We recently recorded a presentation explaining how some simple modifications to client’s current financial plans can increase either how much wealth they leave at death, or how much they are able to spend in retirement. The full video is available below, but I will summarize it here:
Money Guide Pro, and all financial planning software for that matter, are great tools that can give a client an idea of the likelihood they can live a fulfilling retirement without running out of money early. However, the assumptions underlying these models are often too conservative.
For example:
- We run most financial plans out to around age 93 (give or take) for both spouses. The likelihood that both spouses live to 90 is about 6%.
- We assume spending grows at a constant rate every year until death, however data from JP Morgan Chase suggests households in the $1-$3m investable wealth cohort reduce their spending throughout retirement.
- We exclude a variety of assets from being used in retirement, including client’s home(s), personal assets like jewelry or collectibles, the cash value of life insurance, and often outside cash.
- We assume spending rises at a constant rate, and doesn’t change in the best, or worst return years for their portfolio. People often reduce spending in a recession (by definition really), and that is not reflected in plans. (more on this later)
- Clients are assumed to pull money out of stocks each year, regardless of recent performance. Ideally, you’d like to avoid selling stocks while they’re down so you don’t lock losses. (more on this later)
- There are other nuances (timing of flows, risk mitigation in portfolio management, etc.) but you get the idea.
So what’s the downside?
Due to the conservative assumptions shown above, the true probability of success is likely higher than what they see in their plan. As a result, clients may opt for lower risk portfolios, or target a modest spending level throughout retirement so that the plan’s probability of success is sufficient.
You might avoid that luxurious vacation you’ve been eyeing, you don’t buy that boat, you don’t fly first class. This might seem superficial at first glance, but you worked your whole life for this money. Avoiding some of life’s simple pleasures because you’re worried about your plan is unacceptable to us.
On the other hand, you might feel just fine about your spending. Perhaps what’s more important is leaving a legacy, or charitable endeavors such as medical research or animal care, or you’d like to pay for your grandkid’s college.
This is the true goal of financial planning, and we believe there are strategies that can help you achieve that without necessarily increasing the risk of you running out of money.
Disclaimer: the following scenarios for each strategy are monte carlo simulations, and will always assume a: 30 year plan, $2 million starting portfolio, 2% inflation rate, and 4% spend rate. This is a fairly typical situation for a high net worth client. Historical returns for benchmarks since 1970 (disclosed at the end).
Strategy 1: Take More Investment Risk. i.e. add stock.
Below we run 1000 trials for two identical clients, one is in a conservative portfolio (40/60 stock bond), and the other is in aggressive (80/20).
As you’d expect, the return is higher and results in the average scenario’s wealth ending nearly 2.5x higher! However, due to the added volatility of the aggressive portfolio, your probability of success drops about 5%.
We feel this on its own is a good strategy for many of our clients. Though the probability of success might dip, the plan is still run under the conservative assumptions explained earlier, so the true probability of success is likely higher.
That being said, there are other strategies we can use to improve plans without necessarily increasing risk.
Strategy 2: Avoid funding expenses out of stocks initially.
Traditionally, client portfolio allocations are held static throughout the life of the plan, as the chart below illustrates (moderate 60/40 stock bond portfolio).
This is standard practice, but there’s no rule that says it has to be this way. The issue is that you are forced to sell stock in the earlier years of retirement, regardless of their returns. Stocks are where the majority of portfolio growth will be made, so if you’re forced to sell them early in retirement, especially after bad years, you can jeopardize the rest of the plan. This is often referred to as the “bad timing scenario” and is main reason why plans fail in a simulation.
Instead, what if we funded the first several years of retirement from only the bond portfolio, like so:
What this means is your overall allocation will get more aggressive over time, but you will have avoided the “bad timing scenario” by only funding expenses from the stable part of your portfolio. By the time you run out of bonds, your stocks will have had several years to grow unimpeded.
If we take two identical clients in a moderate portfolio, one who funds expenses the traditional way, and one who funds expenses from bonds first, your results are as follows:
Just as in scenario 1, this scenario has a greater return (due to having more stocks over the period). This time, however, the average ending wealth jumps 75%! And the best part… your probability of success goes UP. That’s having your cake and eating it too.
Strategy 3: Dynamic Spending
We always assume clients spend the same amount (adjusted for inflation of course) every year, regardless of whether we’re in a boom, or in a recession. In reality, people tend to spend more in a good economy, and less in a bad economy, in what’s sort of a self-fulfilling prophecy.
So we can come up with some simple rules for when you’d spend more or less depending on the prior years returns. In the following simulation, we assume spending has no increase if the portfolio lost money in the prior year, 2% increase in spending if it was less than 10%, and 5% increase if the return was 10% or better. (note: we’re keeping the allocation static the traditional way in this simulation i.e. no strategy 2). Here are the results:
Despite similar returns, the dynamic spending client is able to spend 12% more in retirement, while INCREASING the probability of success.
This is a very simple, and modest, dynamic spending rule. We could be more aggressive on cost cutting in down years, or in spending more in good years. However, we believe it’s difficult to substantially change clients’ spending habits, so it seemed appropriate in this illustration to use modest rules.
Finally, we combine strategy 2 and 3 to get the below:
The results are substantial. With a modest increase in returns, ending wealth increases 69%, spending increases 12%, and the probability of success goes up.
Of course, these are simulations. Every client’s actual experience is going to be different. We’ve played around with different assumptions for each simulation, and of course some are better, and some are worse. But nearly always, applying one or all of these strategies has led to improved plans.
Though we’re happy with the results and would like to implement some of these changes in clients’ plans soon, there’s more work to be done.
Future Work:
- Inflation Stress Testing
- Customized Starting Points for the “Bond First” Portfolio Allocation
- Design a Stock and Bond portfolio that’s optimized for Strategy 2
- Customizing plans to emphasize either a large legacy; or maximizing spending.
- Customizing the strategies for different life stages. Ex. How does it change if you’re pre-retirement, or well into retirement.
Please remember this is for illustrative purposes only. Actual plans and results will vary based on the individual circumstances and assumptions used in the simulations. That being said, if you have questions about the topic generally, please feel free to reach out.
Please enjoy the video for an in-depth description of this topic.
