William W. Jennings

Further Evidence on Institutional Ownership and Corporate Value

Whether institutional investors monitor corporations and improve firm value is a key question for corporate governance and investment management. I find little empirical support for the hypothesis that institutions undertake monitoring that increases firm quality and valuation. Granger causation tests show that while quality firms do attract institutional investment, institutions do not monitor and firm value subsequently declines. Instead, institutional incentives are critical; some institutions with strong incentives to monitor do, indeed, monitor. Institutions with concentrated portfolios successfully monitor while institutions with a larger percentage stake do not. Pensions and endowments are better monitors than insurers, banks and mutual funds.

Perspectives from the Literature of Private Wealth Management

Private wealth management is the investment management specialization focused on high-net-worth individuals and families. Portfolio design and investment solutions in private wealth management are customized to reflect the complexities of the investor’s unique circumstances. This literature review reflects the current best thinking on private wealth management.

The Extended Portfolio in Private Wealth Management

The authors assert that a private wealth manager should manage an individuals extended portfolio that contains financial assets like stocks and bonds along with non-financial assets such as human capital and future benefits from Social Security and defined-benefit pension plans. The optimal allocation of an individuals financial portfolio must recognize that it is but one part of an extended portfolio. If human capital is bond-like then, when human capital is substantially larger than financial assets, an individuals financial portfolio should be heavily allocated to stocks. Similarly, benefits from a defined-benefit pension plan or a fixed payout annuity are essentially “bonds” in an extended portfolio. Everything else the same, individuals with such bond-like extended portfolio assets should allocate a larger portion of their financial portfolios to stocks. The article examines these and other investment implications of this extended portfolio framework.

Two key concepts for wealth management and beyond

Asset allocation is profoundly influenced by at least two underappreciated concepts. First, tax-deferred accounts—for example, 401(k)s—are like partnerships in which the investor owns (1 – tn) of the partnership principal and the government owns the remainder, where tn is the marginal tax rate when the funds are withdrawn. Second, the government shares in both the return and the risk of assets held in taxable accounts. The authors discuss these concepts’ implications for wealth management. In this study, we presented two key concepts and discussed some of their investment implications. The first concept is that a tax-deferred account (TDA), such as a 401(k), is like a partnership in which the investor owns (1 – tn) of the partnership principal and the government owns the remaining tn of principal, where tn is the marginal tax rate when the funds are withdrawn. The second concept is that the government shares in both the return and risk of assets held in taxable accounts, unlike funds in TDAs or tax-exempt accounts (e.g., Roth IRAs). These concepts have important implications for several areas in wealth management. The after-tax value of funds in a tax-deferred account grows tax exempt. The calculation of an individual’s or a couple’s asset allocation should be based on after-tax balances in each savings vehicle. In contrast, the traditional approach fails to distinguish between pretax and after-tax dollars. When calculating an individual’s or a couple’s asset allocation, pretax balances in TDAs should be converted to after-tax dollars by multiplying the pretax balances by (1 – tn). There is an optimal asset location, which is inextricably linked to portfolio optimization. Individuals should locate lightly taxed securities in taxable accounts and heavily taxed securities in tax-advantaged retirement accounts to the highest degree possible, while maintaining their risk–return preference. The main factor in the decision to save in a tax-deferred account or a tax-exempt account is a comparison of the marginal tax rates in the deposit year and in the withdrawal year. In general, if the expected marginal tax rate in retirement is lower than this year’s tax rate, then the individual should save in a TDA, and vice versa. Similarly, the most important factor in a Roth conversion decision is the comparison of the marginal tax rates in the conversion year and in the withdrawal year in retirement. If this year’s marginal tax rate is lower than the withdrawal tax rate, it pays to convert funds to a Roth account this year. The optimal conversion amount would push an investor to the top of the tax bracket just below his or her estimated marginal tax rate in retirement. To convert all of an individual’s pretax TDAs to after-tax dollars in the same year is seldom appropriate. Suppose a U.S. retiree faces a 25 percent marginal tax rate. To make the portfolio last as long as possible, he or she generally should withdraw funds from taxable accounts before TDAs or tax-exempt accounts. This rule has exceptions, however, most of which are based on our first key concept. For estate tax planning, choosing whether to gift or bequeath assets is analogous to choosing between a traditional IRA and a Roth IRA—that is, a comparison of the tax rates today and those expected in the future is the critical factor. Reprinted from Financial Analysts Journal, vol. 68, no. 1 (January/February 2012): 14–22. Author affiliations are accurate as of the original publication date. This article was corrected in March 2012.

The value of retirement income streams: the value of military retirement ☆

Abstract We examine issues surrounding the value of military retirement income. We then provide estimates of the expected present value of this income stream after taxes for singles, married couples, widows and widowers of military retirees. Finally, we contend that individuals should treat the after-tax present value of military retirement income as a bond in their family portfolio. When so considered, it can dramatically affect the family’s asset allocation.

Energy Stocks as a Separate Portfolio Allocation

This article examines energy stocks in the context of a diversified investment portfolio. Several factors—the importance of the energy sector, energy stocks’ potential to hedge energy risks, growing interest in real assets, as well as anecdotes of sophisticated investors focusing on energy investments—motivate this look at energy stocks. The author demonstrates that a separate allocation to energy stocks enhances portfolio efficiency and potentially hedges against inflation and inflation surprises.

Examining the Use of Investment Policy Statements

Using a sample of Investment Policy Statements from college and university endowments, the authors examine the form and use of these important documents. Direct examination of the IPS reveals subtleties that surveys may obscure. In addition to providing statistical insights into endowment management, the authors extract what they view as best practices from the Investment Policy Statements themselves. This study provides valuable insights for individual and institutional investors and their advisors.

Fees Eat Diversification's Lunch

Diversification is often spoken of as the only free lunch in investing, yet we show that it is not free and is properly considered only in light of its costs. More-exotic asset classes typically come with a higher price tag. We show that fees on diversifying asset classes are high relative to their risk-adjusted diversification benefit. Because there is meaningful cross-sectional variation, fees need to be part of asset mix decisions and strategic asset allocation.

Implied Discount Rates for the U.S. Military Blended Retirement System

We evaluate the 2018 option for U.S. military service members to switch from the legacy defined benefit (DB) pension to the new DB/DC hybrid Blended Retirement System. We show that the required return on the pre-retirement matching and incentives in the new system is unrealistically high. Alternatively, those switching to the new system must anticipate a substantial improvement to the current levels of incentive Continuation Pay. We construct our own analysis and a calculator that takes a financial economics perspective missing from previous analyses of the decision as well as consider the positive attributes of the Blended Retirement System. We conclude that those facing the 2018 choice between the two plans should favor the current DB plan if they anticipate serving 20 years.

Socially Enhanced Indexing

While socially responsible investing (SRI) is large and growing, current SRI offerings have shortcomings—including style biases, excessive expenses, tracking error and an incomplete menu of screens. We propose using factor-based models in SRI-screened investment universes to create “socially enhanced indexing” or SRI enhanced indexing. Using commercial software and readily available portfolio screens, socially enhanced indexing offers mass customization of values-based investment programs on the cheap.