Monte Carlo analysis has become an increasingly popular arrow in the financial planner's quiver, as an improvement over the oversimplified traditional straight-line projection. Unfortunately, though, use of Monte Carlo analysis has begun to focus excessively on a singular probability of success, that itself can be almost as misleading as straight-line projections when not viewed in proper context. However, this is not a flaw of the Monte Carlo approach itself, but instead of the tools being used by financial planners. Instead, what's ultimately needed is software that shows not just the probability of success, but also the magnitude and consequences of failure, and a sensitivity analysis that helps clients understand the impact of the trade-off decisions they have available. What can ultimately result is a "next generation" of Monte Carlo analysis, that provides a more useful, relevant, and actionable framework to help clients make effective financial planning decisions.Read More...
As more and more baby boomers retire, an increasingly popular strategy is to split pre- and after-tax funds in a 401(k) at retirement, with the goal of rolling over the pre-tax funds into an IRA, and converting the after-tax funds into a Roth IRA, taking advantage of the non-taxable nature of the after-tax contributions.
Yet the effectiveness of the strategy is ambiguous at best; recent guidance from IRS Notice 2009-68 would suggest that the approach shouldn't be allowed at all, and although some esoteric and technical workarounds have been suggested, none have truly been tested or subjected to IRS scrutiny. As a result, while many 401(k) plans are willing to issue separate checks to accommodate those who wish to try the strategy, and the odds of getting caught are low, caution is still merited about whether the client will really end out with the desired tax treatment.Read More...
While the safe withdrawal rate research provides useful guidance to understand how much clients can safely spend as a baseline, it is based on historical index returns - even though in reality, clients cannot even invest directly in an index without incurring some investment costs, and many pay for the cost of a financial advisor in addition. As a result, many planners recommend that clients adjust their spending downwards to account for the costs and fees.
Yet the reality of the research is that while investment expenses do have a real cost, it has far less of a spending impact than most assume; a 1% expense ratio might reduce a 4% withdrawal rate not to 3%, but instead to 3.6%. This surprising result occurs because of the self-mitigating impact of investment expenses that are recalculated based on the client's account; when accounts are declining, the fees decline as well, while inflation-adjusted spending rises.
The end result is that while financial planners should not ignore the impact of expenses on sustainable spending, it's important not to overstate the impact, either, or clients may unnecessarily constrain their spending when they could be safely enjoying more of their money!Read More...
Cash reserve strategies that hold aside several years of spending to avoid liquidations during bear markets are a popular way to manage withdrawals for retirees. In theory, the strategy is presumed to enhance risk-adjusted returns by allowing retirees to spend down their cash during market declines and then replenish it after the recovery. Yet recent research in the Journal of Financial Planning reveals that the strategy actually results in more harm than good; while in some scenarios the cash reserves effectively allow the retiree to "time" the market by avoiding an untimely liquidation, more often the retiree simply ends out with less money due to the ongoing return drag of a significant portfolio position in cash. As a result, the superior strategy for those who want to alter their asset allocation through market volatility (the effective result of spending down cash in declines and replenishing it later) appears to be simply tactically altering asset allocation directly, without the adverse impact of a cash return drag. Nonetheless, this still fails to account for the psychological benefits the client enjoys by having a clearly identifiable cash reserve to manage spending through volatility - even though the reality is that it results in less retirement income, not more. Does that mean cash reserve strategies are still superior for their psychological benefits alone, even if they're not an effective way to time the market? Or do total return strategies simply need to find a better way to communicate their benefits and value?
"Planners and academics need to work together to develop a profession with evidence-based practices." That is the message given at the FPA Retreat by Dr. Michael Finke, a professor of personal financial planning at Texas Tech University, and a co-author of mine at the Journal of Financial Planning.
Yet while the Journal of Financial Planning is a great resource, and it has been the go-to outlet for research on retirement planning from the perspective of practicing financial planners, especially regarding safe withdrawal rate strategies, the academic research approaches the retirement challenge from a different perspective and focuses on different tools and strategies.
Ultimately, researchers can use their technical skills to investigate optimal retirement strategies, and practitioners can guide these investigations by suggesting real world constraints and ideas for solutions, and even by sharing in the nitty-gritty process of conducting the research. Let’s encourage these interactions to get rigorous analyses which can be applied to real-world problems.Read More...
In planning for retiring clients, it's crucial to get an understanding of what the client's goals are in the first place - so that recommendations can be made about how to financially secure those goals. In the context of setting a spending goal, a popular delineation is to separate retirement spending into "essential" versus "discretionary" expenses - not unlike "needs" versus "wants" for accumulators - with the idea of using guarantees to secure the essential expenses, and less certain growth assets with some risk to fund the discretionary expenses (since they're 'only' discretionary and not essential, by definition).
Yet in reality, even discretionary spending still constitutes an important part of a retiree's overall lifestyle - the loss of which could be very psychologically damaging. As a result, merely securing the essential expenses of retirement and leaving the rest at risk still, in the eyes of most retirees, would constitute a failure of the overall retirement goal. Instead, clients often choose to ensure that all their spending can be sustained - by continuing to work as long as necessary (as health allows) to secure all of their goals. Does that mean the distinction between essential versus discretionary retirement expenses isn't necessarily helpful after all?
As the retirement income research evolves, an increasingly common question is whether the popular safe withdrawal rate approach is better or worse than an annuity-based strategy that provides a guaranteed income floor, with the remaining funds invested for future upside.
Yet the reality is that as it's commonly applied, the safe withdrawal rate strategy is a floor-with-upside approach, too. Unlike the annuity, it doesn't guarantee success with the backing of an insurance company; yet at the same time, the annuity is assured to provide no remaining legacy value at death, while the safe withdrawal rate approach actually has a whopping 96% probability of leaving 100% of the client's principal behind after 30 years!
Which means an annuity is really an alternative floor approach to safe withdrawal rates - one that provides a stronger guarantee while producing a similar amount of income, but results in a dramatic loss of liquidity, upside, and legacy. Does the common client preference towards safe withdrawal rates and away from annuities indicate that in the end, most clients just don't find the guarantee trade-off worthwhile for the certainty it provides?Read More...
Although Social Security benefits are a major part of retirement planning, since the Social Security Administration stopped mailing statements to workers last year, most planners have been limited in their ability to get updated Social Security information for clients - especially new clients who may not have a prior benefits estimate, and/or who may have never previously reviewed their earnings record.
Fortunately, earlier this month the Social Security Administration launched a new online platform allowing anyone to access their own Social Security benefits estimate and earnings record.
In response, many planners are now starting to walk clients through the process of claiming their online Social Security account - which can be done on the spot, in the planner's office, in less than 5 minutes! - and reviewing the benefits estimate and earnings record as a part of their new or existing client meetings!Read More...
As a growing body of research shows, our brains are not quite the logical, rational decision-making machines we think they are – or at least, wish they could be. Instead, our brains take shortcuts; we substitute easier questions for difficult ones, often without realizing it, and respond accordingly with our words and our actions. This can be especially problematic in the world of financial planning, where we often ask clients to make difficult decisions with limited information.
As a result, questions like “what is an acceptable probability of success/failure for your retirement plan?” often get switched for other questions, like “how intensely bad would you feel if your retirement plan failed?” While the questions are still similar, there is an important difference: if you have not clearly defined both the meaning of success and the meaning of failure, your clients may misjudge the intensity of the consequences, leading to an irrational and inappropriate decision about how much or how little “risk” to take.Read More...
In order to do a financial plan for a client, it's necessary to determine the client's time horizon - which at the most fundamental level, is the time the client is expected to live. The client's life expectancy can impact the number of years of anticipated retirement, and even the age at which the client chooses to retire. Unfortunately, though, it's difficult to really estimate how long a client will live, and the consequences of being wrong and living to long can be severe - total depletion of assets. As a result, many planners simply select a conservative and arbitrarily long time horizon, such as until age 95 or 100, "just in case" the client lives a long time. Yet in reality, the life expectancy statistics are clear that the overwhelming majority of clients won't live anywhere near that long - unnecessarily constraining their spending and leading to a high probability of an unintended large financial legacy for the next generation. As a result, some planners are beginning to use life expectancy calculators to estimate a more realistic and individualized life expectancy for a client's particular time horizon. Will this become a new best practice?Read More...