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Businessman walking a tightrope (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.

I advocate for a lifetime financial planning process that regularly revisits a reasonably conservative expected path, but also multiple possible personal and economic futures that could produce dramatically different results. Three of the most common alternate economic futures are: a significant market decline early in retirement, a long-term care event, and an early death. A variety of others could be considered, including but certainly not limited to: high inflation, boomerang children and extreme longevity.

Most of the Monte Carlo-related conversations I see advisors having are solely focused on variation of the path of market returns, with the resulting conversation solely focused on improving the probability of success, without thorough consideration of the consequences of failure under a variety of personal and macroeconomic futures. The result is often a recommendation of a more aggressive portfolio to try to make up for the potential of a shortfall, which may increase the probability of success while additionally increasing the consequences of failure.

Should advisors instead focus solely on the consequences of failure? Absolutely not, except for possibly the most conservative clients. Doing so would eliminate significant upside potential that could have accrued either to the client’s lifestyle or to the client’s heirs. Instead, it is a balancing act for every client with a reasonable definition of what is an acceptable consequence for failure.

It is dangerous to advocate for client plans with zero visible consequences of failure. Minimizing the consequences of failure inevitably means pursuing more conservative strategies. Pursuing conservative strategies, whether investment- or insurance-oriented, eliminates significant upside potential that can accrue either to the client’s lifestyle or to the client’s heirs, and gives clients a better ability to deal with risks that you can’t even fathom at the beginning of a retirement.

Instead I would argue that the central dashboard for financial planning decision-making should include a base case with a reasonable, but realistic, estimate of long-term returns. Couple this with a variety of stress tests that demonstrate the impact or consequences of a risk event with clear explanations of the base case and the risk events tested. If there is a realistic possibility of failure, then we should discuss the consequences of that failure and adjust the plan to bring those consequences into an acceptable range. None of these conversations happen with a focus only on the probability of success.

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Joe Elsasser, CFP, Covisum

Joe Elsasser, CFP, RHU, REBC, developed his Social Security Timing software in 2010 because, as a practicing financial advisor, he couldn’t find a Social Security tool that would help his clients make the best decision about when to elect their benefits. Inspired by the success of Social Security Timing, Joe founded Covisum, a financial tech company focused on creating a shared vision throughout the financial planning process.

In 2016, Covisum introduced Tax Clarity, which helps financial advisors show their clients the hidden effective marginal income tax rates that can significantly impact cash flow in retirement. In early 2017, Covisum acquired SmartRisk, software that allows advisors to model “what-if” scenarios with account positions and align a client’s risk tolerance with their portfolio risk.

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