Developing Confidence in Planning

No one can predict the future, but you can't tell that from most planning forecasts.  We don't know how long we are going to live, what surprise events will develop, nor what is going to happen in the economic world of returns, inflation and taxes.  Yet all of these things must be specified when developing a financial plan.  The results of that plan determine how much you should be saving before retirement or how much you can spend after retiring or how much will be in your estate when you die.

Instead of intelligent forecasting comments, we are told that we'll have, say, 89.1% success probability if we follow the plan.  If it's a written plan, it's likely to have a footnote in very small print with a disclaimer that says the future may not be like the past.  If it's a computer program, we'll have to accept a disclaimer for everything from incompetent programmers to an act of God before we can even open the program.

Fortunately, there are some things we can do to provide some insulation from the uncertainties in planning, but first I'll delve into the myth about success probabilities that is so popular.  I'm going to do this by going back in my own history and give you an analogy that may help you understand some things that most financial and estate planners apparently don't grasp.

An airplane design analogy:

I started my working career in The Boeing Company in a stress group that was responsible for determining if the airplane designs were strong enough to withstand the loads from take-off, gusty flight conditions and rough landings.  My first project involved the design of a very advanced and highly classified new airplane.  I was responsible for the preliminary design of the wing structure.  In order to size the wing structural members and skin, we needed to know the loads and the strength of the materials.  Our stress group computed the loads, and we got "allowable" stresses for various materials from a group that specialized in the strength of materials.  The higher the allowable stress, the less material the airplane needs to withstand the loads.  Excess structural weight translates to less payload weight, so we need the structure to withstand high stress levels.

The strength of materials was determined by testing many samples, mainly in "pull" tests where machines pulled at each end of carefully cut samples and measured how much stress the materials could take either before deforming unacceptably or failing completely.  After many pull tests, the materials group used the statistics from those tests to give us a design allowable stress that had a high probability of surviving.

This is analogous to a planner using the statistics of investment returns and inflation in preparing a plan.  Planners call the results "success probabilities."  You want a conservative success probability just as you want a high probability of getting to your destination in an airplane.  Of course no planner ever recommends the ultra high success requirements used in the design of an airplane.

Financial planners can't sample the future.

Moreover, the financial planner can't go any further because the planner can't sample the future to determine the statistics of the future.  Unlike a financial planner, a materials-specialist sets up stringent material content and process specifications that establish not only the chemical content of the materials to be produced in the future but also their process control procedures and test requirements. This helps ensure that the materials produced in the future will be like those that were tested in the past.

But it doesn't end there because after the materials are produced and delivered, the materials are tested again in Boeing's plants to further confirm that they meet the specifications.  For example, they might require that a sheet of aluminum for a wing skin would have several pull specimens cut from the sheet and tested to see if the statistics of that sheet actually match the same kind of strength statistics that were used in the design.  The materials specialist then makes a technical calculation of the "confidence" that that sheet will survive by comparing the results from these samples with the more extensive tests used to develop the allowable stresses.  If the confidence level doesn't meet the specified requirements, the sheet is rejected.

However, a financial or estate planner can't set specifications for the economy, sample the future, nor have the opportunity to reject the results if they don't meet the assumptions used in the plan.

Monte Carlo programs are now the rage.

Unfortunately, most professionals have become so enamored with statistical programs such as Monte Carlo analyses that, unlike the materials specialist, they fail to remember that they are not able to sample the future.  So they blithely say that they have a certain success probability that a retiree will be able to live on such and such income for a certain number of years.  What they really should say is that IF the statistics of the future turn out to be very similar to those of the past and our assumptions of economic events in your life come true, then the chances of succeeding (or success rate) is some specific number.

Monte Carlo analyses were widely used in the development of the nuclear bomb because physicists could statistically model the behavior of atoms.  They knew that those atoms would behave the same in the future as they have for eons of time.  I have had a lot of experience with Monte Carlo analyses because we used them in war games to develop and refine some very sophisticated weapons systems.  Some of the parameters were very likely to be the same in the future as in the past, but many weren't, so we had to look at an array of assumptions such as how the enemy might react or improve its defense measures.  Then we tried to be careful to point out the assumptions so that we didn't mislead the people involved in decision making.

There are many kinds of uncertainties.

The advent of computer programs that make projections automatically lull professionals to sleep.  They tend to make everyone thoughtless.  Consider event assumptions.   Perhaps an aging parent needs some uninsured care and doesn't have sufficient funds.  Perhaps a daughter with several children gets divorced and desperately needs financial help. Perhaps a person gets severely disabled and needs 24/7 care.  Events like this might be minor to a wealthy person, but a client's own divorce can have devastating consequences to all but those that have resources in the stratosphere.

Often, economic uncertainties are more important.  No amount of statistical modeling of the past can tell you what will happen to returns, inflation and taxes in the next ten years, for example.  There is a very popular professional planning program that prides itself in making very detailed tax calculations thirty or forty years in the future.  Yet tax laws change practically every year.  For much of my working career, my tax rate was 50%.  When I was young, the maximum tax rate was 94%.  In 1988, the rate dropped to 28%, its lowest value in modern times.  In 1991, it went up to 31%, then 39.6% in 1993.  Allowable deductions change almost every year, and now we even have phase-outs of phase-outs at the national level and changes in state and local tax laws even more frequently.  Who knows what tax rates will be in only a year or two after any election?

Investment returns are even more fickle.  One of the most famous and well educated financial personages published a widely quoted paper in 1999.  He based his results on literally millions (not the usual 500 or 1,000) of Monte Carlo iterations (with constant tax rates, naturally) for each of a number of scenarios and became convinced that the best course of action for a retiree was to invest in an all stock portfolio, withdraw 7.5% in the first year, and increase the withdrawal by the amount of inflation until death.  Then he cited extraordinarily high "success probabilities" with accuracies of 0.1%.

I tried to get the journal that published the article to print a counter argument, but that didn't fly.  A professor of finance with a doctor's degree trumps a lowly engineer like me.  However, any retiree who retired in 2000 and followed the eminent professor's advice would be very sorry today.  Someone like my father who retired in 1965 would have been in even worse shape.  The professor withdrew his paper from the Web last year and hopefully is a little wiser to the ability of Monte Carlo to predict the future.

The fact is that no one knows what financial surprises may be ahead.  The professor didn't even have to deal with event uncertainty.  All that he had to do was make some reasonable projections of returns, inflation and taxes for the next few years.  Event uncertainty is of extraordinary importance to young people who may have to forfeit years of retirement savings for a family problem, savings that otherwise would compound for many years.  Event uncertainty can destroy the remaining savings of the elderly who have been carefully nursing their remaining investments because of any one of a number of possible uninsured losses.

Improving a client's confidence:

Now that you have this background, the success quantification by professional computer programs is not likely to be very comforting.  So how do we get confidence in the planning process?  If we are dealing with people who are concerned about outliving their investments, we use what we perceive will be conservative financial assumptions and gradually shift allocations from equities to the kind of investments that have much less risk like CDs and bonds held to maturity or immediate annuities.  If we do a new conservative plan each year, as we age, we experience the surprise events, use some of the reserves, and get some of the event uncertainties behind us.  Using the previous examples, aging parents finally die, or the children of the divorced daughter finally become self supporting adults, or the divorce of a spouse becomes a past event.

If the economy goes awry, a retiree with reserves and a conservative outlook has some cushion to accommodate it.  If the economy turns out better, retirees can raise their sights somewhat but still use conservative projection values.  The plan will never be perfect so, unlike the theory, retirees will not spend their last nickel on their last day on earth, but hopefully will have enough money if life is longer than average.  If they die earlier, they'll leave something for their children or some worthy cause.

Plans change.

The younger a person is, the more likely the forecast will change significantly from year to year.  Plans change; that is the nature of planning.  Don't believe that a person can set out on a course where retirees can spend a certain "safe" percentage of their income and then continue to simply increase that by the amount of inflation in every succeeding year until death.  Realistically, people have to change their outlook every year.  If they don't, they'll likely overspend so much in bear markets that they can't recover.  Or if they really get lucky, they'll be at their planner's door asking why they can't spend more.  And you know what?  The advisor will give them a new plan which is what they should have developed as a matter of course.

[Caption] The illustration above shows that plans change appreciably depending on the economy that follows retirement.  This is far different than the constant inflation-adjusted spending assumptions used by virtually all planning programs today.  Source: Dynamic Financial Planning Pro from www.analyzenow.com assuming $10 million initial investment, 40% tax rate and 60% stock allocations decreasing 1% each year.

One of my big gripes about the planning programs used by the vast majority of professionals is that these supposedly sophisticated programs do not make a new affordable expense calculation every year using whatever were the previous year's ending balances in each Monte Carlo iteration.  Advisors would like you to come back every year for a new calculation anyway, so why don't they use models that perform the calculation for every year of the simulation instead of just the first year with an inflation adjustment for all of the following years?  This is not hard to do.  I demonstrated this by incorporating this feature in the Dynamic program on www.analyzenow.com.  This gives a more realistic perspective of human behavior.  For example, virtually everyone who has any significant dependence on the stock market would modify their spending in the year after a market crash or increase spending following some years of extraordinary market growth.  That's human nature.

A rational exhaustion plan:

Estate planners with older wealthy clients might have an easier job than financial planners dealing with clients who want to save or spend enough so that their stash won't be exhausted before they die.  But both financial and estate planners have some trouble with people like me who have resources quite in excess of their own lifestyle requirements but want to leave relatively little in their estates by giving money away before they die.  Of course it's possible that either I or my wife could die much earlier than our current expectations, and it's very likely that neither of us will live as long as my planning horizon.  So we still need an estate plan that provides for relative wealth now but can accommodate changes as we age and consume and gift our current resources.  With the exception of gift funds, we try not to make irrevocable commitments which might turn out to be folly if the tax law changes.

We make a conservative new plan each year right after we sign our various tax returns.  Then we spend what we feel is reasonable and, at the end of the year, gift the remainder of the affordable bottom line that we get from our planning analysis.  Between charities, four daughters, four son-in-laws and thirteen grandchildren, we can easily gift the difference.  By giving the money away while we're living, we can see some of the results and have more confidence that our resources will be well employed.  By keeping the sum of our own spending and the gifting within the planning assumptions, we improve our financial confidence.

Improving investment confidence:

There is no secret how to improve investment confidence.  Diversified investments reduce risk.  The natural process of investing in more fixed income investments as we age reduces the risk.  We might put some part of our investments in immediate annuities that will make payments till whenever our death actually occurs without exhausting investments on some assumed death date.  We can reduce the uncertainty of inflation with inflation-adjusted government bonds or competitively priced inflation-adjusted immediate annuities.  Many can sensibly reduce the uncertainty of tax rates by investing in tax-exempt bonds.  Some people can avoid future tax increases by investing in Roth IRAs or Roth 401(k)s.  We can use insurance for long-term-care.

Reducing effects of event uncertainties:

Apparently there is some secret to developing confidence relative to events because I don't see many plans with provisions for events of various kinds.  The answer is clearly to include the events you know will occur as discreet elements in the plan.  At the other end of the spectrum are the complete unknowns.  You provide for at lease some part of these with an arbitrary reserve for unknowns.  In between the circumstances that are known and the unknowns are things that you know you will eventually have to replace.  You can calculate these using the same old-fashioned disciplines used by competent business planners or home owner's associations where the reserves are proportionate to the current replacement costs multiplied by their age divided by their useful life.  As with the rest of the elements of a plan, replacement reserves need to be recalculated each year using current values.

Planning perspective:

The ultimate answer to the need for planning in spite of uncertainty comes from examining the alternative, that is, no planning.  No planning is a disaster.  President Eisenhower likened planning to his experiences as a general.  He said you can't enter a battle without a plan.  Yet that plan may change every day as the enemy modifies its tactics to counter your tactics.  Retirement and estate planning is no different.  Retirement and estate plans just have a different time scale.  Things don't change as fast in your life as they do in war.

Like an ostrich, our federal government has its head in the sand with regard to financial planning.  There is no plan to reduce the national debt, bring trade balances to parity, reduce the unfunded obligations for federal pensions or social security, and, worst of all, the future obligations of Medicare and Medicaid.  The most logical plans are politically unacceptable and will continue to worsen as the older cohort of our population increases in size and voting power.  Do any planners really believe that this can go on for the remaining lives of most of their clients without some devastating blows that go far beyond common projection assumptions?

Most people rely heavily on their professional's judgments.  I know I did when I was too busy with managing an organization with over twenty-thousand employees and numerous government customers whose constantly changing and increasing regulations were compounded by exhausting audits.  My personal professional financial planner was probably as competent as they could be in those days, but I only saw one projection based on very nominal conditions.

It's not sufficient for a professional to try and pass off uncertainty by providing success probabilities and a disclaimer that the future may not be like the past.  Professionals must admit to uncertainties, clearly state assumptions and show results for perceived optimistic and conservative scenarios.  They should insist on periodic updates as a way to get many of the uncertainties behind them and offer a plan with some resiliency to ever changing economic conditions.