The Benefit of a Financial Plan in Retirement Planning

One of the primary purposes of a financial plan is to identify how clients can achieve their financial goals while exposing themselves to the smallest amount of risk possible. For instance, I recently worked with a couple who just transitioned into retirement. This couple was accustomed to living a lifestyle that required $72,000 of annual gross income. However, this client’s million dollar nest egg was cut in half during the bursting of the credit bubble in 2008, and consequently, the clients were incredibly risk averse. In fact, their portfolio was 100% cash, and they didn’t want to invest in anything that wasn’t 100% guaranteed.

This couple was on track to receive $36,000 annually from Social Security. Research indicates that a portfolio utilizing only money market investments (3-month Treasury Bills) would have achieve an annualized rate of return of 5.86% since 1970 (and a return of only 3.72% since 1926). Assuming annual inflation equaled 3%, a $500,000 portfolio growing at 5.86% would be able to provide an inflation-adjusted annual income of $28,014 until the clients were 90 years old. Obviously, $36,000 from Social Security and $28,014 of portfolio income would equal a total income of just over $64,000, not enough to enable the couple to continue their standard of living.

Knowing these clients were extremely risk averse, I looked for investment options that would raise their annual income but still allow them to sleep at night. I found that since 1970, a diversified portfolio consisting of just 10% stock, 30% bonds, and 60% cash would have averaged an annual return of 7.45%. In addition, during the last 39 years this portfolio had only one year where it did not achieve a positive return, and that was during 2008 when it lost just 0.1%. Thus, history indicates that this portfolio is extremely unlikely to endure significant losses, but the higher return would provide an inflation-adjusted income of $33,097. This would bring the clients’ total projected annual income up to $69,000.

At this point my clients were able to determine if they could be happy living on an annual income that was $3,000 less than what they were accustomed. As you might expect, it was determined that this income would provide for all their basic needs, but the couple wanted to know what type of portfolio would enable them to continue their exact standard of living. I found that since 1970, a portfolio consisting of 10% stock, 60% bonds, and 30% cash produced an annualized return of 8.36%, which after adjusting for inflation produced an annual income of $36,190, enough for the couple to continue their current lifestyle. However, this portfolio came with a slightly increased level of risk. During the last 39 years, the portfolio produced a negative return twice with a -1.19% return in 1994 and a -0.77% return in 1999.

After careful deliberation, the clients decided they were willing to accept the small additional risk of the 10% stock, 60% bond, and 30% cash portfolio in exchange for keeping their anticipated annual income steady. Both clients were further comforted when I pointed out that the 30% cash portion of the $500,000 portfolio ($150,000) would provide more than four years of income necessary to supplement Social Security and keep their annual income at $72,000. Thus, even if the markets crashed, they would essentially have four years of cash under their mattress to provide for them while the economy recovered. Further, the 60% bond portion ($300,000) of the portfolio would provide an additional eight years of income if necessary. Consequently, the clients would have more than 12 years of funds available without having to touch their investments in stocks, allowing the market plenty of time to recover from a catastrophe. By comparison, it took the U.S. stock market seven years to recover from the Great Depression.

This is an example of how financial planners utilize retirement planning tools to identify the target rate of return necessary for a client to achieve their financial goals. Financial advisers can then consider that target return when developing a customized portfolio for that client. This process allows the planner to develop a financial plan that will guide the client to the retirement they envision while minimizing risk. Of course, the lower the risk the higher the probability that the plan’s projections will come to fruition.

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Lon Jefferies is an investment advisor representative with Net Worth Advisory Group, a fee-only financial planning firm in Salt Lake City, Utah. He is a member of the National Association of Personal Financial Advisors (NAPFA) and a candidate for CFP™ certification. He possesses an MBA and bachelor’s degrees in Finance and Marketing from the University of Utah. Lon has written articles for local magazines such as Business Connect, Utah Business Magazine, and Utah CEO and has been quoted nationally in publications such as the NY Times and Investment News.

View Net Worth Advisory Group’s website at http://networthadvice.com and Lon’s blog at http://www.utahfinancialadvisor.blogspot.com

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