When you consider the financial planning industry as a profession, the future is extremely bright. This is partly because the financial planner is the only advisor who can–and must, I’d argue–gather such a comprehensive amount of client information. Being privy to such a wide range of personal and confidential data brings with it a significant responsibility to act in the client’s best interests or, should I say, in a fiduciary capacity. Moreover, following the fiduciary path can easily place the planner in the enviable position of gatekeeper, or single most trusted advisor. To accomplish this, the practitioner must not only have a keen intuitive sense, but also superior tools at their disposal. These tools are a significant key in creating the type of analysis a client will highly value.
When you examine the landscape of current financial planning software, you find strengths and weaknesses with each application. The existence of these shortcomings has driven some practitioners to create proprietary planning software.
In an attempt to help you, my peers, provide better planning to your clients, I’ll explain the process I follow and the proprietary planning tool I have developed over a period of several years. The type of software, and the planning process itself, is only limited by our imagination and our ability to bring our vision into reality. This is precisely the path I am traveling. Let’s take a closer look together.
Determining How Much
Have you ever had a client ask you, “What amount of annual spending in retirement is reasonable?” Perhaps they asked if $75,000 was prudent. What did you say?
The trend chart above displays the ending value of a client’s financial assets in the 30th year based on five different spending levels. Annual withdrawals start at $55,000, increase in increments of $10,000, and peak at $95,000 (Y axis). After the first year, withdrawals are adjusted for inflation. We began with a portfolio of $1 million; assumed a 7% annual return, and a standard deviation of 10%. Monte Carlo simulation was employed on all five scenarios with 1,000 trials on each.
So what does the chart mean? The red shaded area measures the 95th percentile while the narrow blue line measures the 5th percentile and is centered on the median. As you can easily see, the point at which the blue line falls below $0 (X Axis) is just before the third scenario. This would indicate that spending $75,000 may exhaust the assets prematurely.
This chart is helpful if you’d like to view multiple scenarios simultaneously
Financial Planning Software
Your opinion concerning the purpose of financial planning will greatly influence your software selection. For instance, if your primary focus is on helping clients plan for retirement, you may not be interested in software which includes estate planning.
The software decision is also greatly affected by your definition of a financial plan. Although there is general agreement on the difference between comprehensive and modular planning, there is some inconsistency on what constitutes comprehensive. Is it a comprehensive plan when you include three modules? How about four or five? I define a comprehensive plan very broadly. As such, I prefer software which analyzes a very wide range of areas. Perhaps I’m just picky, but since I couldn’t find that “perfect” solution, I built my own. In my practice, I use an Excel spreadsheet with about 70 different tabs and an add-on called Crystal Ball. Crystal Ball is a tremendous application providing Monte Carlo simulation, optimization, and much more.
When a client engages you to prepare a financial plan, it is frequently because they are seeking answers to specific questions. While this is typically the case, most clients will have blind spots or issues for which they need help but were unaware.
There are a number of important questions an advisor should address in the planning process. Here are a few of the questions I seek to answer for clients:
What’s the probability of running out of money?
What is the annual investment return needed to reach all financial goals (i.e. required return)?
What is a safe withdrawal rate (see chart above)?
What is the amount of capital needed to fully fund all goals (i.e. critical capital required)?
What’s the probability of experiencing negative returns in the portfolio?
Does the client need life insurance and, if so, how much?
Is long-term care insurance necessary?
What’s the probability of exceeding the Federal estate tax threshold?
What’s the probability of leaving a legacy of a specific amount at a specific point in time?
What are the client’s debt ratios and are they in line with standard guidelines?
The Required Return
This is one of the most important questions you will answer. Basically, the required return is what the client needs to earn in order to achieve all goals. If this figure is 8%, then a portfolio of CDs will probably fall short. On the other hand, if it is 4% then why assume unnecessary risk? In this case, a portfolio of lower-risk vehicles could easily accomplish the task. Knowing the client’s required return will enable you to create a portfolio where the level of risk assumed is appropriate to the risk needed to reach their goals.
If all you do is fill out a risk questionnaire (which measures a client’s willingness to take risk) and create a portfolio based solely on its findings, then you’re flying blind. Without determining the return necessary to achieve all goals, how will you know if you’re on target? The probability of achieving a client’s required return should also be analyzed for various time periods (see chart below).
Now, let’s examine the planning process.