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By Paula H. Hogan, CFP®, CFA

Editor’s note:  Being ready for retirement requires having a plan to manage the key retirement risks of longetivity, inflation, medical and long-term care, and market and interest rate risks.  Here are some good reminders from a financial planning point of view of what we as retirement couselors need to keep in mind when helping clients transition into retirement.

From popular culture, one might think that personal wealth management is a question of personal taste and that all you really need to do is figure out your risk tolerance, build a portfolio that reflects that risk tolerance, and then hang on, expecting the best. Sometimes that works. However, there is a different approach, one rooted in several fundamentally important core principles. When building a financial plan according to these core principles, you are following the scientific approach, not the personal taste approach. In other words, you are basing strategy on principles that have been well developed in the academic world through a rigorous peer review process and that have also stood the test of time.

The scientific approach to the management of personal wealth reflects a central concern for risk management. A key insight is that you can’t control returns, but you have some control over risk. Analogously, you can’t control the weather but you can control how much time you spend outside and whether you wear a hat in winter, live or don’t live in a hurricane zone, or pack an umbrella when spending the day outside.

In financial planning, it is the focus on risk management that protects your most cherished hopes and dreams.  In practice, it can be difficult to tell the difference between the scientific, risk management perspective and the more pop culture, hope‐for‐the‐best approach to financial planning. However, take a look at the following core planning principles behind the scientific approach and begin to see the fundamental differences.

CORE PLANNING PRINCIPLES FOR A SCIENTFIC APPROACH TO PLANNING

People care most about their lifetime standard of living, not wealth. For example, as you consider your own planning, are you targeting a specific portfolio amount in retirement, or are you thinking about a desired lifestyle? That’s a key question. It matters how you define financial success.

Absent a big inheritance, the most important determinant of your lifetime standard of living is your human capital, your lifetime ability and willingness to earn income. Sobering but true; your personal gifts, and what you do with them, are the main levers for influencing your lifetime standard of living. (In technical terms, human capital is the net present value of your lifetime earnings.)

Since protecting and enhancing human capital is of central importance, so also therefore are education plans, career choices, work/leisure decisions, and the purchase of disability and life insurance designed to replace earned income if needed. Does your financial plan start with a careful analysis of the vibrancy and safety of your current and future income? Does your financial plan include protection from a disruption or loss of earned income? Are you thoughtful about how to maintain and improve your personal well‐being? Physical and emotional well being can also contribute to financial well being.

Financial capital is complementary to human capital and should be tailored to it. In general, the riskier your earned income, the less risk you will likely want to take in your financial portfolio. (The recently unemployed don’t usually double up on stock exposure in order to ‘make up the difference’ in income.) The more you expect your earned income to rise and fall with the markets, the less market exposure you will likely want in your financial portfolio. Despite what you might hear in the popular media, it’s not so much about risk tolerance—how much risk you are willing to bear; it’s fundamentally about risk capacity—how much risk you are able to take.

There is an overall boundary condition to funding lifetime hopes and dreams. Unless you die with debt, lifetime income (earned income, inheritances, Social Security, and pensions) must equal lifetime uses (taxes, insurance, bequests, personal spending). Thus funding your personal goals requires specifying their importance to you and then funding these goals to the extent possible, subject to this lifetime income constraint, and with the least amount of risk. It’s true; we can’t have it all.

Risk is goal dependent. In general, the more strongly you care about a financial goal, the less risk you’ll want to take in financing that goal. For example, your base lifetime standard of living, the lifestyle that you do not want to go below, is most appropriately funded with a safe investment that offers lifetime inflation protected income. If saving for your child’s college education is a high value for you and you do not have an alternate means of paying college bills, the less risk you will want to take in the college savings account. Goals that are more wants than needs can be funded with riskier assets.

Stocks are risky, even if held for a long time, and so are not appropriate when safe financing is required. In popular culture, there is a deeply rooted, but fundamentally incorrect belief that if you have a long time horizon you can and should own stocks because stocks aren’t risky if held for the long-term. In the scientific world‐view that belief is a jaw dropper for the following very specific reason. Shortfall risk—the risk that the portfolio will not be at least equal to a specified level—increases with time. Need convincing? Try buying portfolio shortfall insurance: the longer the time period, the higher the premium. What’s particularly important about this principle is how often it is ignored in popular culture. Remember: if your financial plan requires excellent stock performance to succeed, is it a plan or a hope?

Saving does not boost your lifetime standard of living but instead smoothes your standard of living. Savings shifts income from times of high earned income to lower earned income and from times of favorable life conditions to the more difficult personal times, for example a period of unemployment, disability, or death of the breadwinner. Saving and insuring are strategies for resolving the reality that the rhythm of income rarely matches the rhythm of spending.

Useful risk management strategies include not just precautionary saving and diversification but also hedging and insuring. Hedging means to sell the upside potential of an asset in return for downside price protection. Insuring means to pay a known price to protect against the possibility of a larger loss on some risky asset while keeping the upside potential for the investment return on that asset. When you plan from a risk management perspective it is much more likely that you will decide to use insurance-based investment products, e.g. long-term care insurance and immediate annuities. Also, as strategies from the derivative markets become increasingly available to the retail investor, there will be a widening array of products that make use of synthetic securities to help you tailor investments to your particular planning needs.

Costs matter and should be transparent. Ensuring a low and transparent cost structure is also a core principle when following a scientific approach to personal wealth management. When you wring cost out of a portfolio, you put more money in your pocket. You will also likely get lower risk as well. (Higher expense producers tend to ramp up risk in order to compete with their lower expense peers.) The right relationship with your advisor and investment product providers includes transparency with respect to costs as well as comfortable and honest communication about contract terms. Costs are your business; it’s your money.

The more you think about these core principles, the more easily you can spot right thinking for your financial planning. Here are a few tips to boost you up the learning curve:

BE WARY

Be wary if someone tells you to increase risk because you ‘need’ a higher return to meet your goals. Be wary if your advisor doesn’t ask enough information about you to understand the character and security of your earned income. Be wary of retirement solutions that depend upon particular stock returns, even if the returns are ‘on average’ or ‘over the long term’ or ‘guaranteed’. Be wary of any suggestion to fund a very highly held personal goal with a risky asset such as stocks. You don’t live ‘on average’; neither should your financial plan. Be wary if costs are not fully and comfortably disclosed. Be wary if someone tells you that your portfolio is safe simply because it is diversified. Diversified risky investments are still risky. Be wary if safe investments are discouraged as being boring or too low returning. Be wary if someone tells you that stocks are a reliable inflation hedge or says that you can afford to invest in stocks because ‘you have a long time horizon’.

BE GLAD

Be glad when your advisor proactively details all sources of the advisor’s income. Be glad when the proposed retirement solution is expressed in terms of lifetime, inflation-protected income and when the key variables under discussion are your expected minimum income in retirement, the chance of successfully securing this income, the necessary savings rate to create that lifetime income, and how long you will work. Be glad when your advisor pays attention to your career and insurance coverages. Be glad when your advisor suggests an inflation‐indexed investment because it is safe and appropriate for a particular planning goal, and not because its immediate return seems competitive currently. Be glad if advice is based on honoring what you cannot afford to lose, not on how much you ‘need to make’. Be glad if your advisor wants to thoroughly understand your values, goals, and priorities, and to incorporate that understanding into the funding for personal goals. Be glad if your advisor begins scenario planning assuming first that goals are funded purely with safe investments, and then shows you the expected impact on your lifetime income if you take more risk, work longer, and/or save more. Be glad if your advisor suggests addressing longevity risk with an insurance‐based solution. Be glad if your advisor discourages thinking about a particular investment return as either ‘bad’ or ‘good’ and instead evaluates a particular investment return in relation to the specified financial goal.

The scientific point of view for managing personal wealth leads to greater clarity and certainty in your personal life and less drama in your financial life. Look for it. It works.

Paula H. Hogan, CFP®, CFA founded Paula Hogan, a fee-only financial advisory firm (formerly known as Hogan Financial Management) in Milwaukee, Wisconsin in 1992. She currently serves on the national board of the Financial Planning Association and formerly on the national board of NAPFA.

Paula is a nationally recognized leader in the financial advisory field:

  • AdvisorOne named Paula as one of Top 50 Women in Wealth in 2011.
  • Bloomberg Wealth Manager named Paula to its 2010 Top 50 Women In Wealth, a national list that includes House Speaker Nancy Pelosi and SEC chairman Mary Shapiro.
  • Bloomberg Wealth Manager also named Paula Hogan to its 2008 national list of 50 Distinguished Women in Wealth Management.
  • Bloomberg Wealth Manager identified her firm as one of the nation’s top advisory firms for four years in a row starting in 2005.
  • Medical Economics included Paula in its list of the nation’s top advisors for physicians in each of its first six national lists.
  • Financial Advisor identified Paula in 2002 as one of “the bright lights who might lead the industry into the future”.
  • Mutual Fund Advisor named Paula as one of the nation’s top advisors in two out of two of its annual lists.
  • In 2002, NAPFA awarded Paula its Robert J. Underwood Award for her substantial contributions to NAPFA and to the financial advisory profession.

Locally, Paula has been recognized as a Milwaukee Magazine 5-Star Wealth Manager in 2009, 2010 and 2011.  Her education includes an Economics degree from Princeton University and a Master of Science degree from the Harvard School of Public Health. She earned the CFP® and CFA designations in 1986.

Paula is a frequent speaker and author in the financial planning field. Several of her articles are posted on the paulahogan.com website.

(c)2011, Paula Hogan. All rights reserved. Used with permission.