By Bob Wood, Muslim Media News Service (MMNS)
One of the few certainties we can count on with our finances is that, over time, terminology and circumstances will change. For example, when seeking professional advice, we previously engaged the services of stockbrokers. Today, few financial professionals call themselves brokers. Instead, they now carry the title â€œfinancial advisors.â€ With that change, has their advice gained any more value?
Having seen for a time the title â€œfinancial advisor,â€ printed after my own name, I understand what is being sold with it. No matter what financial services people call themselves, rest assured that they are selling something! While a stock broker might use analyst reports to excite a customer about buying a certain stock or mutual fund (that pays an appropriate commission), a financial advisor appears to use more personalized methods.
When I began working as a financial advisor for a large financial company, we stood apart from the competition by using a personalized financial plan as a sales tool. We advisors built a comprehensive plan for each client, considering his or her individual situation, risk tolerance, financial goals and time horizons.
Now, most financial services companies previously employing â€œstock brokersâ€ have evolved them into comprehensive financial planners, with many using designations attesting to their studies in financial planning subjects such as investing, estate planning, tax planning and insurance coverage.
All things considered, a personal financial plan is a wonderful concept. How better to know how to achieve all your financial goals with the highest degree of certainty? Annual reviews can keep the plan on track as changes occur in your personal, work or employment situations.
So far, so good! Having a plan in place is surely better than not having one at all, right? Well, maybe. I vividly remember the day when the realization hit me that virtually every financial plan I wrote for clients was fundamentally flawed in significant ways. I came to the conclusion that every plan written by me was basically useless, and some of those very plans won awards for excellence!
Hereâ€™s the problem I see with the plans I wrote, as well as those written by others. Any plan making projections about what will happen in the future, especially for longer time periods, must rely on assumptions that can prove to be stunningly inaccurate.
I donâ€™t know how good you are at making predictions, but I can assure you that financial professionals are no better than you! Yet, as a group, we make assumptions about the rate of inflation, stock and bond market returns, a clientâ€™s income stream and expenses. We also have assumed that employer benefits will remain constant.
The problem here is that none of these variables will remain fixed as we assume in a financial plan. We anticipate that inflation will average 3%/year, for example. The big issue here is that prices never rise in linear fashion. Instead, we always see fluctuations. I wonder how many recent financial plans assumed that the current rate of inflation would be running at least twice as hot as long-term averages have suggested?
If we assume that inflation will average 3%/year over the next 10 years and that your current monthly expenses run about $3,000/month, we can project that in 10 years your monthly expenses will rise to about $4,000/month. But if inflation averages just one percent more each year, your monthly expenses would jump to $4,400. If inflation rises more than expected, up to a 5% annual average, your expenses would run close to $4,900/month.
Deciding to retire at the end of that 10-year period would also make a big difference. Using the rule of thumb commonly employed to figure how much savings you will need to provide that amount of income, we calculate that you will need about twenty times annual expenses, excluding income other income sources such as Social Security, a pension or rental income.
To provide income of $4,000/month, you would need about $1 million in savings. But adding in the estimate for 5% inflation would require over 20% more in savings!
Another trouble spot in the commonly used set of assumptions is that, in retirement, you will need only a portion of the income you earned each year while working. About 80% of your work yearsâ€™ income is often considered sufficient in retirement. Check out the validity of this assumption by asking someone who is retired how much less they spend now than they did while working!
Do you really think that filling all that extra time, previously used working or getting to and from work, really allows retirees to spend less money each year? Donâ€™t count on it!
Maybe the biggest flaw in written financial plans is the expected growth of your savings put at risk in the stock market. The plans I wrote generally assumed that stock market gains would average about 9%/year. The big problem here is that long-term stock market performance has never been that good!
Yes, those smart people who have studied performance of the major stock averages like the Dow Jones Industrial Average for its past 100 years tell us that 9%/annually is the average return. The problem is that â€œaverage annual returnsâ€ do not find their way into your accounts.
As pointed out by Ed Easterling in John Mauldinâ€™s book, Just One Thing, the compounded average annual return in stocks is closer to 5%, and thatâ€™s what you see in your account statements over time. Check this out by using the value of 66 for the Dow in 1900 and plugging that number into your financial calculator as the present value. Use todayâ€™s value as the future value to see the result you get.
The answer might go a long way in explaining why we know so few people who actually claim getting rich in the stock markets. You should also note how close the Dow and S&P 500 are in value today as compared to their previous market peak in early 2000. A plan assuming the 9% average annual gain would have projected $1 million in savings to have grown to about $1.8 million today!
But with major averages close to where they started seven years ago, what are the chances for that gain? So what value did the financial plan written in 2000 actually provide?
Another trouble spot of the financial plan involves tax planning. Again, many assume that a retiree will spend less money than he did while working. But since, in the real world, this situation seldom happens, we should expect the same level of spending, which actually increases due to inflation over time, and this situation will require a level of income in retirement similar to that while working.
Why some assume a lower tax rate in retirement also baffles me. Of course, this supposition helps sell the use of tax deferred savings accounts like IRAs and 401(k)s, and where else can such money be invested but in the stock market?
Writing a financial plan of action certainly makes more sense to a client than simply â€œwinging itâ€ and hoping for the best. But the use of fatally flawed assumptions reduces a planâ€™s value by anywhere from a little to a great deal.
To make the most of your personal financial plan, insist on using the most conservative estimates possible. Assume that inflation will be higher than long-term averages. The falling value of the dollar absolutely insists on using this critical step.
Assume investment returns at the lowest end of the range, closer to 5% than 9%/year. And figure that your expenses in retirement will increase to fill all that free time other than what you plan spending on your couch, watching Oprah!
The worst that can happen, using these more conservative assumptions, is that you will over-plan your savings and end up with more than you really need. The best that can happen is protecting you from wishing, as you enter retirement, that you had saved more while you had the chance.
The adjustments to your financial assumptions may look small now, but the longer you live, the more of a difference they will make. â€œReal-worldâ€ assumptions were missing from the financial plans I wrote when that was my job. But Iâ€™ll bet that I wasnâ€™t alone in planning on gains that are unlikely to occur.
If you have a written financial plan in place, review it with your financial advisor and change those overly-optimistic assumptions. Or at least, build in a broader range of assumptions to use in your advisorâ€™s Monte Carlo simulation (approximating the probability of certain outcomes by running multiple simulations using random variables). If you decide to do this yourself and use an on-line calculator, assume the worst. What harm could it do?
Have a great week.
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., firstname.lastname@example.org.