In this Part 3 of the Retirement Planning Series, the final installment, I describe how we use financial projections to inform the investment strategy.

In Part 1 I introduced the idea that retirement planning was a critical first step when working with an advisor because it informs two critically important questions:

  1. What’s a sustainable level of spending for the rest of my life?
  2. How should my portfolio be invested to maximize the probability that I will remain financially independent for the rest of my life?
    • Note the nuance here. “Maximizing success” is not the same as “maximizing returns.” These are very different objectives and, often, they’re at direct odds with each other.

Previously, I spoke about the importance of considering BOTH our “financial capacity for risk” and our “emotional capacity for risk” when shaping the investment strategy for our nest eggs. It’s a quick read that can be accessed here:

Thoughtfully run projections help us address our “financial capacity for risk” because it tests the sensitivity of the achievement of our financial goals against adverse market environments. We’re essentially testing our financial capacity for volatility and loss, which must be considered before pursuing any investment strategy.

I’ll briefly describe the process below using an actual client case study.

Case Study

As I mentioned in Part 2, the first thing I do with any new client is prepare a baseline scenario of financial projections, which includes everything AS IS. This baseline helps to identify any obvious, immediate red flags.

In the case of this client, their initial baseline scenario resulted in a 97% probability of success even using conservative assumptions. I target an 85% probability of success for most retirees so 97% implies they’re in great shape.

97% means that if 1,000 households had these same circumstances and never revisited their plan again simply letting inertia carry them through to death that only 30 of those households would have run out of money prematurely.

What it practically means for my clients is that there is a 3% chance we may need to reduce spending at some point in time. The difference is that we don’t set and forget our plans but update and review them at least annually to proactively adjust as necessary.

That 97% is just a baseline. We need to stress test these results against unexpected events to identify any blind spots.

Some stress tests that are often appropriate are: premature death, long-term disability, long-term care need in retirement, higher than expected inflation, worse than expected portfolio returns, etc…

But the test I’m focusing on here is the market stress test where I force an immediate stock market decline into the projections resulting in a corresponding drawdown of the portfolio.

For this test currently (not at all times), I assume a 60% decline in stocks and 5% increase in bonds.

Since this particular client owned 100% stocks anyway, the corresponding hypothetical portfolio decline was 60%.

The resulting probability of success dropped to 49% from 97% as a result of an immediate stock bear market! Far below my comfort zone for somebody of this age nearing retirement. In other words, this client did not have the financial capacity for the risk they were taking on.

Once we became aware of this potential threat to financial independence, the next step was to rerun new scenarios with different investment allocations. We’re essentially back into the most appropriate investment strategy as opposed to simply guessing and hoping.

When we adjusted the hypothetical portfolio to target 50% in “risk assets” (stocks, commodities, real estate) down from 100% stock exposure, we actually INCREASED the probability of success from 97% to 99% even though the long-term expected returns were lower!

Then, when I simulated the same bear market stress test on the 50/50 portfolio where bonds make 5% and stocks lose 60% the hypothetical portfolio only declined 27.5% as opposed to 60% resulting in a 98% probability of success versus 49% from the Baseline stress test! A vast improvement even in the face of a severe stock market shock.

In this particular case by simply adjusting the investment allocation we dramatically improved this client’s likelihood of remaining financially independent.

As I told the client, it’s as if there is 30 seconds left in the game, you have the ball and are up by a field goal. All you have to do is take a knee and you win the game. But, instead, you’re trying to score another touchdown. Take the knee. Remove anxiety about day-to-day, week-to-week even year-to-year random gyrations of the market and enjoy your retirement.

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