Will I have enough? – How to move towards true wealth and avoid a nasty surprise.

"In theory, there is no difference between theory and practice. In practice, there is." ~ Yogi Berra

Will I have enough? Sooner or later, everyone will inevitably ask themselves this question, and probably more than once. After all it strikes at the heart of our own financial security. As we get closer to retirement this question gets even more scrutiny.

Of course no-one can answer this question definitively. It depends on so many variables, often well into the future. How much will I need to spend? What will my income be? What returns will I make on my investments? All we can do is make a realistic plan and then execute it well.

The key question then becomes “what is a realistic plan?” This is where things get controversial. I fear that many people are being guided in a dangerous and overly theoretical direction. It could work out, but very often standard planning advice can be based on highly theoretical assumptions and involve glossing over some hidden and substantial risks. My own approach, and the approach of a significant minority, varies substantially from standard methodology. In addition to being far more realistic, this approach is also far more effective in practice.

Choose for yourself what you believe makes the most sense, but make sure that you understand your own plan, including it’s assumptions as well as all the risks.

Defined Benefit Pension Plan Disaster

To understand how best to develop a financial plan it helps to understand how some plans can go horribly wrong. We need to look no further than Defined Benefit Pension Plans (DBPP). Despite all the efforts of highly qualified actuaries and helpful government legislation this multi-decade movement has turned out to be a train wreck.

DBPP were set up decades ago to provide pension benefits for company employees. However, it is now becoming increasingly apparent that in aggregate these plans are now in huge deficit, and many have no chance of providing the funding for their employee’s pensions. For many this realization comes at the worst possible time – at or just before retirement, when they are least able to make up any deficit. So great has this problem become that corporations are now closing down these plans as fast as they can, in favour of providing defined contributions to their employees.

In consequence, although corporations are still providing some assistance, the whole question of pension provision and planning is effectively being passed back to the individual.

In effect, an entire savings industry with all those supposedly smart people, have suddenly thrown their hands up in horror and dumped the problem back with the hapless employee, who now has much less savings or pension than he had previously been led to believe.

What do you think they were doing all this time? How could they have got everything so wrong?  What on earth does the employee do now? First of all we need to understand what went wrong. Once we have learnt a few lessons we will be better able to understand how to make our own plans.

For a year of my life, as an actuarial trainee, it was my job to audit several of these plans and so I received first hand experience of all the mechanics that went in to examining and valuing them. I was never very comfortable with this process, and this is why I was happy to move on after a year. The audit seemed like it was a science, but after going through a few of them it soon become apparent to me that the whole process was entirely arbitrary. You get together the assets, liabilities and contributions being paid into the pension plan and then make some assumptions, primarily about the rate at which you discount payments years into the future and also the investment returns you will receive.

Maybe this sounds reasonable, but the results are bit like tapping the Hubble Telescope. Just a slight tap and you will find yourself in a different galaxy. Tweak your assumptions and a huge pension plan deficit miraculously becomes a healthy surplus. Which assumptions do you suppose the pension plan consultants decided to show to the company? Which assumptions do you suppose the company executives decided they wanted to use? Cumulatively, it is hardly a surprise that over a number of years of “rosy but reasonable” assumptions a shortfall or deficit tends to materialize.

Fancy projections, dangerous outcomes

The problem with this methodology is that the whole analysis starts with theoretical assumptions. No doubt these assumptions seem reasonable and can be defended, but starting here in your planning, or placing too much emphasis on these theoretical assumptions, starts you off on very shaky ground and creates additional problems as you go along.

Very long term returns, say over 50 years or so have historically been relatively stable, and so arguably it makes some sense for an institution with a time horizon many decades into future to use a return assumption. Nevertheless, this approach proved disastrous for the theoretically long living DBPPs.  However, for individuals these return assumptions make even less sense. The key time horizon is often a great deal shorter for individuals, and 5, 10, or 20 year investment returns have been very volatile. So guessing your investment return assumption over a shorter time period is even more hazardous. Remember, we don’t know what the weather will be like next week. How on earth does it make any sense to assume we know what our investment returns are going to be over the next decade or so?

Nevertheless, thanks to the prevalence of return assumptions in many investors plans, individual investors often come to believe that their financial plan depends on achieving a particular return, say, a 10% investment return. This then somehow becomes their whole focus. They then start shopping for investments or an investment adviser that can provide what they believe they need.

This is the point at which their plan can become dangerous, because a highly theoretical outcome starts driving the process to achieve that outcome! In a rush to achieve a 10% return investors overlook the risk they are taking to achieve this target and the risk management that is necessary. With a sole focus on a 10% objective an investor could easily end up with a high risk portfolio. Government bonds yielding 4.5% clearly would be rejected, presumably as well as low growth, but great value equities. The only investments that may seem to match the return expectation would be high growth companies. This could mean that an investor ends up with a highly volatile portfolio. This may work out, but then again it may not. High growth companies tend to be highly volatile. What happens if the assets fall by 25% or even 50%? What would the investor do then? Take even greater risk because they now needed a 20% return to reach their target?

This is an extreme example of what can happen if a plan is too theoretically based and the investor does not understand the investment process. Despite the now acknowledged failure of DBPPs the actuarial investment projection approach is still alive and well. Investors will often, quite reasonably, ask where they stand in terms of their retirement needs. Usually what happens is that they are given some projections based on current asset levels, and inevitably the focus falls on investment returns, as the implicit assumption seems to be that everything depends on what your returns will be.

This is not a sensible or practical way to formulate a plan, as we have seen from the DBPP experience. It is also very over simplified and a highly theoretical approach that tends to detract from a healthy investment approach that will deliver good long term investment results without excessive risk.

Reality based planning towards true wealth

There is another approach, which I believe makes much more sense, one based less on pie-in-the-sky and more on what we can realistically plan for. For this plan, the starting point is how much we spend each year or plan to spend. This is something we all have direct control over. It defines at the outset what is the essential purpose of all our assets, which is primarily to meet our living needs and places our investment approach in this context.

Once we have established our annual living expenses, we need to calculate our total “passive income” (PI). Primarily this will be our wage or pension income, it should also include any income that results from passive investments or businesses, that involve no additional action on your own part. Trading profits or capital gains do not count here, but income from your investments would, so long as they can be regarded as recurring income.

The health of your finances can then be determined by comparing your annual spending plan with your PI. If your income matches or exceeds your spending then congratulations! You are wealthy by my definition. Other people may have more assets than you do, but they may not be as wealthy if they are not living within their expenses. As regards your investments, you have gained a good deal of freedom. In order to further increase your wealth you still need to carefully measure your risk against your return, and manage your positions to avoid losses, but at the margin you can clearly embrace more risk than otherwise, depending on your willingness to do so.

If your PI is below your annual spending then don’t worry, I strongly believe that the great majority are capable of becoming wealthy as defined above, within a few years, if they choose to take appropriate action. The benefit of this approach is that it shows clearly where you currently stand, and automatically it will suggest some things you can do to move closer to becoming wealthy. In the mean time you can still invest but you may need to take care about how much risk is appropriate.

There are a number of great benefits to this approach, and three in particular stand out.

Benefit #1. This approach gives an immediate and realistic assessment of where you stand financially. Also you can continue to measure your progress year to year. You will not suddenly wake up one year before retirement and find that, after all, you do not have enough to live on.

Benefit #2. Your attitude to investing can be appropriately viewed in the context of your financial position. This will inform the level of risk and type of risk that is appropriate for you to take, which should be the first consideration before you start investing.

Benefit #3. This methodology appropriately avoids the one-size-fits-all approach to financial planning, which often suits the planner better than then client. Your investments need to be tailored to your own particular needs.

Conclusion

We have highlighted two very different approaches to financial planning. I believe that too many investors are still directed towards a return based approach to their investments. In other words they start with an idea of the assumed return they need to achieve in order for their financial plan to work. This approach is unrealistically based on guesswork and ignores key elements that are necessary for long term investment success. Indeed it is putting the cart before the horse as it defines the result even before the investment process has begun. It has also proved to be a disaster in the case of DBPPs.

The second approach does not involve any arbitrary assumptions, but is based on a careful and realistic analysis of the spending and income of each individual. This analysis helps define the appropriate level of investment risk in the context of each individual’s particular circumstances, and can be easily measured on an ongoing basis.

The key to successful investing is to find a way to maximize the return for the risk you are willing and able to take. First of all, I believe you need to understand how much risk it is appropriate for you to take. Once you have decided this you need to try and maximize the return you can achieve for the risk level you have chosen. Successful investing is initially about assessing risk both in your choice of investments and also in your money management – how you size your positions, take profits and cut losses. If you do this well then you are on the path to achieving the most optimal investment returns that are appropriate for your own particular circumstances.

 

 

 

 

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