Broker Check

Investment Planning or Financial Planning?

May 14, 2020
If you fell asleep on February 18th of this year and woke up the afternoon of March 23, noticing the S&P 500 was down about 37% during those 5 weeks, there's really only one word to describe your feelings: SHOCK. Given a few minutes to process this information, your next thought would likely be, "What does this mean for me?" 
The answer to this question is likely answered by which of the following circles represents your approach to creating financial security. If you consider investment planning and financial planning to be synonymous terms and have built a plan reliant only on the stock market, the red circle represents your situation. With even moderate risk portfolios down substantially over that time, you would have rightly been concerned. 

But if the second circle - with many different pieces of the financial planning pie (tax planning, retirement income planning, product diversification, cash flow management, etc.) -  if this circle represents your approach, there should have been a greater level of comfort, knowing that a plan had been developed to insulate from the full brunt of an investment related shock. Notice the red is still a substantial segment, but is far from the entirety of the plan. 
Why is this distinction so important? Let's walk through an actual client example (with numbers rounded for simplicity). While this is a retirement income planning example - the concept extends to all manners of financial planning. 
A retired couple plans to live on a minimum of $120,000 per year. They have a number of income sources in place. There is a municipal pension providing $75,000 per year, the spouse is receiving over $30,000 per year from Social Security, there is another $20,000 per year of income from small pensions and annuities, and one spouse plans to work part time for a few years. There is permanent life insurance on both spouses to provide accessible cash value and a lump sum at each death.
Leading up to recent events, there was $500,000 of additional assets in retirement accounts. At the low point, this dropped below $400,000. For a retiree, this can be a concerning turn of events. Fortunately, the market has recovered since then, but even if it did not, what did the drop in portfolio value mean to this client? 
  1. All income was guaranteed through Social Security, Pensions and Annuities.
  2. Part time work provided a buffer to handle extra "fun money" and surprise expenses. Given this is not certain, we have left this out of the discussion. 
  3. When inflation starts to impact them down the road, they could begin drawing from the IRA to offset the inflation impact. Of course, at 72 years old, they will be required to begin distributions to satisfy IRS RMD rules. 
The 4% rule is a traditionally accepted strategy used by investment professionals generating retirement income from an investment portfolio. While there are serious limitations to the 4% rule, if we use it here for our example, the portfolio would be assumed to provide $20,000 per year, inflation adjusted, from the $500,000 balance. Assuming after the drop that it remained at $400,000, it would have been assumed to provide only $16,000 per year, inflation adjusted. Obviously, no one wants a 20% drop in income. But what would this client have experienced?
A $4,000 drop in income in their plan was NOT a 20% drop, but just over a 3% drop from $145,000 per year of income ($75,000 pension, $30,000 SS, $20,000 pension and annuity, and a $20,000 portfolio withdrawal) down to $141,000 (same income with $16,000 portfolio withdrawal). And that is without considering the part time income. If this couple were relying only on the stock market, a 20% drop would equate to a 20% drop in income. That's clearly not what they experienced. 
While you may not have that pension, there are ways to guarantee more income throughout retirement. In your situation, both spouses might have Social Security benefits and you have options to create additional guaranteed income within your plan. 
Again, no one would choose to have their portfolio drop in value. Imagine yourself in this clients' shoes. If SHOCK happens and the market drops your portfolio by 20%, you are still okay. You would have a plan based on a relatively minor reliance on the stock market. A plan that looks like the second pie rather than the first. While shocks are still unsettling, they are not catastrophic to a well developed plan. 
So given that, what risk level should you have in your portfolio and across your plan? Risk is the likelihood we do not achieve our goals but instead have an adverse outcome. This couple has little risk in their plan even when there was still moderate risk in their portfolio. In the next article, we will dig deeper into the concept of risk and explore how it permeates our plan, working into how we manage it to increase the likelihood of a desirable outcome. 

As always, your feedback and questions are welcome. Click here to schedule some time for us to talk. 
*Diversification does not guarantee profit or protect against market loss. All investments and investment strategies contain risk and may lose value.