In a November 2014 paper, Nobel laureate Joseph Stiglitz explores how technology adoption affects income and employment (“Unemployment and Innovation,” National Bureau of Economic Research). Most people think innovation makes workers more efficient, enhances productivity and increases wealth, but Stiglitz came to an unsettling conclusion. Substituting technology in some cases may actually lead to stagnant wages. Neither the people who lose their jobs because of innovation, nor the skilled labour that get those jobs, necessarily benefit.
For instance, the Great Depression was, in part, a shift from an agrarian-rural society to an industrial-urban one, thanks to technological change. Will the financial services industry suffer a similar upheaval as it shifts to serve a new generation of wired investors, and transitions baby boomers from wealth creation to capital preservation? How can advisors stay on the winning side?
Technology and the advice gap
Figures from Boston-based analytics firm Cerulli tell us that by 2017, the number of U.S. registered advisors will fall 25,000 to 280,000, which would be an 18% drop since 2005. Advisors reflect the boomers they serve, averaging over 50 years of age themselves. As these advisors retire, firms must learn how to manage more assets per advisor. This is a positive picture for those remaining in the business, but as advisor supply falls, the nature of client demand is also changing. Generation Y will soon dominate the workplace, as boomers, who control 80% of Canada’s wealth (so says Investor Economics), move into retirement. The financial services industry is unprepared.
Investors with $1 million or more to invest will always have providers lined up to compete. Average boomers with more modest portfolios have fewer options. A former colleague who counsels members of group savings and defined contribution pension plans says he’s seen retirees withdraw their funds from programs with annual costs of 0.80% to 1.2% and reinvest them in retail mutual funds at 2% and higher. A 2% fee consumes 31% of accumulated capital over the 20 years (see “Consumption calculations,” below) that the retiree can expect to live at a time when they need to preserve capital more than ever. Although robo-advisors are targeting Gen Y with asset allocation, automatic rebalancing, tax-loss harvesting and all-in fees of 0.55% to 0.75%, they can benefit retiring boomers as well.
Challenges in the industry
No growth
The industry rewards growth. Advisors’ bonuses and compensation have traditionally been driven by assets managed or administered. To increase income, advisors need to grow their books.
Retiree account balances may rise immediately after retiring, as employment expenses decline, but eventually investors start to draw down their savings.
Advisors must shift from growing assets to preserving them. Boomers face the risk that rising advisor minimums will collide with their declining portfolio balances.
No declining interest rates
Few people expect the next 30 years of interest rates to repeat the decline of the last 30. How should portfolios be built for retirees to provide steady income while minimizing the chance that they run out of money? Let’s rethink conservative balanced funds for retirees, which usually allocate 40% to stocks and 60% to bonds.
In a low-to-rising interest rate environment and with a 4% annual withdrawal rate, adjusted for inflation, a 40:60 portfolio presents a 65-year-old with a 24% chance of running out of money before she dies. A one-in-four chance of going broke is a disaster. A 60:40 portfolio reduces the chance of financial ruin to 14%, or about a one-in-seven chance.
In a paper published in the Rotman International Journal of Pension Management in 2013, my colleague Ioulia Tretiakova, director of quantitative strategies, demonstrates an asset allocation approach to reduce this probability to 7% (below that of all stocks).
Using other risk disciplines (e.g., constant risk portfolio rebalancing, or taking more risk when behind the goal, and less when ahead) and an annuity, we reduced the theoretical chance of running out of money to zero. Meanwhile, we gave the investor an opportunity to buy a less expensive annuity, providing access to capital years into retirement and addressing longevity risk. This approach is an example of what an algorithm-based solution can provide, although no existing robo-advisor offers it—yet.
Probability that a 65-year-old would run out of money before death
Conditions: 4% of initial balance, inflation-adjusted annual withdrawal, pre-tax; low to rising interest rates; mortality-weighted. We used joint and last survivor to replicate a defined benefit pension plan, which means payouts continue until the death of the second person (spouse) as defined by mortality tables. This period is about 25.5 years, which is longer than the life expectancy of either men at age 65 (18.7 years) or women at the same age (21.7 years).
Summary
Advisors who can embrace and exploit technology by using algorithmic platforms can win. They reduce the time they spend on portfolio management, an activity with diminishing opportunity to add value, and spend more time gathering assets.
They can employ low-cost products, like ETFs, to address boomers’ increasing need to preserve capital, and Gen X’s and Gen Y’s demand for transparency and value.
They can enhance financial, tax and estate planning to redefine and unbundle their value proposition to investors. Stiglitz’s concern may be well founded for advisors who fail to use technology to their advantage, sell high-cost products that fewer will be able to afford and fail to recognize the changing dynamic of a new generation of investor.
by Mark Yamada, president of PUR Investing Inc., a registered portfolio manager and software development firm.
Disclosure: PUR Investing Inc. sub-advises for, and provides risk-based model portfolios to, Horizons ETFs.