While crafting a “financial plan” for clients has been a staple of financial planning for decades, virtually no financial plan today actually constitutes a real “plan” for anything. After all, the whole point of planning is to formulate the strategy of how to handle a range of possible future scenarios. If A happens, then we’ll do B. If C happens, we’ll do D instead.
Yet financial plans today, and the financial planning software that supports the process, is incapable of illustrating such scenarios and the appropriate responses! Answering a simple planning question like “how much do the markets have to decline before I need to cut spending in retirement, and how much would I need to adjust my spending to get back on track” cannot be easily answered with any financial planning software available today!
Ultimately, as financial planners, we cannot eliminate the uncertainty of what the future may unfold, but we can eliminate the uncertainty of what to do and how to respond to those possible future scenarios. And by crafting a real plan about how to deal with that future, we can make it far less stressful as well, and eliminate the danger of needing to make a potentially regrettable high-stakes decision in the worst possible (and highly emotional) moment!
But ironically, in the end the very software that we rely upon to do financial planning and help clients navigate their uncertain future may actually be the greatest inhibitor to truly formulating a real financial plan for clients to deal with it!
What Does It Really Mean To Formulate A “Plan”?
The dictionary defines a plan as “a detailed proposal of doing or achieving something”, and the verb of plan(ing) as deciding upon or arranging in advance.
In the military context, battle plans are recognized as essential. And this is true despite the famous saying that “no battle plan ever survives contact with the enemy” because the process of engaging the plan, progressing towards the goals, and seeing what happens once the enemy is engaged, will itself change and alter what the next step should be. Notwithstanding this challenge, the military engages in planning because it’s only by trying to consider what the plan should be, and how it might be impacted by future events, that contingency plans can be created to know how to handle “unexpected” problems that arise.
The process of forming contingency plans across a wide range of potential futures is the exercise of scenario planning, where the military practices various scenarios and watches to see how they unfold, to gain a better understanding of how a real-world future situation might evolve and how it would best be handled. In fact, ironically the military’s training scenarios are often done in a manner that is so “life-like” (to ensure good learning opportunities) it sometimes scares civilians who don’t realize it’s just practice; thus, last year the military’s disaster training scenario included how to plan for a zombie apocalypse! And even though that particular scenario is rather unlikely to occur, it still provides an opportunity for learning from scenarios where it’s necessary to contain a widespread threat, secure critical infrastructure, provide medical services, and secure the safety of the general population.
What Is An Actual Financial Plan?
In the context of financial planning, drafting a “battle plan” for the future should similarly involve formulating contingency plans about how to handle a range of possible future scenarios. The key distinction is not just about looking at different scenarios, but about crafting plans about how to respond to them (particularly the problematic ones).
For instance, traditional financial planning once modeled the future by simply projecting how the plan would fare given average returns. Of course, the caveat is that while the future might involve getting average returns (or a sequence of returns close enough to approximate that result), there are other future scenarios that might involve lower returns (or a worse sequence of returns) as well.
Accordingly, financial planners shifted to using Monte Carlo, so that we can quantify how often the future scenarios are likely to turn out to be problematic. We might run 10,000 future scenarios, find that 9,500 of them succeed and 500 of them fall short, and quantify the results as a “95% probability of success” in achieving the goal.
Yet as previously discussed on this blog, rarely does anyone in “the other 5%” of scenarios actually just keep on spending under the original plan until one day he/she wakes up broke and all the checks are bouncing. Instead, at some point, an adjustment occurs to get back on track. Of course, the later the adjustment occurs, the more significant it may have to be in order to get back on track. But ultimately, most probabilities of “failure” are really just probabilities of needing to make an adjustment to get back on track.
In fact, one might say that anticipating those adjustments – how much of an adjustment, and under what conditions it should occur – is the whole point of doing a plan in the first place. After all, the point of planning is not really about figuring out what to do if nothing bad happens. It is about figuring out what to do if something bad does happen, and how to respond and stay on track.
Thus for instance, if the financial planning projection shows that a 20% market decline would necessitate an “adjustment” of some sort, the whole purpose of planning is to figure out, in advance, what that adjustment will be. In other words, it's not just about recognizing that there's a 10% (or whatever) probability of adjustment, but also what the magnitude of the adjustment would be, based on the magnitude of the event that triggered it in the first place. If an adjustment becomes necessary, is the plan to spend less and save more now, to make up for the market losses in time for retirement? Or to keep saving as is, but try to stay on track for retirement by planning to spend less in retirement? Or is the plan to keep saving as is now and spending as planned in retirement, but simply retire later to ensure the money doesn’t run out?
In fact, an ideal plan might even go one step further, and formulate the tactics of how to handle each of these potential planning scenarios. If a market decline would necessitate an adjustment, and the plan is to cut spending to save more and make it up, what spending will be cut? The restaurant and entertainment budget? Travel? Something else? If the plan is to cut spending in retirement instead, then which spending cuts will be enacted? A smaller retirement home? A smaller travel budget? And if the plan is to retire later, how many years later would the client need to work after a 20% market decline, in order to get back on track?
Using Financial Planning Software To Formulate An Actual Plan For An Uncertain Financial Future
If the fundamental goal of financial planning is to come up with tactics to handle (i.e., to formulate a plan for) future contingencies, it is notable that today’s popular financial planning software solutions are not actually capable of facilitating and illustrating such scenario planning!
While some tools at least allow for an initial stage of collaborative planning, where a client might be able to see how the plan would be impacted if there was a market decline or another adverse event, the software tools all lack the ability to model what an effective response would be. In other words, to formulate a real plan with a client, software should be able to illustrate an adverse event, and the appropriate steps to respond, to formulate a plan that can be expected to work and get the client back on track!
For instance, imagine that a prospective retiree has a $1,000,000 portfolio and plans to withdraw $45,000/year (adjusted for inflation) over a 30 year time horizon from a balanced portfolio invested for a 7% return. The financial planning software might show that this strategy has a 5% probability of failure, given that a significant (e.g., 30%) market decline in the first few years which doesn't recover quickly could severely damage the longevity of the portfolio.
In this case, simply showing the potential retiree that the plan "could" fail, if the adverse market event does occur, is simply describing the problem. It's not actually formulating a plan to resolve the issue.
An actual plan might be an intention to cut spending if the portfolio declines severely. Thus, the ideal planning software might illustrate for the potential retiree what happens if the plan is to start with an initial withdrawal rate of 4.5% (which is $45,000 of inflation-adjusted income on a $1,000,000 portfolio), but to cut spending by 10% if the portfolio drops at least 20%. Now the retiree actually has a plan about how to handle the market decline.
Unfortunately, as shown above, the planning software would reveal that a 10% cut isn't enough of an adjustment if the portfolio declines as much as 30% in the first two years. A deeper cut is needed. However, the retiree might not want to implement a drastic cut immediately, since 1-year portfolio declines often recover, rather than declining again for a second year. So the plan is altered to create a two-stage spending adjustment - spending will be cut by 5% if the portfolio declines by 15%, and then will be cut by another 10% if (and only if) the portfolio falls yet another 15% (for a 30% total decline in value).
Fortunately, this approach actually works, and the software illustrates that the retiree's new plan - to engage in certain spending cuts as appropriate/necessary based on what happens in the market - will work. Of course, in the overwhelming majority of scenarios, the markets will perform better, and these spending cuts will never be necessary. But that's the whole point of having a plan in the first place - to know what to do if the adverse event happens, along with having a strategy (for even better spending) if the markets "cooperate" (with favorable returns) instead!
From the perspective of financial planning software, the key distinction here is that good planning software can – or at least, should – help facilitate the discussion about what kinds of tactics will be necessary to get back on track after an adverse event, so the client can plan accordingly. Planning software should be able to illustrate not just the decline, but how a 10% spending cut after a 20% decline isn’t enough, but a 5% cut followed by an additional 10% cut is sufficient. And again, the point of the exercise is to determine what actually “works” – whatever spending adjustments are necessary based on certain market declines or target portfolio levels – to formulate the actual plan, which in turn can then be enshrined into a withdrawal policy statement to document the actual “plan” for the future.
And notably, formulating plans doesn’t have to be exclusive to retirement withdrawals and liquidations. The same is true when planning for accumulators trying to decide when to retire, those who are planning around job and career changes, or simply planning for the contingencies of adverse health events that could impact the ability to earn and the cost of medical bills. Not because the goal is to sell insurance – although that might be the outcome – but simply to illustrate the risks, and formulate whatever the plan would have to be to get back on track.
In fact, arguably all financial planning should begin by looking at scenarios and making adjustments, because in reality most people don’t even know how to set long-term financial planning goals in the first place, until they actually see what the possible scenarios are!
Formulating A Real Plan To Achieve Goals Requires Real Plan Monitoring
Because a real plan involves not only setting goals, but also formulating a plan about how to respond to the inevitable speedbumps along the way, in the end financial planning software should not only help in the formulation of a plan, but then also help clients track their progress on an ongoing basis!
In other words, financial planning software should not just give clients access to run their own long-term projections, but specifically monitor whether they’re approaching the agreed-upon thresholds that would trigger an adjustment in the plan in the first place! Otherwise, financial planning software is just the equivalent of training a pilot in a flight simulator without including any way to control the plane; if the pilot can’t control the plane and monitor its path, the simulator will do little more than illustrate the plane crashing, rather than the more relevant opportunity to practice steering out of the disaster!
For instance, if the real retirement plan calls for a 10% spending cut if the portfolio is down 15%, and another 10% spending cut if the portfolio falls 30%, the planning software should help clients easily see whether they are close to needing to engage “the plan” and make the spending adjustment. If that’s the plan, a client with a $1,000,000 portfolio shouldn’t need to wonder whether recent market volatility is a problem or not; instead, the client knows that if the account balance hits $850,000 there will be a spending cut, at $700,000 there will be another spending cut, and can even have a plan for what those cuts would be. At that point, the software simply reports whether the client is or is not close to those points where the cuts must occur.
Reducing The Fear Of Uncertainty With Real Financial Planning
Ultimately, the key point of all this planning is to reduce the natural fear that clients have about their uncertain future. While it’s not possible to actually know the future, and which contingency plans will have to be enacted, there’s a difference between uncertainty about the future, and uncertainty about what to do in the future. Financial planning can’t resolve the former, but it can do a lot to eliminate the latter.
In fact, from my own personal experience, I find that one of the greatest contributors to client anxiety in the face of market volatility is that most are struggling to figure out “does this market volatility really matter” and will it impact goals? As advisors, we are trained to always tell clients to “stay the course” and stay invested and ride out the volatility… which both fails to fully acknowledge client fears, and more substantively fails to clarify for clients the difference between “temporary” volatility and a genuine impairment of their plan.
In other words, “everyone” knows that at some point, a market decline is so severe that stay-the-course platitudes aren’t enough, and it will require adjustments to get back on track. What clients don’t know is the point at which those adjustments will be necessary, and how much of an adjustment will be necessary – in part because financial planning software gives us no tools to formulate and illustrate such a plan. Instead, the ‘point of no return’ threshold for the client is unknown. And that uncertainty is often exacerbated by the fact that clients tend to overestimate the significance of short-term volatility, and misjudge how little of an adjustment is usually necessary (if any!) to stay on track.
Thus, formulating the plan can reduce anxiety by reducing the uncertainty. Now clients know exactly what they will do in any of the possible scenarios – if the market falls by X%, cut spending by Y% - and it’s only a question of when and whether to execute the next step of the plan, with no longer any uncertainty about what needs to be done. And in the process, clients will be able to make real-time decisions about how to respond to market volatility with a plan formulated during times of rational calm, rather than trying to formulate the response itself in the midst of emotionally turbulent times!
The bottom line, though, is simply this: real financial planning is not just about projecting the future and what does or does not work, but is also about formulating plans on how to handle various future scenarios and the adjustments that would need to be made to get back on track. It is time for financial planning software to facilitate real planning by actually giving advisors and clients the tools necessary to formulate such plans… along with the ability to monitor how clients are progressing towards their goals, and whether they are close to reaching trigger points that require an adjustment to stay on track!