A financial plan should be the cornerstone of any family’s wealth management strategy and should detail their investment, business, retirement and estate goals and objectives. It should include realistic tax and cost of living assumptions and most importantly, it should be able to tell with reasonable confidence whether the plan is achievable through most economic scenarios. The reality is most plans don’t and here is why.
Typically when you sit down with a financial advisor for the first time you are asked a variety of questions about how much you have saved and how much you think you will need each year of your retirement. In addition, you may be asked what size estate you would like to leave to your heirs and what degree of investment risk you are willing to tolerate. This information is input into a program with an assumed rate of return based on the risk profile, a tax rate and inflation rate and “Voilà” you either have enough savings to meet your goals or you need to save more money.
One of the principal reasons financial plans fail is that they don’t test the plan against real economic scenarios. Many financial plans make the unrealistic assumption that the investment portfolio during retirement will earn the same rate of return each year. I have used two examples below to illustrate how the impact of this assumption can drastically affect the outcome of your plan and consequently the one life you have to live. I’ve kept the examples fairly simple by only changing one variable and leaving out tax and inflation.
In my first example, we have Mr. and Mrs. Smith, who have managed to save $ 1 million dollars over their working careers and currently have the money sitting in a bank account. They have both just turned 65 and have decided to retire. They have no other savings or sources of retirement income and feel they can comfortably live on $70,000 per year which they would like to start withdrawing at the beginning of the following year. They visit their advisor who runs a typical financial plan, assesses their risk tolerance and income needs and figures a balanced portfolio with 50% in bonds and 50% in a diversified portfolio of blue chip stocks should meet all their goals and objectives. Based on this asset allocation, the advisor determines that they should average a 7% rate of return, which will generate the $70,000 a year they need. They are relieved and happy and ask the advisor to proceed with the plan.
Unfortunately, the year we will use for this first example is the beginning of 2008. By the end of this year their balanced portfolio is down 14.9% or $149,000 and with the additional withdrawal of $70,000, their portfolio value has fallen to $781,000 by the first day of their second year of retirement. With an estimated 29 years of retirement to go and their portfolio down 21.9%, they are obviously concerned that their money may not last for the remainder of their retirement. To keep the example simple we will assume from the second year onward the portfolio does actually earn a 7% rate of return each and every year (highly unlikely, but theoretically possible). Mr. and Mrs. Smith still need to take out $70,000 each year to live, but because the portfolio is now worth $790,000, the 7% generates less than the $70,000 they need each year. As a result, from that year onward they have to withdraw part of their capital each year to meet their income needs and by age 88 their portfolio has run out of money and they are broke!
In my second example we have the same couple, but they were lucky enough to retire one year later at the beginning of 2009. They still have their $1 million sitting in their savings account and still implement the same financial plan with their advisor. By the end of 2009 their balanced portfolio is up 19.7% or $197,000 and after the withdrawal of $70,000, their portfolio value is sitting at $1,127,000. Like the first example, we assume for the next 29 years the portfolio earns a 7% rate of return each and every year. Mr. and Mrs. Smith continue to withdraw $70,000 each year to live and because the portfolio value was $1,127,000, they never need the full income earned each year and the portfolio continues to grow. If we assume Mrs Smith lives to her full life expectancy of 96, the portfolio would be worth $2,034,429.
These two examples illustrate how different the outcome can be by just changing one variable; in this case the rate of return earned in the first year of retirement. In the first scenario, Mr. and Mrs. Smith were broke at age 88, in the second example, they had taken out $70,000 for 30 years for a total income of $2,100,000 and still had $2,034,429 left at death. Although we’ve used data from a volatile two year period, imagine what the potential range of outcomes would be if we took a more realistic economic environment where the rate of return fluctuated yearly and the income requirement increased yearly due to cost of living increases.
There are a number of software programs available today that allow you to test your financial plan against different economic scenarios. I’ve included a link to a simple calculator that lets you choose withdrawal rates, time periods and asset allocation to determine the probability of success based on historical returns. http://www.jhgifl.com/lightboxes/calc_seqret.cfm
The simple lesson learned from this example is that a complete financial plan should provide a stress test of the plan against many realistic economic scenarios to determine the likelihood of the plan succeeding in different economic environments.
In summary I believe there are five key critical components a financial plan should have in order to be successful. Firstly, and most importantly, you must have trust in the advisor that will construct the plan for you. Secondly, the financial plan must have sufficient clarity about what you are trying to achieve with your money. Thirdly, you must be confident that your advisor has the competence and tools to develop a realistic financial plan that is dynamic and flexible. Fourthly, you must be certain that your advisor will monitor, review and update the plan regularly as your goals and objectives change. Lastly, you must be confident that your advisor will communicate regularly how these changes will affect the outcome of the plan so that you can make more informed decisions. After all, you only have one life to live!