio within tax-advantaged wrappers.

The retirement-income cost of a fee-only advisor

A financial advisor typically charges a fee that is a percentage of a client’s assets, generally around 1%. On top of this, the client also will pay custodian fees and fund management fees that can add an additional 20 to 40 basis points. So, for example, if a client has $1 million in assets, the advisor would typically charge a $10,000 annual fee and the client would pay an additional $2,000 to $4,000 in yearly fees for custodian and fund management services. This means the total advisory costs would be 1.2% to 1.4%.

There are two problems with this type of fee structure in retirement:

1. The advisor is typically changing the asset allocation away from higher yielding stocks and towards lower yielding bonds in retirement

This means that the advisor’s fee now makes up a larger portion of the client’s overall return. If the stock portfolio is earning 8% and the bond portfolio is earning 4%, then a 1% fee is only 12.5% (1%/8%=12.5%) of the return of the stock portfolio. But it is 25% of the return of the bond portfolio (1%/4%=25%). When we add taxes into this, then the advisor’s percent of the client’s after-tax return is even higher as we’ll see down below. As the advisor increases the client’s allocation to bonds in retirement, the advisor’s fee relative to the client’s return starts to get increasingly high and eats into wealth and retirement income that would have otherwise gone to the client.

2. The advisor’s fee is paid on an after-tax basis

Another problem with the percentage of AUM fees in retirement is that the advisor’s fee gets paid after-taxes. This further reduces the retirement income and long-term wealth of the client. The advisor’s fee relative to the client’s after-tax income is now higher.

As an example, let’s assume a client has a $1 million bond portfolio that earns 4%, or $40,000 annually. Let’s assume the client’s effective tax-rate is 25%. That means the client pays $10,000 in taxes and is left with $30,000. The client then pays the advisor’s 1% fee, or $10,000 which is 33% of the client’s after-tax income. After taxes and the advisor’s fee, the client is left with only $20,000. The advisor’s fee is 33% of the client’s after-tax return. Of the total 4% gross return, the client only makes 2% after taxes and advisory fees.

There are a number of important questions to ask here:

1. Is shifting the portfolio allocation away from equities and towards bonds a viable retirement solution relative to other solutions available?
2. What is the impact on the client’s ability to meet their retirement income goals and on ending wealth if the fiduciary advisor they hired to help them takes 33% or more of the client’s after-tax income from the retirement solution they recommended?

When an advisor uses a greater bond allocation in place of a proper retirement solution, this is the actual drag that is taking place due to the advisor’s fee, since the taxable bond solution is both lower-yielding and highly taxable.

3. Is it a fiduciary retirement solution to recommend a client give up 33% of their returns for the rest of their life with no protection or guarantees that the client will be able to safely withdraw a given amount of income?

4. More importantly, are there better solutions out there that improve both retirement income goals and wealth than the traditional stock-bond asset allocation the fee-only advisor is recommending?

We can quantify the impact of this using these financial planning simulations. Previously we saw the chance of a client meeting their retirement income goals using different asset allocations. What would these chances look like if we added in the cost of a financial advisor? What would be the impact on wealth at age 95?

Charging an ongoing 1% total advisory fee for shifting HNW clients away from stocks and towards bonds hurts the client’s retirement income and wealth goals. The client would be better off maintaining a 100% stock allocation with no advisor than paying an advisor 1% if the advisor’s sole retirement plan involves shifting asset allocation towards a 70/30 or 60/40 stock-to-bond portfolio allocation without implementing strategies that would help achieve the clients’ retirement goals.

Charging a 1% ongoing fee in retirement reduces the client’s chance of meeting their retirement goals and reduces the after-tax wealth they leave to their clients by millions of dollars unless the advisor has specific strategies they can implement to make up for the large cost of the fee.

In fact, in the three scenarios above, using an advisor reduced the client’s chance of meeting their retirement goals by 17%-31%. Using an advisor also reduced the after-tax wealth left to beneficiaries by $5.6 million in the 60/40 portfolio and nearly $10 million dollars in the 100% equity portfolio.

The safer the portfolio the client uses, the greater the impact of using an advisor. For example, if a client chooses a 60/40 portfolio, their chance of meeting their retirement income goal decreases by 31% (from 77% to 53%). Furthermore, the after-tax wealth left to their heirs decreases by 92% from $6,072,735 to just $490,429.

Another way to think about this problem is to focus on the effect on retirement income with and without an advisor. In the above table, I focused on the chance of success for the client to meet a retirement income goal of an inflation-adjusted $200,000 per year starting in retirement. The chance of meeting this goal without an advisor is 80% for a 100% stock allocation and 78% for a 70% stock/30% bond allocation. If the client uses an advisor, then the chance of success of meeting that retirement goal drops for each of these allocations. The only way for the chance of success to be the same with or without an advisor with the same asset allocation is if the client were to decrease their retirement income goal of $200,000.

how much does the client have to decrease their retirement income goal using an advisor versus without? That is essentially the value proposition that the advisor must justify to break-even for charging the client a fee of 1% for the life of the client. We can see the answer to those questions below.

As the table above shows, paying an ongoing advisory fee hurts the client’s ability to withdraw retirement income on an ongoing basis for a given asset allocation. The advisor has to find a way to add value that makes up for the loss of retirement income due to their ongoing fee. For example, if the client chooses a low-cost index fund with a 70% stock allocation and 30% bond allocation, they will have an 80% chance of meeting their retirement income goal of $200,000/year. But if they used an advisor with that same asset allocation who charged a 1% total advisory fee, for the client to have the same chance of meeting their retirement income goal they would have to reduce their retirement goal from $200,000/year to $159,000/year. That’s a loss of $41,000/year (21% lower retirement income) to the client. The advisor would have to find other ways to recoup this cost through advanced financial planning strategies just for the client to break-even.

Conclusion

Financial planning in retirement can have immense value. This includes creating tax-efficient investment and withdrawal strategies from a client’s taxable, tax-deferred, and tax-free accounts as detailed in previous Advisor Perspectives articles by Pfau and Reichenstein. But if clients are paying an ongoing fee in retirement that costs the client and their beneficiaries millions of dollars, then the value of this planning must at the very least offset these costs.

The wealthier an individual is, the more they need complex estate, tax, investment, and retirement planning solutions that are integrated to ensure the pieces all complement each other. Many retirement strategies advisors use for clients involve shifting the allocation from stocks to bonds. This is hardly the sophisticated strategy I’m referring to here. In fact, shifting the clients away from stocks to bonds hurts the majority of clients – particularly those in high tax brackets – as this article showed.

Bonds are lower yielding and more tax-inefficient than stocks. In fact, the ability of bonds to provide diversification benefits to portfolios has been shown to be extremely regime dependent. When bonds have negative returns, stocks and bonds tend to have a positive correlation – thereby defeating the purpose of using bonds as a diversifier to offset equity risk in the portfolio. We saw this firsthand in 2022 when rising interest rates caused bonds to suffer losses while those same rising interest rates resulted in losses in stock valuations.

Furthermore, the use of bonds as a retirement strategy comes with no protections against interest rate and credit risks.

Losing millions of dollars via fees that eat up 20% or more of the client’s after-tax return for retirement solutions that don’t provide retirement benefits is a heavy burden for the client and their beneficiaries.

The only one who benefits from this arrangement is the advisor who gets to easily scale a business by adding the client to same investment model and strategy their other retirement clients use while spending minimal time addressing issues that could add economic value to clients.

Rajiv Rebello, FSA, CERA is the principal and chief actuary of Colva Actuarial Services. Rajiv works with UHNW clients, RIAs, family offices, estate attorneys, and CPAs to help them implement fiduciary life insurance, annuity, and alternative investment solutions (including tax-free PPLI solutions) into their current practice in order to help increase clients’ after-tax returns and reduce volatility in their clients’ portfolios. Rajiv can be reached at [email protected].

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