Several years ago, toward the end of the bear market of 2000-2002, one of my more sophisticated clients asked me an interesting question. He asked about a Monte Carlo simulation that we had done in the late '90s, which indicated that his "odds of success" were about 95%. Since the market had reduced his assets and a new Monte Carlo analysis showed a success rate of about 80%, his question was, What were his real odds of success?
Several months ago, I wrote an article for this magazine entitled "Withdrawal Rates-The Magic Bullet?" in which I discussed what many planners consider a paradox when advising clients about safe withdrawal rates. In that article, I recalled, "Bob Veres, in a recent E-Column, wrote about the paradox of safe withdrawal rates. He used two hypothetical clients who each have $1,000,000 at the end of a given year. Client A retires that year and Client B the following year. Unfortunately, the market loses 20% in the ensuing year and Client B is left with $800,000. Now, if we follow the studies and recommend to each client that the safe withdrawal rate (improved by inflation) is 4%, Client A gets to withdraw $40,000 (increased each year by the rate of inflation) and Client B only $32,000. If we run the numbers for 30 years, we discover that Client A has a much more enjoyable retirement (my calculator tells me that he gets to spend an additional $400,000-if inflation is 3% per year)."
Of course, the flaw in this view is that it assumes planning ceases to exist after the first year, and that no changes are made for the entire 30-year period regardless of the client situation, market conditions, changes in goals or any one of myriad events that would cause a planner to advise changes to the client's long-term plan. After all, isn't that why they hire us?
While I cannot imagine any planner putting his client on a withdrawal program starting with some arbitrary percentage (such as 4%) and improving that by inflation each and every year for 30 years without ever making changes, the question posed by my client may be entirely different and may be a real paradox of planning.
Let's summarize what may be a typical planning process for a new client. After obtaining the necessary information regarding our clients' situation, including their goals, assets, cash flow, tolerance for fluctuation, attitudes, values, history and other important data, we provide long-term projections. I know that many planners (including those at our firm) use Monte Carlo simulations to determine the clients' odds of success. So let's say that we have determined for a particular couple a 60% chance of attaining all of their goals with an allocation of 50% in equities (a portfolio they said they would be comfortable with).
Since they, and we, are uncomfortable with a 40% chance of failure, they are offered options. They could reduce their spending, change some goals, allocate more money to equities or choose some combination of these things. They tell us that they are willing to make modest changes in some other goals, but to be comfortable with the future they would rather allocate 80% to equities and live with the increased fluctuation.
So far so good. Let's fast-forward to a review we conduct three years later. We discover that because of a robust market they can reach their goals with an allocation of 60/40. What do we do? It seems to me that a planner sticking to the original investment policy would not be following what I consider sound planning. The mantra should not be "stay the course" regardless of whether the market is increasing or decreasing. These hypothetical clients already told us they were uncomfortable with fluctuation. They were willing to accept it when faced with the choice of changing their goals. But now that that is no longer necessary, why would a portfolio reallocation not be on the table at this review?
It seems to me that managing the portfolio based on indices established by the advisor becomes very important, sometimes at the expense of his clients' comfort levels. And the paradox? If they had come to see us three years later and discovered that the 60/40 allocation would work, that is the policy we would have most likely implemented. Why would we not consider changing it?
Let's examine another hypothetical situation. At our initial planning sessions we discover that these clients will have an 83% chance of success with an allocation of 50% in equities (their comfort level based on data supplied to them). So this is the investment policy we implement. However, in their review three years later we discover that they have spent a little more than they indicated they would and, to exacerbate the situation, the market has not cooperated. So now they have less money than projected. As a result, their odds of success have dropped from 83% to 64%. What do we do? If part of our ongoing advice does not include changing the allocation of the portfolio, what are these clients to do? Of course, I'm not talking about trying to time the market, but making course corrections when necessary. Most advisors probably discuss spending habits, future goals and other corrections that could be made, but they rarely consider changing the portfolio allocation. If this is something they would discuss at the initial meeting, why is it off limits at review meetings? The paradox here is that if these clients had seen us three years later, another portfolio allocation would have been discussed as an alternative to increase their odds of success from 64% to 80% or more. It seems to me that "stay the course" trumps sound planning in many cases.
David B. Loeper, CEO of Wealthcare Capital Management, in a white paper entitled Measuring Temperature with a Ruler, demonstrates that changing allocations based on periodic Monte Carlo simulations can have a significant impact on a person's ability to achieve lifetime goals.
He uses as an example a hypothetical client who is widowed at age 21 in 1926. She has been left a $100,000 life insurance policy and requires $5,000 per year (improved by inflation) for the rest of her life. To make sure these protections are long term, he assumes she lives to be 100. Assuming she has an equity exposure of 80% (which results in an 83% success rate in the initial Monte Carlo simulation) he demonstrates the difference between "staying the course" and using a dynamic asset allocation that tries to keep the success rate above 80%. With the static investment policy, she was broke at age 55. When the allocation was changed to reflect circumstances, however (it only needed to be corrected nine times in 80 years), the portfolio was worth about $4,900,000.
Unbelievably, even if the advisor staying the course were able to obtain a return of 1.5% over the indices each and every year for 80 years, the widow's value at the end of that time would have been about $1,100,000 or $3,800,000 less than the dynamic portfolio. However, if she started withdrawing from the portfolio just one year earlier, even though the portfolio returned 1.5% above the indices, she would have been broke at age 55!
Of course, this advisor would have been able to boast that he beat the market and achieved above-average annual returns that were superior to the dynamic portfolio. But it would have been at the expense of his client's wealth.
So as financial life planners, what is it that we manage? At a meeting, an advisor asked one of our shareholders the question that so many of us are asked: "What is your firm's AUM?" His answer, "That's not really relevant for us; we measure GUM." "What is that?" the other advisor asked. "Goals under management," our associate answered. Many advisors are obsessed, it seems, with reporting time-weighted returns and seeing how they compare with various indices. How many of us report the only investment return that matters to our clients? Internal rate of return and how that relates to their long-term goals. What solace will it be to our clients if we had been able to beat some arbitrary index at the expense of them reaching their goals?
I have written before about the difference between a money manager and a financial planner. Money managers have portfolios as their clients. Financial planners have people. It is our job-no it is our obligation-as planners to help our clients achieve their goals and dreams. That may involve changing our portfolios and the way we report results.
Roy Diliberto is chairman and founder of RTD Financial Advisors Inc. in Philadelphia.