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To manage wealth, the astute planner must look ahe

Illustrations by Jonny Mendelsson

Don't believe everything you hear. Especially on television. Even from an otherwise intelligent, well-intentioned financial planner.

On Monday, September 27, 1999, on CNBC's program "Power Lunch," a financial planner was addressing the question of why people fail in their investment programs. According to the planner: "The mistakes most investors make are to fail to define their financial goals and to fail to invest with an eye towards achieving those goals." He then went on to say, "Once the financial goals have been defined, selecting the investments to achieve those goals is easy."

Sorry, but that just ain't so.

There should be little argument with the idea that investors should invest with an eye towards achieving financial goals, but it is not true that selecting investments is easy once the goals have been defined. Determining the appropriate investment solution requires that financial goals not only be quantified, it requires that future portfolio values be projected - which brings into the calculus the current mix of holdings across taxable and tax-deferred accounts, projections of expected returns, savings, and taxes. The right investment solution must consider the complex tradeoff between competing financial goals across retirement planning, estate planning, and insurance.

Providing solutions that integrate the inputs to the investment solution is highly challenging. It is, in fact, one of the most complex and difficult analytical problems in finance. The reality is that financial advisors simply do not have the analytical tools to do this job. This will be remedied with the introduction of a new generation of computer software. With the computing power available today and the emergence of the Internet as a distributor and supporter of advanced investment management and financial planning software, we are on the verge of a revolution in the practice of investment management and financial planning.

The analytical integration of investment management and financial planning is well described by the term "comprehensive wealth management." It is "comprehensive" in that it incorporates investing, retirement planning, estate planning, and insurance. It is "wealth management" because it is based on projections of cash flows and disbursements to and from the client's investment accounts and projections of future portfolio values.

Although a number of firms offering financial advisory services claim to provide advice and investment management solutions designed to meet client financial goals, the fact is that the software required to provide really comprehensive wealth management is not sufficiently evolved. In a call to the local office here in California of a firm claiming to offer comprehensive wealth management, an account executive explained that the company is basically a money management firm. Their specialty is managing money. All the other "services" are secondary and they are not analytically integrated.

One financial advisory firm using the less ambitious term "wealth management" is Accredited Investors of Minneapolis, Minnesota. What sets Accredited Investors apart is that it has developed a tool for measuring the client's progress towards reaching financial goals. According to Ross Levin of Accredited Investors, the process employed at traditional financial service firms is to prepare a financial plan for the client at the beginning of the relationship, which then becomes a blueprint for ongoing investment management. "Wealth management, in contrast, involves a financial plan that is constantly evolving to reflect the inevitable changes in every client's financial and personal life," according to Levin. While some financial advisors will argue that financial planning has always been sensitive to changes in a client's financial and personal life, what sets Accredited Investors apart is its development and use of The Wealth Management Index.

The Wealth Management Index uses numerical assessments of a client's financial situation, which can be used to evaluate where work needs to be done and whether progress is being made toward reaching the client's stated financial goals. The Wealth Management Index is broken down into five sections with weights attached:

25% Asset protection
20% Disability and income protection
10% Debt Management
25% Investment and cash flow planning
20% Estate planning

In each of these areas subcategories are defined and the client is given a score based on how well the client is doing in each area. The scores across the subcategories are summed to provide a score for each of the main categories, and a grand score across main categories is calculated to produce the overall Wealth Index score. Clients with a Wealth Management Index between 85 and 100 are judged to be on course to achieve their financial goals. Clients with an Index between 65 and 84 need to be more focused on their plan, while clients with scores below 65 need "a major financial planning overhaul."

Since it numerically organizes the financial and investment management process, the Wealth Management Index is highly useful. The weightings in the Wealth Management Index are based on the advisor's professional judgments, and the scores in the Index show how well the client is doing in each of the subcategories.

The Wealth Management Index treats financial goals as additive but, as Levin points out, when working with the index subcategories, making choices to achieve one of the financial goals can compete with achieving another of the goals. Gifting programs increase the possibility that the client will outlive his or her financial resources. The purchase of annuities to guarantee lifetime income reduces the size of the client's estate. Increasing life and disability insurance coverage reduces retirement income unless the client is willing to reduce current consumption.

Wealth management invariably involves managing a set of uncertain tradeoffs, and must provide the financial advisor with the tools to efficiently manage these tradeoffs. Although the Wealth Management Index will report tradeoffs at the subcategory level, the process Levin outlines is not actually quantitatively integrated. For example, it does not permit the user to make a change in an input, such as the expected return on stocks, the savings rate, or retirement date, and have the scores for each of the main categories and the composite score of the index automatically recalculated.

From Levin's work and the work of other financial planners, it is clear that clients are primarily concerned with asset protection, retirement planning, estate planning and insurance issues. In his seminal work "Portfolio Selection," Harry Markowitz makes it clear that the quantitative framework to be used in determining optimal investment solutions should reflect the real concerns and objectives of the client. While applications of the broad vision Markowitz expressed in 1959 were drastically limited by the computational power available at the time, today computer processing capacity is much less of an issue. Markowitz also expressed concerns about the ability of the investor to formulate the inputs required for portfolio selection. Here he was mainly concerned with the large number of covariances required to do portfolio selection. Today the investment problem is largely seen as an asset allocation issue rather than a security selection problem, which reduces the number of inputs.

A new approach: Comprehensive Wealth Management

A comprehensive wealth management framework can be organized into the following steps:

  1. Defining financial goals
  2. Projecting income and savings
  3. Projecting investment returns
  4. Projecting future portfolio values
  5. Projecting funding of financial goals
  6. Determining the most desirable investment solution

In the first step along the road to comprehensive wealth management, clients (with the help of the financial advisor) quantify their financial objectives. These ordinarily include funding retirement expenses, protecting income and assets, and estate planning. Other goals can also be considered, such as funding education or buying a home. The projection of wages and salaries and the budgeting of consumption and savings are currently a common practice in financial planning.

However, the projection of investment returns is something many financial advisors avoid. Many of those who make projections often use historical returns. By contrast, comprehensive wealth management requires that projections be made of investment returns at the asset class level net of costs for each client's investment accounts. The number and definition of asset classes can be determined by the preferences of the financial advisor, but the projection of asset class returns is necessarily a matter of judgment. Asset class returns can be forecast based on projections of long-term economic growth, corporate profitability, and asset class valuations. Future portfolio values can be projected based on current holdings, savings, asset class returns, and taxes.

The prospects of funding financial goals can be projected based on the distribution rules from taxable and tax-deferred accounts, and projected future portfolio values. For any investment strategy, the prospect of achieving financial objectives can be calculated and the tradeoffs evaluated.

This can take one of several forms. One of the forms is to calculate a set of financial ratios. Retirement funding can be evaluated in terms of a retirement funding ratio (RFR). RFR is the ratio of projected funding of retirement expenses to a targeted level of retirement expenditures. An RFR of 1.5 indicates that the projected funding of retirement expenses exceeds the goal by 50%. The prospect of achieving estate-planning objectives can be quantified in terms of a Wealth Preservation Ratio (WPR), the ratio of the projected value of the estate passed in relation to a benchmark such as current net worth or an estate planning goal.

In evaluating estate planning options, sets of WPRs are generated for various estate planning horizons. Income protection can be quantified by the Life Insurance Coverage Ratio (LCR) and the Disability Coverage Ratio (DCR).

So far, we've ignored the concept of risk. In Portfolio Selection, Markowitz introduced the idea that investors should evaluate risk as well as return in determining the most attractive investment solution. This is true in Comprehensive Wealth Management as well. The risk associated with not achieving retirement and estate planning goals needs to be quantified and evaluated. There are several approaches to doing this, including Monte Carlo simulation and Scenario Forecasting. In Scenario Forecasting, RFRs and WPRs are calculated that are associated with one or more downside scenarios. With Comprehensive Wealth Management, financial advisors evaluate risk and return in terms of the most likely RFR and the Downside RFR and the most likely WPR(s) and Downside WPR(s).

The following is an illustration of the output of a comprehensive wealth management analysis given a client's current asset allocation strategy:

Retirement Funding Ratio 1.45
Downside Retirement Funding Ratio 1.05
Wealth Preservation Ratio .75
Downside Wealth Preservation Ratio .50
Life Insurance Coverage Ratio .80
Disability Coverage Ratio .00

A quick analysis indicates that retirement goals are well covered in both the most likely and downside scenario. The client is projected to have 45% higher retirement income than targeted in the most likely scenario and 5% more retirement income than targeted in the downside scenario. But the client is projected to leave an estate 75% as large as targeted under the most likely scenario and 50% as large under the downside scenario. Life insurance coverage is projected to cover only 80% of the client's projected family expenses, while the client has no protection from disability. Improving the tradeoff across financial goals requires a reallocation of assets.

The next example illustrates an alternative solution. The solution involves a reallocation across asset classes and an increase in the use of insurance. The comprehensive wealth management software would produce a new set of financial ratios for the financial advisor to evaluate:

Current Alt.
Retirement Funding Ratio (RFR) 1.45 1.25
Downside RFR 1.05 1.03
Wealth Preservation Ratio (WPR) .73 .90
Downside WPR .52 .73
Life Insurance Coverage Ratio (CR) .80 1.00
Disability CR .00 1.00

By giving up some excess retirement funding the client is able to secure a better mix of estate planning and insurance coverage. Other solutions may provide even more attractive tradeoffs. Given adequate computer resources (now under development by several organizations) comprehensive wealth management software can quickly produce a set of alternative solutions for the financial advisor to evaluate.

An aggregate scoring of an investment, financial planning, and estate planning solution is also possible where rewards, penalties, and constraints are attached to competing financial objectives. The program would seek out the most attractive set of tradeoffs. The solutions can be summarized in terms of a Financial Success Ratio.

Comprehensive Wealth Management recognizes that both client circumstances and investment opportunities change. The objective is to keep the client on course towards achieving his or her financial objectives, which requires that progress towards achieving goals be monitored and periodically reviewed with the client. It also requires that changes in the financial plan and investment strategy be implemented as changing circumstances dictate.

Driven by the dramatic advancements in computer processing power, on desktops and over the Internet, and given the financial modeling expertise available today, there will be no reason why comprehensive wealth management can't be available soon to independent financial advisors at low cost.

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