Financial Plans are Fragile: 3 Ways to Fortify Yours
Building a personal financial plan is an excellent exercise. It requires you to articulate your ideal future life and think through the various paths to reach it AND consider all the ways it might go wrong because Financial Plans are Fragile.
As is the case with most plans, the only (almost) certainty is that they will not go accordingly. Despite the Financial Media and Wall Street's attempts to convince us that there are people, products and firms that can provide certainty to our financial lives, the truth is that we live in a world of uncertain outcomes. Yes, some outcomes are more probable than others, but the possible outcomes are infinite.
Good news is that there are approaches to fortify your financial plan against uncertainty! Before we discuss these three approaches, let's talk about what can go wrong with a financial plan.
We Can Retire, Right
Again, financial plans are fantastic, but I have seen them provide false security for clients making huge financial and life decisions. All financial plans are built upon a long list of assumptions including investment returns, tax rates, life span, earnings and expenses. These variables range from impossible to very difficult to predict, especially over several years.
Personal financial crises such as running out of money in retirement and having to financially rely on the government or kids is not something you want a 10% probability of happening or even a 1%.
Here is an example of what I have seen in client meetings and how risks are often significantly underestimated or overlooked altogether.
Advisor: Good morning, Mr. and Mrs. Client! How are you all doing?
Client: Things are alright all things considered but work has been increasingly difficult for both of us over the last few years. How close are we to being able to retire?
Advisor: Yes, we can help you with that. We have run some numbers that we would like to review with you.
Client: Okay. Great!
Advisor: Yes, we ran the numbers, and it looks like you could retire next year. By then you should have around $2M in savings which is "The Number" we have discussed. Based on our assumptions we calculate that at age 90 you will have ~$5M in assets and you have a small probability of running out of money!
Client: That is good news! Well, can we ask what were your assumptions?
Advisor: Great question. We assume your investments return 10% per year (historical average return of stocks since 1960), your expenses stay at $150,000 per year, you both die at 90, social security pays the expected amount, and tax rates stay the same as today.
Client: Oh, OK. I guess that sounds reasonable enough. We will go home and think about it, but it is such a relief to know retirement is an option soon.
Advisor: Thank you! Let us know if anything comes up....like rollover that 401(k)!
What Can Go Wrong?
This is actually not a terrible interaction as there is some financial planning, albeit mechanical. The advisor has clearly spent time with the client, put time into the analysis and is not focused on selling any insurance or investment products. But, once you start to challenge the underlying assumptions you will see how fragile this couple's financial future is if they follow the advisor's guidance.
Below is a list of assumptions in the original financial plan and the impact on the couple's financial future if those assumptions underperform.
Investment Returns (Assumption 10%): If investment returns are actually 6%, the couple will run out of money at age 78.
Expenses (Assumption $150,000/year): If expenses creep up to $185,000/ year, the couple will run out of money at age 81. If you also reduce investment returns from 10% to 8%, the couple runs out of money at age 75!
Social Security / Taxes / Life Span: Each of these variables are critical pieces to your financial plan. A combination of lower than expected social security payments, higher tax rates and living long than expected will have a negative impact on your plan.
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Unknown Risks: Of course, there are unknown risks that are impossible to plan for. All you an do is build up your savings to help you weather any unforecasted storms.
3 Ways to Fortify Your Financial Plan
#1 Eliminate Single Points of Failure
Engineers design airplanes to be safe even in cases of multiple system failures. Engineers assume things will go wrong and incorporate backup systems to accommodate those expected failures. In most cases there is a backup to the backup to the backup. There is much more certainty in outcomes in the engineering field, but there is also a strong aversion to risk. If 1 in 10,000 flights crash, that is unacceptable, of course.
It is helpful to think like an engineer when evaluating your financial plan. Identify any single points of failure (investment returns and expenses are common ones) and put in place back up plans if worse than expected outcomes occur.
In eliminating single points of failure you become less reliant on the accuracy of your forecasted assumptions.
#2 Margin of Safety
Benjamin Graham, the famous investor said, "The purpose of the margin of safety is to render the forecast unnecessary."
It is important to build a financial plan that will survive a range of outcomes because forecasting is difficult and we do not want our financial futures dependent on any forecasted assumptions.
Some may believe that margin of safety is just being conservative, or a hedge. Yes, if we calculate a 90% chance to win a game AND we can play the game 100 times, there is not much need for margin of safety. But, even in this scenario you will want enough chips to survive an improbable losing streak.
#3 Don't Bother Being Rational, Being Reasonable is Enough
Humans are not rational, but it is tempting to assume too much rationality in financial plans because being rational is easy in a spreadsheet. In some cases making the rational, or optimal, decision can lead to terrible outcomes if you are not able to act rationally when everyone else is not.
The most obvious case is how you allocate investments. Yes, if you have a long-term investment horizon, investing in stocks is rational because it is expected to provide higher investment returns than cash or bonds.
BUT, it is important to ask yourself what will you do when the stock market is down 30%. If you might be tempted to sell stocks at the worst time during a down market, you may consider settling for the reasonable investment allocation vs. the rational one.
Wrap-Up
The key takeaway is to bring a healthy dose of skepticism to evaluating your financial plan. Money decisions are often emotional and it can be tempting to buy into a financial plan that provides you the result you want and overlook the risks. Financial plans are a great exercise, but they are not intended to match reality.
Thanks for reading,
Mark Chisenhall, CFA, MBA
Taurus Financial Planning
Taurus Financial Planning is a Fee-Only Wealth Management firm based in Bentonville, AR. The firm offers comprehensive financial planning, tax planning and investment management to corporate executives across the country.
Taurus Financial Planning is a Registered Investment Advisor with the State of Arkansas. This information is provided as a guide to assist you in your financial planning. The specific examples are provided for illustration purposes only and are not representative of specific investments or guarantees of future returns. Please consult with a professional for specific questions regarding your particular situation. If there is any error or inconsistency between this document and the official company plan documents, your company plan documents will govern.
This publication is for informational purposes only and is not intended as tax, accounting or legal advice or as an offer or solicitation of an offer to buy or sell or as an endorsement of any company security fund or other securities or non securities offering. This publication should not be relied upon as the sole factor in an investment making decision. Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made by the Author, in the future, will be profitable or equal the performance noted in this publication.