Private Wealth Midwest Forum on 8/17/2016 at the University Club of Chicago

Don Duncan’s Presentation:

In this era of low projected equity and fixed income returns, it is unlikely that advisors will be able to generate significant alpha unless they operate in niche markets and conduct proprietary research that gives them a competitive advantage.  The low hanging fruit has been picked.  Instead of looking to hit home runs, advisors need to focus on hitting singles.

We have found that the best way to hit singles is by generating Gamma. This term has been used by David Blanchet, Head of Retirement Research at Morningstar, to describe the value added by applying financial planning principals to asset management.   His white paper is titled, “Alpaha Beta and Now Gamma.”  He estimated that Gamma can add as much as 1.59% additional return per year.

David and I did a presentation on behalf of the CFA society of Chicago where I provided examples of Gamma using asset location, dedication and diversification.  I can tell you that Gamma, defined as increasing after tax wealth, is primarily related to reducing tax drag.

Asset location in its simplest form is putting equities that pay qualified dividends taxed at 15% in taxable accounts and income producing assets taxed at ordinary income tax rates in IRAs.  Municipal bonds in a taxable account are better after tax wealth generators that corporate bonds in the same account.

An example of asset dedication would be for clients that want to provide legacy assets for the children to do serial conversions into Roth IRAs. Even if the parents and the children are in the same marginal tax bracket the potential for future tax free compounded returns is impressive.  An even better strategy is 529 plans for grandchildren or even great grandchildren. If the compounding time period is long enough, even a 10% penalty for withdrawals not used for education can be overcome with the tax deferral.

Asset diversification is focused on combining assets that have non-correlated cash flow generating capacity with tax advantages. A combination of systematic withdrawals from a financial markets portfolio (qualified dividends, long term capital gains and muni bond interest),  rent received form investment properties (some  of which is sheltered by depreciation), payments from annuities (some of which is return of basis), managed income from a profitable business would be examples of asset diversification cash flow.

Another Gamma opportunity is tax arbitrage between generations, between different entities and different time horizons

Because of the complexity of our current tax regime. Currently we have 5 different interrelated tax schemes (ordinary, AMT, surtaxes (Medicare and net investment), phase-outs and estate taxes); we have found that you have to actually have to plug the scenarios into tax planning software.

  1. A different generation strategy would be gifting appreciated assets to low tax bracket family members and having them recognize the gains at their lower rates. The assets stay in the family but at a lower after tax cost.
  2. A different entity example would be moving high income assets into a special needs trust for a handicapped family member. Have the trust distribute the income which will be taxed at very low rates and potentially offset by medical deductions.
  3. Timing of Capital Gains is the last example I will provide. People in the 15% tax bracket or lower can have capital gains taxed at 0%. For one of our clients that retire in 2014 we generated over $500,000 of gains.

DDD Wealth Planning Panel Presentation