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April 16, 2019 at 01:34 PM
(Image: Shutterstock)
Welcome to Hidden Value, the column where Joe Elsasser, CFP, addresses common financial planning issues with insights advisors and their clients may not have considered.
A lot of thought and effort has gone into transforming financial planning from its origins in financial product distribution. Today, financial planning is about helping people make the best decisions across a broad spectrum of issues, well beyond investments or insurance, to pursue their goals. This has led many financial advisors to incorporate Monte Carlo simulations in their planning.
Monte Carlo simulations clearly demonstrate to the client that there is a range of possible outcomes, and while many of those outcomes are better than what we plan for, some are definitely worse. Focusing on a probability of success helps advisors avoid any false sense of security clients may have about a straight-line projection.
I agree that it is incredibly important for clients to understand that a variety of outcomes are possible, however, if the focus of financial planning is to move people to the best possible decisions, the industry needs to recognize that “a probability of success” is really a poor mechanism to do so.
People experience events, not probabilities. More importantly, people can’t visualize probabilities, but they can visualize events. If you have a 99% probability of success of crossing a tightrope that is three inches off the ground with a $1,000 reward for doing so, you’ll likely try it. Now, imagine a second situation. You have the same 99% probability of success and the same $1,000 reward, but this time you have to cross a tightrope strung between the top of two buildings in New York City. Would you try? The only difference between the two scenarios is the consequence of failure.
In retirement planning, a teacher with 95% of her retirement income need met through pensions and Social Security faces a very different decision than a retired middle manager who has only 40% of her pre-retirement income need met through Social Security. The difference, of course, is the consequence of failure. The teacher would make modest lifestyle changes, but the middle manager has to make dramatic changes.
In reality, absent the occurrence of a significant risk event, people don’t abruptly run out of money. Instead, they change their lifestyle little by little and year by year to account for their updated situation. They get more stressed every year, and in turn, make further decisions that add to stress, like taking on debt.
