Journal of Financial Planning: December 2011
On March 9, 2009, the Dow Jones Industrial Average sank to levels it hadn’t seen since 1997—the banking sector was in collapse, and the entire economy was in disarray. It’s safe to say that every retirement scenario in America changed on that day, and not in a good way. It was also a day when financial advisers around the country had to deliver some bad news to their clients who were on the brink of retirement: they might have to work another year or two, or not travel as much as they had hoped.
And the pain continues. According to FPA’s Financial Adviser Retirement Income Planning Experiences, Strategies, and Recommendations study,1 based on an August 2011 survey of almost 600 planners, over the past year alone 15 percent of advisory clients nearing retirement have had to delay their retirement date. Ten percent needed to significantly adjust their lifestyle because of economic conditions.
For those advisers who had already talked to their clients about the possibility that market unrest could play havoc with their retirement plans—and had sown the seeds to protect against such an event—the process was much easier. Evelyn Zohlen, CFP®, president of Inspired Financial in Huntington Beach, California, was ready for that day. “It’s so much easier if you’ve had conversations about this with your clients in advance,” she says. “It’s a challenge to set expectations around there being a day that the market will drop 30 percent, and we’ll take an 18 percent hit, so let’s talk about what you would do.”
There’s no doubt that the landscape has changed, probably irrevocably, for retirement scenarios. “In the last 10 years, people have had to ratchet expectations down,” says Ron Floyd, CFP®, a managing director with the Hunter Group in San Diego. “They’ve pulled back a little bit and understand that assets have to last longer. And that you’re not going to get double-digit returns.”
When Can I Retire?
If nothing else, the new environment has made many clients realize that they need guidance in order to navigate their way around their retirement plan. And make no mistake: clients want guidance, particularly on figuring out what date they can or should retire. “People do have some number in the back of their minds,” says Sean Curley, CFP®, founder of the Retirement Planning Specialists in Greenwood Village, Colorado, “but there is this great sense of uncertainty as to how to even figure it out. Sometimes it’s, ‘Can I retire at 60? I can’t stand this job another two days.’”
“They’ve got this idea that they would like to be retired by their early 60s,” says Zohlen. “But when you ask them why, or what does that look like, or what kind of resources do you anticipate you’ll need to maintain your standard of living, they don’t have a very good answer. They’ll say, ‘My parents retired in their mid- to late 60s, and I’m going to do better than that. That’s when all the successful people retire.’”
Overwhelmingly, financial advisers describe their clients as delegators, people who know they need to participate in the process but expect their adviser to take primary responsibility for their financial success. The FPA survey found that 81 percent of clients fall into that category, as opposed to only 14 percent who are validators—people who want an adviser solely for second opinions and occasional advice.
The key, according to many advisers, is demonstrating to the client why a certain retirement date makes sense over automatic plans. “We’re moving away from the old turnkey thinking—well, 65 is here, so I’m retiring tomorrow,” says Floyd. The Hunter Group, like many retirement planners, uses Monte Carlo simulations to project where their clients will end up under many scenarios. The FPA survey found that 44 percent of all advisers use Monte Carlo or other types of simulations to evaluate the soundness of a retirement plan. (See the “Monte Carlo Software” sidebar for interviewee preferences.)
Scenario Factors
“We stress test various data points across ages to see the probability of leveraging cash-flow issues through Monte Carlo analysis,” says Floyd’s colleague Greg Powers, CFP®, ChFC, AIF®, a wealth adviser with the Hunter Group. “As we start to stress test some of these parameters, we ask them to understand the trade-offs.” Those parameters include not just retirement age and income but various possibilities for things like market returns and inflation. “It’s counseling and coaching,” says Floyd: “What if you end up with a $2,000-a-month medical charge that right now costs $150? What if your Social Security doesn’t inflate at all? What if your rate of return drops one full percentage point on average? You have to talk about the tolerances that are here, not just shoot for a single answer.”
These models need to be comprehensive in order to fully assess the client’s chance of success. Curley’s model takes into account a desired target retirement age, investments, pensions, Social Security, any anticipated inheritance, and as many expected expenses—from housing costs to traveling—as possible, recognizing that these costs may change over time. Travel, for instance, would likely diminish with advanced age. He also includes any support retirees expect to have to provide for their kids or grandkids—or for their own parents.
Expenses can be very tricky to forecast. At the Hunter Group, they break down budgets into a non-discretionary component, a quasi-discretionary component, and the truly discretionary, to create greater options for the client. “Cash-flow-level modeling can open up opportunities for the client from a charitable standpoint as well as an income-generation standpoint,” says Powers.
“Too often our peers just do a simple reverse calc to say, ‘You need this amount of money, here’s your number,’” says Floyd. “What we’re finding is that more and more we need to drill down into that cash-flow-specific level of planning.”
Gauging Odds of Success, and Adjusting
Then you start running the numbers, flipping around the variables to see the odds of succeeding in different economic environments. “The probability of success when we run that baseline model may initially be something like 65 percent, which is lower than I would like to see,” says Curley. “So then we’ll start looking at alternative scenarios: What if we delay retirement by a year? What if you increase your savings between now and the time that you retire? What if we change your allocation to include more or less equities? What if we reduce your retirement expenses by a couple thousand bucks a year? We may end up looking at 8 or 10 or 12 scenarios, just to give the clients some range of what their choices are. Somewhere in there, we’ll find some path that’s accessible to the clients.”
Curley likes to get his clients to a 90 percent confidence level. He grades them pretty much like school grades, with a 90 being an A and anything below 70 failing. “I like 90 percent,” he says. “I feel OK at 80 percent. Seventy is kind of iffy, and below 70, I’m not terribly comfortable with that.”
That’s important because there’s a solid number of clients who stand a reasonable chance of outliving their retirement funds. According to the FPA survey, advisers estimate that only about half of their clients have little or no chance of running out of money in retirement. Nearly 20 percent of clients face a significant chance of exhausting their assets.
That’s when the adviser has to start proffering alternatives. For those who haven’t yet retired, if the outlook appears in doubt, it’s a lot easer to make small changes. “The client says, ‘I’m really not sure, but maybe I should make a transition where I consult for 30 percent of what I used to make,” says Ron Floyd. “‘Can I retire on a lowered lifestyle for a while, then we’ll step it back up?’ Each time, we’ll model this on these Monte Carlo simulations and talk about the probability of success, and keep circling back to things the clients can control. They can control when they save, how much they save, when they start to spend, the risk they’ll take, and their legacy goal.”
This iterative process lends itself to being revisited over the years, which has the added benefit of keeping the clients involved in the process. The FPA study found that 59 percent of advisers surveyed provide ongoing monitoring of retirement plans, reviewing current and expected expenses and re-evaluating income sources. “We believe that yearly reviews are a key element to their success,” says Floyd. “We have to be careful that we’re not just hitting them with a hammer—we want them to be comfortable enough to stay engaged with the process.”
One other benefit of this sort of holistic approach is that clients can see what items they are overlooking in planning their retirement, and assess the impact those might have. It’s much easier to convince clients how much money they’ll need in retirement when there’s a comprehensive plan to demonstrate it.
“There’s this myth that I will only need 70 or 80 percent of my current income to live on in retirement,” says Zohlen. “But I don’t know anyone who wants to reduce their standard of living in retirement. They say, ‘Well, I won’t be paying as much in taxes,’ but that’s not necessarily true if it’s all coming out of your IRA. There’s a reduction in work-related costs, but unless you plan to stay home and watch Oprah all day, you’re going to be doing things like traveling and hobbies.”
The new investing environment means that clients will need to be more willing to make adjustments to their plans. Some advisers have found that clients intuitively understand their habits need to change. “I had one client who was taking $7,000 or $8,000 out of their portfolio every month, out of a portfolio of a half-million or so. And of their own accord, they dialed it back to close to $4,000 over the last year,” says Curley. “I think that’s a reaction to people being more risk-averse right now. But I also think there is a reduction in spending appetite, and we’re seeing that broadly across the economy.”
Relying on Government Programs
The biggest driver of expenses for retirees is, of course, health care. Most clients have spent decades on employer-funded health insurance and are unprepared for how expensive it is to insure themselves. “The majority of folks know that Medicare isn’t going to cover it all,” says Zohlen. “For the demographic that is aware, I think how much is still going to be a surprise. They’ve never had to buy a Medigap insurance policy, and they’re horrified at how much it costs. And it’s even worse when they realize that even that doesn’t cover everything.”
Zohlen points out a worst-case scenario—people in their late 50s to early 60s who are not working but don’t yet qualify for Medicare, who must completely self-insure. She had two 64-year-old clients last year—both in good health—who had six months remaining until Medicare kicked in. Even for that short period, the cost was $2,500 per month. “For people who have aspirations of early retirement, that is a whole planning entity unto itself,” says Zohlen. “Even for affluent people, if I have to add $2,000 a month, that’s about a 10 percent increase in their expenses on an annual basis. Financial planners get shot for that kind of thing! But it’s my job to deliver that kind of bad news.”
Complicating these matters is the idea that government assistance is always susceptible to change, especially for individuals with an extended time horizon. “We’re on the conservative side, saying the costs are likely to go up, and help from government agencies will probably be flat or go down,” says Powers. “We just have to bake in some more expense that you’re probably not aware of today—managing expectations, especially for people who have been on rich corporate plans.”
Another governmental wild card is Social Security. Although the program is often spoken of as if it were on its way out the door, advisers agree that the benefits will be there, at least for people who are already in or nearing retirement. “By and large, people 55 and up are likely to get what they bargained for from Social Security,” says Sean Curley. “In some people’s minds, they think, oh, I better take it now, I’m 62, because they might pull it out from under me. But I don’t see anything on the table where that would be the case.”
But for younger generations, modeling Social Security is somewhat of a guessing game. “Our conversations with our clients have changed, particularly with regard to Social Security,” says Greg Powers. “We’ve seen the disclaimer where by 2037 there will only be enough to pay out about 76 percent of scheduled benefits. We’ve been asking, what if your Social Security benefits are reduced? Or what if we continue in a low-inflation environment? Social Security, if you plan for it correctly, should be a million-dollar asset, and should be accounted for and planned for very prudently.”
That million-dollar figure comes as a surprise to clients who have come to think of Social Security as a bare-bones program, designed to keep people out of poverty. But the math is clear. “You’re looking at a $30,000 per year asset; let’s say there’s 2 percent inflation, and you’re into retirement for 25 years,” explains Floyd, “those numbers get very big.”
But the numbers only get that big if clients approach Social Security prudently. Many advisers report that their clients want to get their hands on Social Security as soon as possible, perhaps out of fear that the program is going to disappear. “That may make sense if you have heart disease or diabetes or something that may shorten your life expectancy, but they miss the insurance that Social Security provides on the longevity side, because that goes on forever and it’s inflation adjusted,” says Curley. “Clients who are healthy and have a long life expectancy, I would counsel to delay Social Security and take more money out of the portfolio earlier in the game.”
Legacy Considerations
Most retirement issues can be addressed fairly early on, but clients tend not to think about their legacy concerns until they are closing in on retirement age. “Sometimes as you get near retirement, you’ve done all the things right and you have excess above what your old definition of success was,” says Floyd. It’s at that point that leaving something behind starts to loom ever more important. “We see people who have to dial it down because they haven’t made good plans,” he says, “and those who exhale because they’ve been so conservative.”
As the legacy issue illuminates, the quantitative process is only half the equation. Many clients also look to their financial adviser for guidance on approaching retirement from a psychological and lifestyle point of view. Again, advisers recommend that the way to approach this part of the issue is to take the long view.
Zohlen suggests taking clients through their retirement scenario. “It’s Monday of the first day of your retirement; let’s talk about what you’re going to do.” Clients may have no idea, or they may assume they’ll constantly play golf or garden. Zohlen describes clients who are adamant about travel and retire in their 50s. Even if they get 10 solid years of travel in, “you’ve got 20, 25 years [left]. What happens in the next 25 years?”
Zohlen encourages clients to think about the fact that they worked diligently toward goals that got them to this point of retirement; what are their goals during this stage? Whether the goals are volunteerism, philanthropy, or family impact, Zohlen thinks, “it’s essential that you spend as much time planning for that as you do for the financial side of things.”
Just as it’s never too early to start saving for your retirement, it’s never too early to think about how you’ll spend those retirement years. Given the economic shocks of the past five years, clients will likely see the wisdom of this as well. “Even if their attention is on their new baby or their new house or other things that are consuming their cash flow, we’re very conscious to keep layering in conversations about longer-term objectives,” says Floyd. “Every conversation will have an idealized retirement age. It’s an evolutionary process; we can only tell you from the mathematics point of view, but we can always temper it with the human nature point of view.”
Tom Nawrocki, a former editor at Worth magazine, is now the editor in chief of Triton Financial Newsletters, which provides communications for elite wealth managers around the country. He can be reached at Tom.Nawrocki@TritonNews.com.
Endnote
- This report, sponsored by Thornburg Securities Corporation, was derived from an online survey of 595 complete responses from financial advisers/planners who are members of the Financial Planning Association (FPA). The survey was fielded in August 2011 and has a 4 percent margin of error at a 95 percent confidence level.
Sidebar
Monte Carlo Software
A sizable number of today’s advisers use iterative Monte Carlo-type simulations to demonstrate a range of retirement probabilities and solutions for their clients. FPA’s Financial Adviser Retirement Income Planning Experiences, Strategies, and Recommendations study found that 44 percent of advisers are now using Monte Carlo or similar analysis in setting up retirement plans.
Many planning software packages include some type of Monte Carlo program; here are three the advisers we talked with found helpful:
- eMoney Advisor: Advisers we spoke with were impressed by its ability to easily revise key variables, then toggle among various scenarios, allowing the adviser to review them side by side. With a wide range of factors to include, “It enables us to construct more intuitive projections that our clients can easily relate to,” says Greg Powers of the Hunter Group. He also appreciates that the vault included with the eMoney platform easily allows him to share those scenarios with his clients.
- Financeware.com: Sean Curley of Retirement Planning Specialists recommends this for its ability to delineate different comfort zones, determining the probability of reaching different goals. Despite being relatively simple, Financeware.com still is reasonably comprehensive for retirement planning.
- MoneyGuidePro: A step down from some of the others in terms of robustness, its intuitive interface makes it a fine choice for anyone new to creating Monte Carlo simulations.