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The Risk of Incorrect Return Assumptions

The Risk of Incorrect Return Assumptions

"It is better to be roughly right than precisely wrong."
-John Maynard Keynes

Historically, the S&P 500, a common benchmark for the US stock market has returned approximately 10% annualized (1926-2015). After accounting for inflation (CPI) over the same period, the real return of the S&P 500 was ~7%. Over the same time period, US bonds (represented by Five-Year US Treasury Notes) returned approximately 5% before inflation and ~2% after.

Determining the correct return assumptions to use in a forward-looking financial plan is impossible. Without knowing the future, we’re required to make a [hopefully educated] guess. One of the easiest ways to do this is to use historical returns, such as those noted above, which is precisely what many online calculators and financial advisors do. After all, it’s simple and defensible. Unfortunately, it may also be overly optimistic and could result in running out of money long before your financial plan projected. This is only truer when you realize that simply using historical market returns doesn't account for the costs of actually implementing an investment plan, such as the advisor’s own fee.

Some might argue that the investments they choose will outperform, thus making up for any fees, and that by performing a Monte Carlo Analysis (a stress test that models thousands of random scenarios) they can properly simulate the uncertainty of future returns. Both arguments are faulty. First, study after study has illustrated the difficulty and unlikelihood or persistently outperforming appropriate benchmarks. Second, while a Monte Carlo simulation is incredibly useful for modeling sequence of return risk and the probability of unfavorable outcomes, one of the primary assumptions driving the simulation is the average annual return. If the average return assumption is inappropriately optimistic, all the results will be upwardly biased.

If it’s dangerously optimistic to use historical return assumptions in forward-looking financial plans, what are we to do? Most importantly, we need to give up our desire for precision. The world of finance is filled with mathematics and vast data sets, which often gives the false impression that we can engineer plans and portfolios with the same level of precision that goes into designing bridges. However, unlike gravity, market assumptions are not a constant. As a result, we should formulate reasonable but conservative assumptions, build flexibility into our plans, and be willing to adapt along the way.

Models that attempt to calculate the expected return of stock markets are very noisy and imprecise as there are so many factors to account for, but many indicate that future stock returns are expected to be lower than they have been historically. How much lower is up for debate and also depends on the time period considered. The important takeaway is simply that the historical figure of 10% (7% after inflation) seems too high by almost all accounts.

Models that predict future returns for high-quality bonds tend to be less noisy than stocks as the future interest payments are known (barring any default). As a result, a relatively simple and historically accurate measure for high-quality bonds has simply been to look at the current yield-to-maturity. As of 12/31/2015, the yield of Five-Year US Treasuries was 1.76% and the yield for Thirty-Year US Treasuries was 3.01%. While it may be reasonable to assume that bond yields will eventually increase toward historical levels, the reality, at least for the short and intermediate term, appears to be that bonds also have an expected return several percentage points lower than the historical figure of 5%.

Any financial plan that uses historical returns as a direct proxy for future returns (which based on discussions with colleagues appears to be many) has significant hidden risks. While your assumptions will have no effect on the actual returns delivered by the market, they will impact many other aspects of your financial plan including how much you need to save and how much you can spend. Using more conservative "expected” returns instead of optimistic historical returns reduces the likelihood that you’ll need to work longer or spend less than you planned for. If it turns out that you estimated too low then you’ll end up with more money than you expected and have greater flexibility in the future.

Lifestyle Risks & Insurance

Lifestyle Risks & Insurance

A financial plan that only considers saving and investing may look perfect on paper, but can easily derail and become worthless if any of the following life events occur:

  • You die prematurely or become disabled before having saved enough to secure your family’s future needs.
  • You live longer than the plan assumed you would.
  • Your home is destroyed by a natural disaster or your automobile is totaled in an accident.
  • A significant legal judgment is brought against you.
  • You end up spending more and/or saving less than the plan assumed.

A truly integrated financial life plan considers these types of risks and mitigates them through lifestyle decisions and the proper use of insurance.

Life insurance and long-term disability insurance can provide protection for your family and ensure the success of your financial plan in the event of disability or premature death. A healthy lifestyle will not only reduce the likelihood of such events occurring in the first place but also make the purchase of life and disability insurance less expensive.

The flip side of premature death or disability is the “risk" that you end up living longer than planned for and don’t have enough money for those extra years. The average 65-year-old is expected to live until age 85, however, one in ten is likely to live past age 95. With a married couple, the likelihood that at least one of them will live past 95 is even greater. The uncertainty of how long you will live can be managed by planning to have an adequate safety margin of assets beyond a reasonable life expectancy and/or using income annuities that will make monthly payments until your death, no matter how long you live. One of the best annuities available is Social Security because its payments are inflation-adjusted and backed by the US Government. Further, making the decision to defer your benefits until age 70 increases the monthly benefit significantly and is one of the best hedges currently available for longevity protection.

Your home and automobiles are likely some of your most valuable assets, but can also be the source of significant liability. Periodically reviewing your auto, home, and umbrella policies to ensure you have adequate property and liability coverage helps prevent your wealth from being devastated by a natural disaster, accidents, and legal claims against you.

One of the biggest lifestyle risks to your plan is spending too much or saving too little. While this risk cannot be mitigated with insurance, in can be effectively managed with awareness and a bit of discipline. Tracking your spending using a tool that automatically captures credit card and checking account transactions (like the one we provide to all clients as part of their planning dashboard) is an easy way to both capture expenses in the aggregate, but also dive into the detail when necessary. Think of it as maintaining your situational awareness, like you do while driving your car by scanning your mirrors and looking out the windshield.

Another way to manage your big picture spending and savings is to update your financial life plan regularly so that you know whether you're on track, ahead of schedule, or falling behind. This is akin to looking at your GPS for traffic updates, estimated time en route, and estimated time of arrival. This information will help you make informed decisions about whether an adjustment needs to be made to your savings rate, investment portfolio, or goals. The earlier an adjustment is identified and implemented, the smaller it will need to be to bring you back on course.

While all of these lifestyle risks have the potential to be devastating, they don’t have to be and can be controlled with proper planning. In fact, they are the risks that are most within your control. By living well within your means, getting the proper insurance, and regularly updating your plan, you can be successful even when unexpected life events occur.

A Personal Definition of Risk

A Personal Definition of Risk

"Being the richest man in the cemetery doesn't matter to me. Going to bed at night saying we've done something wonderful... that's what matters to me."

-Steve Jobs

When thinking of financial planning and investing, the assumed purpose is wealth maximization. In a broad sense, this is accurate. You wouldn’t engage in these activities with the hope of losing money. Yet, in reality, increasing your wealth is not the ultimate goal, only a tactic to help you achieve something far more important.

The true purpose of financial planning and investing is to achieve greater freedom; freedom that will enable you to live the life you want. When viewed in this context, risk becomes less about market gyrations and the volatility of your portfolio and much more about whether or not you are moving toward the life you want.

The first step in the financial planning process should, therefore, be focused on gaining clarity on what’s important to you and what you want your life to look like. The best way I’ve discovered to accomplish this is by exploring deeper and more reflective questions than are typically asked in a financial advisor’s office. For example, imagining what you would do if you had all the money you needed, but also reflecting on what you would miss out on if you had only 24 hours left to live. Another exercise might ask you to think about your ideal day, week, and year and then contrast it with your current reality.

Questions and exercises like these, while not directly related to your money, help you gain clarity and help us understand what is most important to you. Once we know what the big picture looks like we can begin drafting a plan with quantifiable and actionable goals that will bring you closer to living the life you want.

Aspects such as investing, taxes, insurance, and estate planning are all still critical components of your plan and ones that should indeed be optimized. The difference is that they should be optimized not just within the context of your finances, but also your life goals. The result will be a truly integrated financial life plan that not only mitigates financial risk but also reduces the risk of missing out on the life you want.

Recognized as Top Young CPA Financial Planner by AICPA

Recognized as Top Young CPA Financial Planner by AICPA

Every January I attend the Advanced Personal Financial Planning Conference hosted by the American Institute of CPAs (AICPA). As a finance nerd, it is one of my favorite events of the year and is widely known as the leading technical conference for financial planners.

Two years ago I was asked to give a presentation on how planners can use technology to work with clients remotely. In addition to all the practical considerations and technology recommendations, the overall thesis of my presentation was that the ability to meet virtually enables clients to find the advisor who is best suited for them in terms of expertise, philosophy, and personality rather than simply the “generalist” who lives closest. Additionally, leveraging technology reduces firm overhead and results in cost savings that can be passed onto the client in the form of lower advisory fees. The response from my colleagues exceeded my expectations. Quickly and unexpectedly I found myself engaging with thought leaders in the profession, which resulted in further opportunities to discuss and speak on topics that were of even greater interest to me.

In June of 2015, I participated in a retirement planning roundtable with some of the top CPA financial planners in the country. In September, I spoke at the national conference for the Financial Planning Association (FPA). In November, I spoke to a large group of finance students and alumni at the University of Missouri (Mizzou) on the importance of integrating human elements and life aspirations into the financial planning process. Most recently in January of 2016, I spoke again at the AICPA conference on how to plan for the next generation of affluence, whose goals tend to be deeper than simply retiring at age 65.

The past two years have been a whirlwind of unexpected opportunities to both refine my thought process and share my ideas with other financial planners, all in an effort to improve our profession and provide better advice to clients. I was honored at this year’s AICPA conference when I was presented with the “Standing Ovation Award” given to the top young CPA financial planners in the country. It was a wonderful feeling to be nominated by my peers and recognized by today’s leaders in the profession. Thank you to all of my clients who provide the inspiration to do this work and to my family and friends who have encouraged and supported me along the way.

2016 is already proving to be an exciting year both personally and professionally. I hope to continue exploring better ways to serve clients and continue my professional advocacy as a new member of the AICPA’s Executive Committee in their Personal Financial Planning Section. However, I continue to find the most meaning and biggest rewards serving current and future clients of Laminar Wealth.

Posted: February 2016

Establishing a Saving Plan

Establishing a Saving Plan

The most significant contributing factor to financial independence is savings. Numerous studies, including recent research by Wade Pfau, PhD. suggest that a savings rate of at least 15% is required in order to confidently maintain your standard of living into retirement. If your current saving rate is close to 0%, then cutting spending to divert 15% or more into savings will be painful. If you are still early in your career and expect future pay increases, I often recommend an alternative strategy to increase your savings rate without the painful and psychologically difficult spending cuts.

Every time you get a raise divert 50% of it to savings. The other 50% can go to short-term goals or to increase your standard of living. The same framework applies for bonuses. Put 50% away into long-term savings and use the rest for short-term goals or splurges. If you make sure 50% of “new money” always goes to savings, you will not experience a reduction in your standard of living and pretty quickly your savings rate will exceed 15%.

Below is a video clip where I discuss this concept when I was a panelist at the American Institute of Certified Public Accountants (AICPA) Retirement Symposium, held in New York City in June 2015.