It may not be possible to reinvent the wheel, but improvements are always welcome. The same can be said of some of the well-worn tools of the planner’s trade, including the life cycle graph, according to Sarah Newcomb, a director of behavioral science at Morningstar.
“Most of us will learn, when we’re training in financial planning, about the financial life cycle. It’s been around for a long time, and it basically plots someone’s net worth along their age,” she said. The line on the chart plots a period of accumulation that reaches a high point, followed by a period of decumulation. “So what’s wrong with the life cycle model?”
Well, it is not as useful as one might think, Newcomb said, and she should know because her job is to take the findings of academic research and incorporate them into tools that help people make better financial decisions. She presented her latest work at the Morningstar Investment Conference in a session called “The Real Financial Planning Lifecycle.”
The life cycle model doesn’t address the fact that individuals do not move in lockstep with everyone else through simplified phases of early accumulation, mature accumulation, disbursement and legacy, she said.
“This model is useful to some extent because it helps you understand where someone is at, and if someone’s at the beginning of the curve, there are certain things you want to be thinking about and planning for. If they’re toward the end of the curve, then you’re going to be thinking about different strategies,” she said. “The issue that I have with this model is that this describes very few people.”
That’s because few people, in her experience, start out at the zero line and stay there their entire lives. And even though some experts have modified the life cycle model to start people off below the zero line—a reflection of the debt they acquire by going to college—that alone is not providing enough flexibility.
Instead, Newcomb has come up with a model she calls “life modes.” It takes into account a client’s financial state at a point in time, not a phase they’re supposed to be in.
The model includes seven “modes” plotted against a Y axis, which represents assets, and an X axis, which represents time (but not age). Each stage is thus characterized by the ratio of debt to assets regardless of how old the client is. The modes include:
• Chaos, which represents the point at which a client’s net worth is negative and trending to stay negative;
• Survival, when a client’s net worth is hovering around zero;
• Stability, when their net worth is above zero but trending flat;
• Growth, when their net worth is above zero and trending upward;
• Acceleration, when a client’s net worth is above zero and trending upward with accelerated growth;
• Decumulation, when the client’s net worth is above zero and trending downward; and
• Legacy, an optional category depending on a client’s circumstances.
“What I’m using to define the mode is the magnitude and slope of the net worth line over time,” Newcomb said. “You could be in chaos mode at any age. You could be in stability mode at any age. It’s the slope and magnitude of net worth over a period of time.”
How this differs from the traditional planning for life cycles is that there is no assumption that a client will start in any one of the modes or end in any other. Nor is there a linear, left-to-right journey anticipated.
“Many people start their lives in legacy mode,” Newcomb said. “Some people will spend their entire lives in survival, or bouncing between stability and survival, or all the way down to chaos and back.”