These ideas are presented as challenges to the investment community. A gauntlet has been thrown down, Mr. or Mrs. Trusted Advisor, who puts everyone into the same grab bag of asset-allocated mutual funds, who tells your clients to invest for the long run, who believes in the efficient market hypothesis. Step into the arena. Academics please join in. The simplicity of the ideas presented here should lead to extreme contest.
Let’s examine the first five challenges in detail. When you, the trusted financial professional, write a financial plan for a retiring client, you ask the client for their current expenses. You then plug these into the financial planning model. But financial planning models are just that: models — models with several problems:
- They are based upon “facts” that are, in reality, guesses.
- The plans are, at best, relatively static.
- They may overestimate living expenses.
- They may underestimate life expectancy.
- Their validity depends upon formulas and starting premises.
- They are not reflexive.
They are guesses, approximations or intimations. Models are neither accurate descriptions of reality nor are they fantasies (unless the input data is false). They are based upon certain mathematical formulas coupled with the client’s data. The more accurate a client estimates current expenses, the better the model can function. Yet, who would look at their expenses of 20 years ago, project them out to today and find that they bear any resemblance to their current cost of living? Models simply cannot reflect the world we know.
Projections dim with time. I tell my clients, “These expenses you have shared with me will create an image of your financial future. The image will bear some semblance to reality for a few years, much like an Ansel Adams photograph. But the further we look into the future, the more this becomes a Monet, the more it resembles Wordsworth’s Intimations of Immortality. We can only guess at the midterm future and we have no idea what the distant future holds, so depending upon this written plan is foolish. The advisor’s valid response should be: “Let’s update the information each year and reproject the data.”
Annual updates are an excellent idea, how many clients will be willing to do the expense sheet homework each year? How realistic will their table of expenses be? Who is so digitally gifted and completely fascinated with their monthly budget to offer this to you annually? Perhaps 1 percent of clients, who are as geeky about numbers as you are, yet they have no contingent inclination to do the math themselves.
The data a client gives you are static representatives, hopefully, of their current expenses. A photograph by Ansel Adams is representative of what he actually saw, yet is not what he saw. Why? His photos are in black and white! They are false images of the landscape. Beautiful, extraordinary works of art, certainly and images of reality, nevertheless.
So too is your financial plan. It is a black and white, false image of a client’s fiscal reality. Numbers are not real. Repeat that to yourself each time you prepare a financial plan, like a mantra. Numbers are representative. They are static. They are frozen in time because they represent what the client told you about the past. Not only are they black and white — they’re also stills. Again, Adams froze time with his works of artistic photography; he did not take a motion picture. Similarly, you are freezing time for the client. The data they give you represent what they think they spent last year. The data move no more than does the moon move across an Adams photograph of Half Dome. It is frozen in time and space. When you imply motion by projecting these estimated numbers into the future, you blur the painting you are trying to create. Suddenly an Adams becomes a Monet!
Living expenses are just that. They are what we spend each year. Who do you know who has not reduced their expenses in 2009 in response to the recession? If it is more than 1 in 100, you can put the article down because this information does not apply to the super rich — only to the middle class and the affluent.
We have all adjusted our lifestyles to reflect the current economic climate. If we had not, then inventories would not have been worn down, layoffs would not have occurred and prices for goods and services would not appear as stable as they are today. Lack of spending reduces demand, which reduces inventory, employment, inflation, etc. If you wrote a retirement plan for a client in 2006, did you allow for a reduction in expenses for 2009?
Did you reduce or increase their expenses in any year? How about on a decade basis? Did you increase their expenses for any year? How about for their 50th anniversary cruise? Certainly you increased their income when their mortgage was paid off, but did you include gifts for the unborn grandchildren? Of course not! How could you have done any of these — save perhaps for the mortgage — without a crystal ball to look into the future?
In Part 2 of this article, we’ll explore how to apply life expectancies and other factors when designing a client’s retirement plan.
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