Wednesday, September 29, 2010

Retirement Planning, Technology and Clients Over 37 Years

Thirty seven years ago, there were very few financial planners. There were very few investment choices and for most of us retirement planning was pretty much a theoretical exercise. I had no retired clients. I built my business with people my age or in their early forties, plus or minus fifteen years. They were mainly concerned with accumulating assets. They were oblivious wondering how they would actually convert those assets into an income stream at retirement.

Back then we used hand held calculators to calculate investment returns and retirement projections. When computers first came out we paid $1.00 per minute for our calculations that can now be done on Excel. It took 20 to 30 minutes to do what we can now calculate in 30 seconds. The retirement sufficiency calculations we used were deterministic, employing static savings, earnings, spending, and inflation assumptions. The results were neat, smooth chart showing a clients money growing evenly and gradually going down during retirement. It was the best we could do at the time. But it brings to my mind the H. L. Mencken quote, “For every complex problem there is an answer that is clear, simple, and wrong.” At my core I’m a math and finance geek. My first spreadsheet program was on Lotus 123. I cut my teeth writing single-sheet spreadsheets and thought I had died and gone to heaven when linkable, multi-sheet spreadsheets came along. They allowed us to build increasingly customizable spreadsheets that could incorporate complex client assumptions. As it turns out, client and investment market behavior was rarely captured in those assumptions.

If you want some humbling entertainment, look at a few of the retirement calculations I performed 20 years ago. I generally find that I overstated the portfolio earnings rate (greatly), the inflation rate (modestly), and the savings rate (ridiculously). I underestimated the increase in the spending level and client’s unexpected large withdrawals. I had absolutely no way to predict divorce or death of a spouse and I were really thrown curve balls on job losses. And let’s face it; in 1999 no one predicted that the U.S. stock market indices would enjoy a decade of negative returns. That’ll leave a mark on any retirement program!

So, here are five things about retirement planning I have learned. They may be debatable; they’re just some of the things I’ve come to believe. Embedded in these beliefs are the three dimensions in which I’m convinced we must serve our clients, if we are to help them to be successful:
In the real world, there’s no such thing as a straight line or a smooth curve. Compare There are some advisers who confuse steady investment and growth with actual retirement planning. It is naively assumed that if the investing is well done, retirement will work out just fine. This does not demonstrate how well the client can meet their retirement expectations. You can do everything right investing your client’s funds, but if their saving or spending behaviors aren’t cooperative, they can still fail to meet their goals. Planners that stop at this dimension are doomed to lose assets and market share as their clients come to realize that their adviser can’t definitively answer the simple question, “How soon can I afford to retire?”

There’s no such thing as a safe investment. Back in the old days, we believed that small-cap stocks were risky, but large-cap stocks, particularly those in the Dow, were safe. I even had clients who would recite the old saying, “As goes GM (… GE or Merrill Lynch), so goes the country.” We now know that’s not so. For years, many believed that investment-grade corporate bonds were safe; until we watched AA-rated bonds default. The biggest trap caused by the bull market of the 1990s was that many of us focused on return, with little regard for risk. If the retirement numbers didn’t work, just bump up the return assumptions with no consideration on the increased risk level! Even today, risk lurks in unlikely places. Ten-year Treasuries currently yield around 4%. I heard a noted economist suggest that the 10-year Treasury could be at 10% by mid-2013. You do the math to see the losses that would result from such an outcome. Retirement planning demands obsessive scrutiny of risk. If we fail at this point, we can ruin lives. Clients must be better educated about the known and possible risks they face in their retirement portfolios.

We need to show clients more than when they’re likely to run out of money if average returns are achieved, we also show them how this could change if we went through persistently poor markets. After the last decade, I would feel remiss if I didn’t share this with the client. This gives both of us time to take actions that offer the best chance to improve the outcome. Performance alone won’t achieve retirement success.

Human beings have little capacity to predict their spending patterns five years from now, let alone 40 years from now. When I think back on financial forecasting techniques I studied and then taught, the accuracy of a forecast was assumed to decrease as the time period increased. We have a great capacity to think about our “daily bread.” We have little capacity to predict what we’ll spend on food in 10 years, let alone our cable TV, Internet, and cell phone expenditures. If you don’t believe me, look at your spending in these areas (if they even existed) just 10 years ago. I can’t wait to see what I’ll be paying for “transporter beam” services in 15 years! It isn’t just a matter of simply inflating today’s expenses; we must also attempt to project where our clients will be spending their money 30 years from now. More practically, how accurate are today’s spending assumptions that you’re using? Most of the budgets I get from clients should be classified as fiction, not biography. This is an area that at one time we blew off, but now pay much greater attention to, no matter how messy it gets.

Human beings aren’t wired to conceptualize large sums of capital. The studies showing the incredible number of lottery winners who file for bankruptcy in a short time have great significance on retirement planning. How many of your clients hold the vast majority of their assets in qualified plans? That probably has more to do with the difficulty in getting to qualified monies compared to non-qualified accounts. Excepting those born into great family wealth, most of us are culturally programmed to think week-to-week or month-to-month in our spending. If we receive a large sum of money (or start receiving a very large income that could stop at any time, as is the case with athletes or entertainers) we can mentally confuse the large sum with a massive monthly amount that will continue forever. Getting clients to see their portfolio as a large fruit tree where they harvest fruit (dividends and interest) rather than lopping off limbs (withdrawing principle) is critical to helping them remain successful. This allows us to use our month-to-month bias in a positive manner.

The answer doesn’t (and will never) rely on one simple solution or product. Over the years I’ve read with amusement articles suggesting that an insurance or investment product manufacturer has or will come out with a “silver bullet” product that will solve all problems associated with retirement income distributions. There is one word that explains why this is unlikely to happen—complexity. The third dimension I face in retirement planning—the cash flow dimension. If I fail here, my clients don’t eat! So, why might a one-product-fits-all approach struggle in the real world? First, the potential benefit from a single product would be greatest if the client had everything in one account. I can only think of two of our clients who fall into that category. Planners using all available tools usually have multiple accounts for each household. In our case, the average is five. Second, the source of distributions may need to change for tax reasons; particularly before 50½ and after 70½. Flexibility of distributions is the only way to cover needed changes as they arise. Third, I have great concern over how tax laws will change over the next decade. The last thing I would want is to have all investments taxed at ordinary income. The flexibility to affect the character of taxable income may grow, not decline, in importance as Congress continues to wrestle with ways to reduce the deficit that it has developed over the past nine years.

Implementing all three dimensions in today’s technological environment is still a challenge. Our systems do the first dimension well, the second dimension okay, and the third dimension poorly. This third area is where I’m hopeful more effort is made by technology providers and intermediaries in the future. Systems to monitor and manage this third dimension are virtually non-existent. That wasn’t a problem when we only had a few retired clients, but it’s a problem now, and I hate to think what it will look like in 10 years.

As a Financial Planner Our Primary Role: The Ghost of Christmas Future
Even if a planner can master all three of the dimensions I’ve outlined, the remaining wild card is client behavior. I’ve come to believe that we can’t actually change client behavior; we can only show them the results of their current course of action in a clear, accurate manner. If they don’t like the outcome, they’ll affect the change.

There is a powerful quote in therapist circles that goes something like this, “Change happens when the pain of staying the same is greater than the pain of the change.” Ebenezer Scrooge’s life was transformed after the Ghost of Christmas Future ran the video forward, showing the consequences of continuing his current approach to life. The pain of changing from a greedy old Scrooge was nothing compared to a life of derision and abandonment.

The sooner clients see retirement issues in great clarity through all three dimensions, the sooner they can affect the change needed to make the picture turn out the way they desire. Retirement math is brutal; simply trying to deal with it by wishing, hoping, and living in denial is a formula for disaster.

Most of our physician clients have to deliver news that their patients don’t particularly want to hear, but they deliver it kindly, yet frankly. By doing so, they permit their patients to choose the course of care, knowing both the risks and the potential benefits that they prefer. Over the next few years, I have been faced with similar challenges with many of my clients. It may not be pretty, but I serve them best when I accurately depict a future that can still be changed. When I see clients today I always have a 1 or 2 page agenda showing what we need to discuss at our meetings. Approximately 3% of those clients see under number two, “You are going to run out of money!” Few if any of those clients do anything about it. They are more concerned with their cable TV today than there food and shelter in the future!

Creative Financial Design with offices in Lansing, Portage and Southfield.