by Rick Adkins, CFP®, ChFC, CLU
Rick Adkins, CFP®, ChFC, CLU, is president/CEO of The Arkansas Financial Group Inc. in Little Rock, Arkansas. He served as the 2003 chair of the Board of Governors of Certified Financial Planner Board of Standards. You can e-mail Rick at RickA@ARfinancial.com.
Twenty-five years ago, for most of us retirement planning was pretty much a theoretical exercise. Our firm had few, if any, retired clients. We were building our firm with folks who were age 40, plus or minus 15 years. They were mainly concerned with accumulating assets. They, and we, were oblivious regarding how they might actually convert those assets into an income stream.
I studied Monte Carlo analysis in graduate school, but in the early years of my career, I had no way to implement the technique. The retirement sufficiency calculations we used were deterministic, employing static savings, earnings, spending, and inflation assumptions. The result was a neat, smooth chart like Figure 1. 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 1970s-based MBA program focused almost exclusively on quantitative methods. We thought case studies were for sissies. My first spreadsheet program was VisiCalc. 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 your firm performed 20 years ago. I generally find that we overstated the portfolio earnings rate (greatly), the inflation rate (modestly), and the savings rate (ridiculously). We underestimated the increase in the spending level and the unexpected large withdrawals. We had absolutely no way to predict divorce or death of a spouse and we were really thrown curve balls on job losses. And let’s face it; in 1999 no one predicted that the major U.S. equity indices would enjoy a decade of negative returns. That’ll leave a mark!
So, here are five of my beliefs about retirement planning. 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 the chart in Figure 2 with the chart in Figure 1. Notice anything different? There are no straight lines or smooth curves. This chart reflects the first of the three dimensions of retirement planning, the portfolio dimension. There are some advisers who confuse this dimension with actual retirement planning. It is naively assumed that if the investing is well done, retirement will work out just fine. This chart shows the effect of the two variables that drive results: (1) portfolio performance and (2) client behavior. What it does not do is 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. Firms 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 percent. I just heard a noted economist suggest that the 10-year Treasury could be at 10 percent by mid-2013. You do the math to see how much principal decline 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. Figure 3 takes retirement planning to the risk dimension—the second level. Here, we haven’t just shown the client 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? I don’t know about you but most of the budgets we 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? (In fact, do you have any clients about whom you could change “the vast majority” to “all”?) 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 (it brings back to mind the Mencken quote). There is one word that explains why this is unlikely to happen—complexity. Figure 4 shows the actual flow of cash between accounts for one of our retired clients. This chart demonstrates the third dimension we face in retirement planning—the cash flow dimension. If we fail here, our 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 distributions taxed at ordinary rates if there are less onerous options (as we have today). 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 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. Systems to monitor and manage this third dimension are virtually non-existent. That wasn’t a problem when we only had two retired clients, but it’s a problem now, and I hate to think what it will look like in 10 years.
Our Primary Role: The Ghost of Christmas Future
Even if we 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. We have the ability to enable clients to make needed changes before it’s too late.
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, we’ll be faced with similar challenges with many of our clients. It may not be pretty, but we will be serving best when we accurately depict a future that can still be changed.
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