Journal of Financial Planning: October 2017
Harold Evensky, CFP®, AIF®, is chairman of Evensky & Katz/Foldes Financial in Coral Gables, Florida, and Lubbock, Texas. He frequently speaks on investment and financial planning issues, and is author of Wealth Management and co-editor of The Investment Think Tank.
Welcome back to musings on research of interest to practitioners. I hope you had a great summer and with a little less pressure, you had time to catch up on your professional reading. Part of my catch-up effort was to review some of my past columns. In doing so I realized that I had neglected our own publication. I assume if you’re reading this, you’re also a regular reader of the Journal; however, like me, you may have overlooked many terrific articles. So, I decided to dedicate this contribution solely to the Journal. Doing so was no challenge as the diversity and quality to choose from was extraordinary. The following are a few that caught my attention and I believe are worth yours:
“Planning for a More Expensive Retirement” by David Blanchett, Michael Finke, and Wade Pfau (Journal of Financial Planning, March 2017). I’ll start with a contribution from the triumvirate of Blanchett, Finke, and Pfau. A paper by any one of these authors is worth reading, so how can you possibly ignore one co-authored by the three? You can’t.
The paper begins with a warning that the use of historical returns as a basis for long-term planning may not be relevant. Although I hope this warning is unnecessary for Journal readers, the authors explore how a low-return environment will impact planning for our clients’ future. Their conclusions are rather sobering. They note that based on historical returns, the optimal savings rate for households that begin saving at age 25 are 4.3 percent for low earners ($25,000) to 9 percent for high earners ($250,000). Based on more realistic forward-looking expectations, they suggest that the optimal savings rate for low earners be increased by 63 percent to 7 percent, and for high earners 82 percent to 16.4 percent.
Delaying the start of savings is even more sobering. Blanchett, Finke, and Pfau project that delaying the start of savings for a high-earning couple (typical clients of practitioners) until age 35 would require an optimal savings rate of 26 percent in order to retire at age 60, and 18.7 percent to retire at age 70. Practitioners need to alert their clients to reality; they need to save early, save more, and probably work longer.
“The Impact of Guaranteed Income and Dynamic Withdrawals on Safe Initial Withdrawal Rates” by David Blanchett (Journal of Financial Planning, April 2017). In a Journal article the following month, David Blanchett follows up with an important piece on the impact of guaranteed income and dynamic withdrawal strategies on safe withdrawal rates. In introducing his paper, Blanchett reminds the reader of a significant blind spot that practitioners have when developing plans based on probability of success; namely, they ignore the magnitude of failure. All too often the interpretation of failure is “catastrophe!” The reality is that a plan designed at an 80 percent success rate and “failing” with a score of 79 percent simply means that the client would face an extremely modest reduction in funding their goals. Although he recognizes that any target success rate is unique to the client, Blanchett recommends consideration of a lower standard (for example, 75 percent) in most cases.
The conclusions regarding the impact on withdrawal rates depending on the magnitude of guaranteed income or dynamic withdrawal strategies were significant and surprising (at least to me). Withdrawal rates varied from “approximately 6 percent when 95 percent of wealth was in guaranteed income, versus approximately 2 percent when only 5 percent of wealth was guaranteed income,” Blanchett wrote. When using dynamic withdrawal strategies and forward-looking return expectations, the impact was less than 1 percent.
“To Enhance Lifetime Retirement Security, Use Reverse Mortgages or Immediate Annuities?” by Mark Warshawsky (Journal of Financial Planning, February 2017). Mark Warshawsky provides an important study comparing two alternative income strategies: tenure payments from reverse mortgages and immediate annuities. His general conclusions are that for individuals of almost all ages and both genders, an immediate annuity is the optimal choice. For couples, the conclusion is more ambiguous. For those with both significant financial and housing assets, the immediate annuity is optimal; while for those with significant housing equity but limited assets, the HECM may be optimal.
He also notes that there are additional factors to be considered. For example, the HECM is likely to pay out for a shorter period than the life annuity as many couples must leave their home when there is a need for nursing home care or for other personal or family reasons. Also the immediate annuity payment is fixed, whereas the HECM payout is variable and influenced by interest rates and housing prices. Finally, there is the potential for a residual value for heirs from the HECM unlike zero residual with an immediate annuity.
“Determinants of Retirement Portfolio Sustainability and Their Relative Impacts” by Jack DeJong and John Robinson (Journal of Financial Planning, April 2017). DeJong and Robinson round out the series of papers on retirement planning issues. The authors examine what they suggest are the six most important factors having significant impact on sustainability: (1) time horizon; (2) interest rates; (3) fees and expenses; (4) asset allocation; (5) inflation; and (6) withdrawal strategy. Echoing the observations of Blanchett, Finke, and Pfau, the paper warns that in a low-return environment—particularly a low-interest-rate environment—it is unrealistic to use a historically based safe withdrawal rate rule of thumb. As a consequence, they conclude the choice of withdrawal strategy is one of the most important decisions to be made in retirement planning.
“A Model for Building a Lower-Cost Portfolio Using Active, Passive, and Smart Beta Products” by Sam Pittman (Journal of Financial Planning, June 2017). Moving away from retirement planning to portfolio design, is a particularly intriguing paper by Sam Pittman, head of retail solutions, global client strategy, and research at Russell Investments. Although all practitioners recognize our clients’ desire for higher returns with little risk, we know that reality requires a balance between risk and returns.
In this paper, Pittman introduces a model that practitioners might implement to balance a client’s preference for “excess performance from active management” and their aversion “to risk of underperformance.” The model produces a recommendation, by asset class, of how much to allocate between active, passive, and smart beta products once the adviser has determined the overall strategic allocation (the fixed income/equity allocation).
An important distinction in the paper is the difference between the uncertainty in the mean excess return of an investment and the investment’s tracking error. What is particularly attractive about this paper is that it does not simply leave the reader with interesting theory; rather, it provides both tables and graphs suggesting very specific allocations under differing client scenarios.
I’ll wind up these musings with two interesting but very different thought pieces.
“What Is Your Financial Planning Weakness?” by David Cordell and Tom Langdon (Journal of Financial Planning, June 2017). Cordell and Langdon are both friends with ties to the Texas Tech financial planning program, so it’s not surprising that they highlight a practitioner weakness that’s anchored in the classic core of comprehensive planning; namely property and casualty risk management. They write: “If you are like many financial planners you may not have thought about property and casualty insurance issues.” Unfortunately, that is all too true.
Most practitioners, myself included, enjoy the investment universe but are less enamored by the subject of risk management. All too often that results in our ignoring the subject. Reality is that as interesting as we may find investments, the planning priority needs to be risk management. If we do an outstanding job with portfolio design and implementation and generate an extra 1 percent or 2 percent returns for our clients, that would be most impressive. However, if we assume the responsibility of doing comprehensive planning and ignore appropriate coverage and there is a tragic automobile accident caused by a teenage son or a guest drowning in the pool of a second home, without liability coverage those events could completely decimate a client’s finances.
“Emotions Matter: How Facial Coding Can Better Connect You to Your Clients” by Dan Hill (Journal of Financial Planning, June 2017). I was vaguely aware of the concept of facial coding largely because my partner Deena Katz covers it in her counseling class at Texas Tech; however I had no idea how established and sophisticated is the technique. In this short article, Hill provides a simple example of how a practitioner might implement this in his or her practice; definitely food for thought.
I hope you found something of value among these papers, and I wish you a very pleasant fall.