Any form of long-term projection is built on the back of assumptions. In the case of a retirement plan, there are several key factors, including portfolio composition (and assumed growth rates), inflation rates, savings, retirement spending, time horizon until retirement, and the duration of retirement. Yet the reality is that not all of these assumptions have equal impact; some are far more dramatic drivers of plan results than others, and which are most important varies by the client situation. In other words, there are assumptions, and there are ASSUMPTIONS! Have you ever examined the sensitivity of your client's financial plan to the assumptions they're using, so you can determine which factors are the most important to focus upon?
A Financial Planning Sensitivity Analysis?
The inspiration for today's blog post is actually an extension of yesterday's discussion about the desire for clients to take their financial plan for a test drive - because in point of fact, one of the primary reasons clients want to look at varying versions of their plan is that they, too, are trying to do their own basic version of a sensitivity analysis to determine what factors are most important.
So what is a sensitivity analysis? At a fundamental level, the concept of a sensitivity analysis is relatively straightforward - change each assumption by a little bit, one at a time, and see how much the result is impacted by each change. For instance, let's assume the client is 25 years old, planned to retire at 65, and have a 30-year retirement time horizon, with a balanced portfolio that had an 8% growth rate, plans to save $300/month, with a goal to withdraw $40,000/year in retirement (the remainder of retirement income will come from his Social Security benefits).
According to a generic retirement projection, this client will have $1,000,000 at age 65, which should safely allow nominal withdrawals of $40,000/year at a 4% withdrawal rate. But what happens if we start to change the numbers? What are the factors that really drive the plan? For instance, what if the client increased his equity exposure from a balanced portfolio expected to earn 8%, up to an all-equity portfolio that earns 10%, given his long time horizon? Now the client reaches the $1,000,000 savings necessary to support $40,000/year of withdrawals at age 60; all that extra equity exposure buys the client a 5-year reprieve from working.
On the other hand, the client could have achieved the same result by simply saving an extra $150/month - putting away $450/month instead of $300/month would have also given the client the same 5-year reprieve from working (i.e., allowing him to retire at age 60 instead of 65). Given the choice, how many clients would rather just save an extra $150/month, rather than jump onto the all-equity volatility wagon? Some might choose one, and some might choose the other, but have you even given your clients such a choice? And have you considered how the choice of steadier returns can actually affect future savings behavior itself?
Notably, the year of retirement itself is still highly sensitive. If the client who was going to retire with $450/month in savings chooses to still wait until age 65, the retirement savings accumulated is $1.5 million, instead of just $1,000,000, allowing a potential 50% boost to the retirement standard of living. On the other hand, the client who invests at 10% returns and still works until age 65 has not $1.5 million of wealth, but $1.75 million; the compounding continues. Of course, it's also notable that retirement projections with high growth rates over a very limited number of years produces results that are highly uncertain, and can lead to very risky advice! Accordingly, while the higher savings approach to early retirement produces less value to the upside, it's also less prone to significant misses if returns don't line up as expected!
On the other hand, the results are extremely different for the client who is age 55, wants to retire in 10 years, but has done very little saving yet. In this scenario, investment returns actually have a very limited impact; the driving force is the amount of savings the client can allocate towards retirement, and the year of retirement - the longer the client can wait, the more investment returns can compound and the more savings that can be committed. So while for the younger client, returns > savings > retirement age, for this client savings > retirement age > returns. On the other hand, even for the younger client, the reality is that returns really only have an impact in the last few years of the 40 year time pre-retirement time horizon; they are actually far less relevant for the first several decades!
Unfortunately, most financial planning software does a poor job demonstrating the sensitivity of a client's plan to the assumptions. In order to examine this issue - or illustrate it for clients - you must run different "versions" of the same plan with varying input assumptions, one at a time. Nonetheless, it may still be very worthwhile to consider, especially if you have software that is flexible enough to do it live, on the spot, with clients. Demonstrating how varying portfolio choices, returns, savings and spending goals, and retirement ages, all impact the overall plan to varying degrees, is a test drive of the plan that can go a long way to building client trust.
So what do you think? Have you ever looked at the sensitivity of your client's plan to the assumptions that were made? Is this something you've ever discussed with clients? Have you had clients who asked for several versions of their retirement plan, because they were (perhaps subconsciously) trying to gauge the impact themselves? Would you ever try this with a client interactively in the financial planning process?