There are well over 600,000 financial advisors of various flavors competing for your personal investing business—registered reps, investment advisors, dual registered, and insurance agents, each with a different angle and way to be paid. Regardless and not surprisingly, most are focused on investing, investment strategies, and getting you into investment products.
As a consequence, most focus on your investment portfolio first and your goals secondly, if at all. Typically they have already assigned you a goal that is implicit in their approach—your goal is either chasing maximum return or trying to tame the market through risk-adjusted total return. The attempt to tame the market with a risk-adjusted balanced portfolio is the big-firm mainstream today. Market chasing is more the purview of the hedge-fund set.
Though these approaches may make sense as investment goals for institutions and endowments, they can be problematic for “people,” especially people in the later stages of their careers whose most important goal is safely funding a potentially long retirement after the paychecks stop. As you approach retirement, your goal changes from chasing maximum or total return to creating secure retirement income. Safety-first instead of returns-first.
The allure of maximum return or the logic of total return can be persuasive, but both involve levels of market risk that may jeopardize access to your savings during a downturn early in retirement just when it may make good sense to start spending some of it down.
For instance, by deferring Social Security benefits and using withdrawals from deferred accounts instead from age 62 to 70, you can postpone and increase monthly Social Security benefits over your lifetime—the best “annuity” you can buy—while lowering your deferred account balance, Required Minimum Distributions, and the taxes that come along with them, after age 70. Lower taxable withdrawals after age 70 can keep you out of a higher tax bracket and under a larger Medicare premium threshold. It makes sense to look at the bigger picture to ensure you’re chasing the right goal.
In their returns-first approach, financial advisors use a number of ways to allocate your portfolio. Perhaps the most common is the risk tolerance quiz, which conveniently aligns with the securities law suitability requirement. Your self-assessed feelings about “risk” and losing money are matched up with conservative, moderate, and aggressive allocations. Behavioral finance suggests this is unreliable, that us our feelings about risk are fickle and change with the news and the market’s direction.
Others use rules of the thumb based on age, such as age-in-bonds, to create a “glide path” for equities as you come in for a landing. Still others have allocation theories based on investing horizon or dynamic strategies like momentum, which is driven by changing investor confidence. Market risk is the same every day—your time horizon doesn’t change the risk.
These rules of the thumb and allocation formulas are generalized and arbitrary, and are often little more than justifications for getting you into financial products. They do not address the specifics of your personal financial status and goals.
Instead, you should make a financial plan that is built around your household balance sheet. Your balance sheet provides the basis for a logical way to manage your savings and investing based on the simple math of your personal finances and your progress in the financial lifecycle.
As you enter the pre-retirement red zone, your plan should evaluate your fundedness—the ratio of your savings to your expected annual expenses—to determine whether you are under-funded, constrained, or well-funded. The options and approaches for using your savings to best maintain your lifestyle vary considerably along the scale from under-funded to well-funded. Without an understanding your fundedness, you might be persuaded by an advisor with a returns-first approach to make a poor choice in the markets that puts your lifestyle at risk.
Beyond fundedness, your balance sheet will show your income floor—the amount of savings you need to cover all expected expenses throughout retirement not covered by SS plus pensions. When you know your floor, you also know your upside—the amount of your savings above the floor that you can risk in the market for growth without jeopardizing your standard of living. This gives you the fundamental knowledge about your financial health that you need as the basis for investment allocations rather than vague feelings about risk and loss or arbitrary measures.
Your plan should also review your specific household risk exposures, which include deep risks like inflation and deflation, taxes and regulatory risks, risks of chance and household shocks, longevity risk, household special situations, and behavioral risks like overspending, and not just the market risk which is the main concern of investing of most financial advisors who follow returns-first methods.
The end result of your plan is the allocation of your financial capital to upside/floor/longevity/reserves as the crystallization of your household risk management plan. From your U/F/L/R allocation, you can determine the allocation to stocks, bonds, longevity investments, and cash that will see you securely through retirement and to your legacy goals. If you have limited or no upside, this may mean no exposure to stocks at all.
Put the horse properly in front of the cart. Make a goals-based financial plan first, understand your fundedness, your balance sheet and your U/F/L/R allocation, and then consider how investing and returns best fit into your plan.
If you’d like more information about goals-based planning and lifecycle savings and investing, please feel free to contact me at firstname.lastname@example.org.
–Michael Lonier, RMA℠