Solving the financial planning puzzle


Properly informed advisers are imperative to the properly informed consent of their clients. Why is this important? Great businesses grow and flourish when their clients’ experiences match their promise.

Professional advisers have long understood that selling investments and investment returns is a mug’s game. There is too much uncertainty. That is why they have moved to goals-based planning. Even then, there is little in financial planning that has got more moving parts than goals-based retirement planning.

In a Money Marketing article published in July last year I raised three interrelated issues:

  1. How would advisers assess and represent the benefits and risks of multi-asset portfolios versus annuities so that their clients could make informed decisions about their financial future?
  2. How would retirees given their new wider investment choices respond? Would they elect to run with multi-asset portfolios or stay with the safety of annuities? How would they deal with home equity release?
  3. Would life companies or investment managers win out? Who would take control of the debate, influence the media and, importantly, get closest to the prospective client?

I cannot find a winner in the public debate. In fact, I am not sure the life companies have argued their case for annuities and guarantees with any great competence at all.

However, in the alternative forum of “money through the door” the results are clear. Most advisers, platforms and promoters of multi-asset solutions have flourished. Investment managers with discrete competencies have also done well. Several life offices have done better than expected, mainly through benefits gained from their earlier diversification strategies. Others more focused on products with capital guarantees look lost. Reverse mortgages have sold well but not, I expect, encouraged by advisers.

Overall, the wealth management industry has had a good year, carried along by positive markets and no new misselling scandals. Retirees, meanwhile, look to have enjoyed the opportunity to make choices about their money.

But retirement planning is proving to be complicated. It is as much about art as it is science and requires empirical disciplines not just heuristics. It provides a great opportunity for advisers to shine.

There are five suitability proofs ambitious advisers apply in practice that lead to their clients’ properly informed consent to the risks in their financial plan:

  1. Prove you know your client: their situation, needs and aspirations
  2. Prove you identified mismatches and looked at alternative strategies
  3. Prove you know the products(s) recommended
  4. Prove you explained the risks in the plan and the product(s) recommended
  5. Prove you received you client’s properly informed consent to the risk in the plan and the product(s).

However, there are many issues that can impact advisers’ capacity to frame their clients’ retirement expectations. These included: sequence risk, the role of annuities in portfolios consistent with investors’ risk tolerances, deferring annuity purchase, the cash flow planning imperative, and home equity release and other mechanisms to create money to spend.

Sequence risk

As far as I can see, the major issue that has emerged in suitability is the claim sequence risk is the biggest threat to civilisation since the Y2K bug.

Sequence risk is the fear that a series of bad returns in the early stages of retirement drawdown will significantly diminish capital values to the point the portfolio is incapable of recovery, cannot support future drawdowns and will not meet its investor’s longer-term needs. However, historical data in the UK, US and Australia suggests this has not been true for the last 40 plus years. Here is why…

Table one shows the account balances at the end of 10 years of a 40 per cent growth portfolio after drawdown of £3,000 per annum, £5,000 per annum and £7,000 per annum, adjusted for inflation each year from an original £100,000 portfolio.

  • The best and the worst balances are exactly as labelled: they are the extreme outcomes. The term good means a result higher than 95 per cent of the results and the term poor means a result higher than only 5 per cent of the results. The average is the average return.
  • The balances are based on the average real annualised 10-year rolling returns (1970 to 2014). The analysis was done on a monthly basis for an asset allocation comprising 35 per cent UK fixed interest, 25 per cent international fixed interest, 25 per cent UK equities and 15 per cent international equities. Total return indices were used as proxies for asset sector performance.
  • Think of the data as the account balances for 421 retirees who left work each month since January 1970.
  • No allowance was made for tax or fees. The asset allocation was rebalanced annually.
  • Fees, taxes and other frictions can amount to 200 basis points or more each year.

If we divide the closing balances by future annual payments of £3,000, £5,000 and £7,000 in real terms, we can see the average number of future year payments (see table two).

  • After 10 years, our £3,000 per annum withdrawing investor had, on average, 45.4 more years of payments. In the poor case, she had 19.2 more years and in the very worst she has 17.2 more years.
  • After 10 years, our £7,000 per annum withdrawing investor had on average 11.6 more years of payments. In the poor case she had 2.7 years and in the very worst she has 1.6 more years.

We can then look at outcomes from a portfolio of 80 per cent growth assets to see the consequences of doubling the growth asset exposure from 40 per cent (see table three).

  • Best, good and average future year payments are better for the 80 per cent growth asset portfolio.
  • Poor and worst future year payments for the two portfolios are very similar.

What is driving the result? Quite simply, it is reversion. After every portfolio drop there has been a recovery within 10 years. The portfolio with the higher growth asset exposure participates more fully in recoveries. There was no financial reason to reduce growth asset exposures.

A flawed understanding, and consequent inaccurate explanation to a client, of sequence risk may result in them believing they de-risk their portfolio by reducing their equity exposures. Over the last 45 years, as the numbers show, such a strategy would have resulted in sub-optimal portfolio outcomes. We would have diminished retirees’ lifestyles for no logical reason.

The real issue is not sequence risk but regular withdrawals beyond what the portfolio returns could carry. If our investor took out £3,000 per annum all was good. If it was £7,000 per annum it was bad. The real issue was capacity for loss.

The past has a habit of repeating itself, particularly in relation to investments. Each and every adviser has to individually come to an informed view on sequence risk.

The risk to a successful retirement is the client (their psychology and behaviour by spending too much and not sticking to the portfolio) and, of course, poor advice.

Risk tolerance and annuities

There is a fairly straightforward approach to suitability that many of our users subscribe to:

  • Agree risk tolerance score with the client.
  • Map that risk score to a multi-asset portfolio.
  • Determine if that portfolio meets the financial needs of the client.

Let us look at a simplified example:

  • Client’s agreed risk score is 50 out of 100.
  • This maps to a portfolio with 67 per cent to 48 per cent defensive assets.
  • Will portfolios with this amount of defensive assets meet the client’s needs? To answer this, project each portfolio outcome using defensible capital market assumptions through a cash-planning tool.

From here, you should think also about what proportion of the defensive assets should or can be allocated to an annuity.

Annuity deferral

Another question that advisers need to find the answer to is whether annuities are,in fact, better bought when clients are in their seventies or older. Longevity issues and spending preferences must be understood. Annuity returns can be expected to be higher later because of decreased longevity.

Alternative funding

Meanwhile, it is important to have shorter-term finance in place. Portfolios need time to perform: 10 years, as the example above shows. This can be done by a line of credit, reverse mortgage, downsizing the family home, selling non-investment assets or borrowing from children against their inheritance.

Cash flow planning

Last but not least, we simply cannot imagine how multi-goal retirement planning can be done without good software. There are useful enhancements either complete or underway in the planning software with which we integrate, as well as several other practical tools in the market place.

Retirement portfolio planning is perhaps the last great frontier for most advisers. Properly informed advice leads to client’s properly informed consent to the risks in their financial plan.

Paul Resnik is co-founder and director of FinaMetrica, and Peter Worcester is a consulting actuary