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No one experiences the average. They experience ups and downs that, over time, equal an average. While financial advisors coach clients to expect volatility when investing, they typically fail to apply the same logic when projecting returns in a financial plan.
That’s why despite the industry norm of going with straight line assumptions for financial plans, it’s vital that financial plans be stress tested – preferably utilizing a Monte Carlo analysis to determine the probability of success when subjected to market volatility.
The foundation of every financial plan involves projecting income, expenses, assets, and liabilities into the future and making recommendations to optimize the client’s desired outcomes.
Part of this requires the projection of investment returns using an average conservative assumption for the future expected rate of return. FP Canada has even published annual guidelines for return assumptions that they recommend advisors use.
Although that’s a good starting point, the problem is that all too often, the analysis ends with those straight-line returns. This brings us back to the fact that markets simply don’t work that way. They go up and down and are unpredictable.
Even though we coach clients to weather volatility from year to year to help them achieve the long-term returns they’re hoping for, there’s a big difference between the impact of volatility on their financial plan when they’re in the accumulation stage of their life versus the decumulation stage.
While accumulating, they have time and can see the volatility play out and, hopefully, get to the expected average. But as they enter retirement, everything changes because they’re no longer adding to their nest egg but taking money out. That’s when they’re introduced to the sequence of return risk.
Addressing return risk in retirement
The sequence of return risk is the risk that people will experience a period of low to negative returns in retirement. The issue is clients’ required withdrawals effectively dig the portfolio into a deeper hole that makes it harder to climb out of.
For example, a withdrawal of 3 per cent of the portfolio value turns a 10 per cent loss into a drop in assets of 13 per cent. Now, instead of needing to make a little more than 11 per cent to break even, you now need almost 15 per cent.
If a few more years of poor to low returns are added – compounded with the fact clients need to take out more every year to offset inflation and that people are living a lot longer than they used to – the next time that financial plan gets updated, it could be telling a story of ruin versus success.
That’s why stress testing financial plans is so important, but unfortunately, to date, is not a requirement or commonplace.
How to stress test financial plans
There are various ways advisors can stress test clients’ financial plans. Although none of them are perfect, each tells us something useful. The most common methods include required rate of return, back testing, scenario testing, and a Monte Carlo analysis.
Required rate of return is the simplest method and simply solves the question of, “How much does a client need to make every year for the plan to be successful?” The lower the number, the safer the plan and the lower the risk they need to expose themselves to succeed. This lower risk also translates potentially into a lower sequence of return risk.
Back testing is a method in which one runs the financial plan assumptions against various historical performance patterns of the portfolio to see how often the plan would have been successful given the target portfolio.
While the past is not a representation of the future, exposing the financial plan to real-life volatility can teach us if it ever worked and how frequently it would have. It’s safe to say that financial plans that didn’t work in the past are probably unlikely to work in the future.
Scenario testing is a process in which you can change one or more of the variables in the plan and see the results. That can include lower returns, higher inflation, death, and, in particular, testing a historical market correction for that portfolio. The testing of a market correction is important to run as it is the best way to test a client’s risk capacity, which is a regulatory requirement.
But of all the methods mentioned, Monte Carlo Analysis is probably the industry gold standard. This analysis exposes the financial plan to 500-1,000 randomly generated sequence of returns, based on the return and risk assumptions of the underlying portfolio, and produces a probability of success score.
Luckily, most, if not all, financial planning software on the market support at least one or more of these methods, and there are other standalone software that can do the rest.
Many may wonder why this is necessary and how much sequence of return risk affects a financial plan that works on a straight-line basis.
Some clients have been told they can spend a certain amount for the rest of their life, and then one day, are told they need to cut their expenses by more than a third.
Advisors are not doing clients any favours by not running stress tests on their financial plans.
The world we live in is probabilistic, not deterministic, and helping clients understand that could be crucial to their success.
Jason Pereira is a partner and senior financial consultant at Woodgate Financial Inc. in Toronto and president of the Financial Planning Association of Canada.
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