Chapter-3 Retirement Needs Analysis and Projections Learning Outcomes Upon completion of this chapter, the student will be able to: Identify the types of information to collect regarding a client’s estimated retirement expenses Analyze financial goals and obligations Calculate financial projections in retirement based on a client’s current financial position Calculate amounts required to fund retirement cash flow needs Analyze the impact of changes in assumptions on financial projections Topics Longevity risk, inflation and the impact on retirement cash flow needs Goal classification and funding Fixed and terminable Fixed and permanent Variable and terminable Variable and permanent Goal development Establishing goals and timelines Determining goal priorities Selecting and administering long-term investment portfolios Risk, return and implications for retirement planning Introduction We have understood setting goals and objectives along with general considerations about healthcare, lifestyle objectives, financial conditions and targets. We will now understand retirement needs analysis and projections. It is very important to remember that any projections are little more than educated guesses. Financial advisors need to do a lot of research while making assumptions but it is also true that there is not one person who can accurately predict exactly what the future holds economically, financially and personally. As a financial advisor, you should help clients understand this truth so they keep the needs analysis and projection process in perspective. CFP Level 2: Module 1 – Retirement Planning Page1
It also means that you shall do a lot of research and spend time to accurately predict return from various products and about economy. Financial advisor also needs to understand that needs analysis is a valuable part of retirement planning. It does mean that you should build a financial cushion into your projections to provide some level of flexibility and responsiveness to situations and events that are almost certain to impact a client’s retirement at some point during that period. You should also be as careful and exacting as possible as you gather information, analyze and use it, along with proper research, to make financial projections and develop strategies to allow the client to support retirement needs. Longevity Risk, Inflation and the Impact on Retirement Cash Flow Needs We have understood by now risk of longevity and inflation so far. Both these factors influence retirement cash flow requirements. However, we have not yet explored the degree to which living longer in an inflationary environment can have an impact on retirement needs analysis. Longevity and Changing Assumptions We know that people are living longer than ever before. Assumptions that a financial advisor and client make regarding the client’s longevity will have a big impact on the retirement plan. In the last chapter, we worked through a retirement cash flow funding calculation, where the number of years in retirement played a key role. In years past, many retirement plans were built on the assumption of a 20-year lifespan after the person entered retirement. So, an individual who retired at age 65 would plan for 20 years of retirement cash flow, until he or she reaches age 85. Based on a first-year retirement cash flow need of Rs.5, 00,000, the person would require a fund of Rs.74, 25,837. Return of 7% and inflation of 3.5% is assumed throughout the period. 20 N 3.3816 I (Real rate of return) 5,00,000 PMT {0 FV} P/Y=1, C/Y=1 PV Solve = 74,25,837 [BEG] However, the amount of anticipated life after retirement considerably affects the required fund. The amount needed to fund 10 years of retirement cash flow will be less and the amount required to fund 30 years after retirement will be more. While making assumptions about longevity of our clients, we need to be conservative; it means we need to assume a longer age, more inflation rate and less rate of return so that any deviation from assumption will be in the interest of investor only. CFP Level 2: Module 1 – Retirement Planning Page2
Let us take an example and consider different longevity (different number of years after retirement.) Mr. Sameer is planning for retirement and he assumes that when he retires at age 65, he will require Rs.6, 00,000 in the first year . Rate of return is 10% p.a. and inflation rate will be 5%. How much corpus will be required if life after retirement is 15 years 20 years 30 years 15 years 20 years c) 30 years 15 N 20 N 30 N 4.7619 I (Real rate of return) 4.7619 I (Real rate of return) 4.7619 I (Real rate of return) 6,00,000 PMT 6,00,000 PMT 6,00,000 PMT {0 FV} {0 FV} {0 FV} P/Y=1, C/Y=1 P/Y=1, C/Y=1 P/Y=1, C/Y=1 PV Solve = 66,30,641 [BEG] PV Solve = 79,93,978 [BEG] PV Solve = 99,30,573 [BEG] Underestimating the life expectancy can become a major concern as we know required amount to be estimated will depend on assumed life expectancy. As we saw above, the difference between planning for a 10-year period and a 30-year period is substantial – around Rs.33 lakh. To make matters more difficult, once an individual stops receiving earned income the die is cast. For the most part, clients will not have additional money to add to their retirement fund. Investment earnings will certainly contribute, as will income from government and employer programs. However, the longevity factor included in calculations will have a (probably the most) substantive impact on the plan’s success or failure. As a result, this part of the planning process deserves special consideration and discussion between advisor and client. As discussed earlier, it has to be conservative estimate or in other words, assume a higher life expectancy. Good financial advice adage is plan for the worst and work for the best. In this case, planning for the worst means including the longest reasonable lifespan for the client. Family history is a good place to start. Some families have historically high or low life spans. If every person in the family line has died by the time he or she reached age 75, and the client is of similar health, it might be reasonable to use that as a starting place for retirement planning calculations. Likewise, if most family members live into their 90s, that becomes a reasonable starting point. But if you plan for the client to live too long and reduce their annual income in anticipation of increased longevity, they may miss out on their desired quality of life and die with additional money they would have preferred to spend. CFP Level 2: Module 1 – Retirement Planning Page3
An advisor may decide not to modify a client’s anticipated longevity, but might alter either the inflation rate or the investment return rate to lower retirement funding requirements. Clients often do not have a good understanding of historical inflation or investment return rates. Further, they usually do not understand how to forecast what those rates might be in the future. They depend on the advisor for guidance. Changes to inflation and return rates can have a big impact on required funding amounts. While planning for them, instead of assuming very high or very low life expectancy, they can do necessary changes in other assumptions. The logic is that the client should be happy with the way planner is planning as well as never short of money. We adjusted data inputs to illustrate that they could be saving enough to fund their entire retirement. They probably feel good about that, but not true. It is better to plan for a longer life expectancy using conservative inflation and investment return factors. Doing this may make it more difficult for the client to accumulate the desired amount. It may also result in having money left over if the client doesn’t live as long as anticipated, or investment returns are higher or inflation lower than anticipated. However, having more money than needed at the end of retirement is better than not having enough, as long as it doesn’t sacrifice the client’s quality of life. If we are going to err, let’s do so by allowing the client to have plenty of money during retirement, and ending life with the ability to leave a bequest to children or a charitable organization. We have assumed in our example the required amount in the first year after retirement as Rs.6,00,000 p.a. But we also know that during retirement, couple does not require 100% of the last spend, they require between 60- 80% of pre retirement expenses. Financial advisor can discuss this with the clients. Some clients may not be interested in reducing expenses during retirement, so all the calculations should be done accordingly. Inflation’s Impact One of the most important factors which can impact corpus requirement at retirement is impact of inflation along with life expectancy. There is a substantial difference between projections based on 4.5 per cent inflation and one that suggests much higher rates. This is relevant for two reasons. First, current inflation in most of the developed world is at the historically low end of the scale. We are using 3.5 per cent as a benchmark (Inflation is high in case of India), and inflation in some countries is closer to zero or even negative. This is known as deflation (or hypo-inflation). While it may seem like a good thing for consumers, over an extended period, it’s a bad thing for a country’s economy. Eventually, prices must increase or the economy moves into long-term stagnation. This often results in job-loss, business-closings, and a general malaise throughout the economy. The opposite situation – hyperinflation – can be at least as bad, because wages and overall personal income cannot keep pace with price increases. Currently, the worst inflation rate (in Venezuela) is greater than 400 per cent (Statista, 2017). While this is an aberration, a few countries have current rates of inflation in double-digits. Let’s look at a quick future value calculation to see the potential impact on a Rs.5, 00,000 annual goal over 30 years. CFP Level 2: Module 1 – Retirement Planning Page4
3.5 per cent inflation 30 N 3.5 I 5,00,000 PV P/Y=1, C/Y=1 FV = 14,03,397 7 per cent inflation 30 N 7I 5,00,000 PV P/Y=1, C/Y=1 FV = 38,06,128 10 per cent inflation 30 N 10 I 5,00,000 PV P/Y=1, C/Y=1 FV = 87,24,701 A 6.5 per cent inflation increase (from 3.5 per cent to 10 per cent) over 30 years period results in an amount that is more than six times as much. At some point, inflation considerations have to include retirement funding sources. Government-provided funds often do not include much, if any, inflation adjustment. Most fixed annuities also do not have a way to adjust for inflation’s impact. If most or all client resources are fixed, inflation can have a much greater impact than when at least a portion of the funds are in vehicles that are responsive to inflation, such as equities. This is directly applicable to developing a retirement funding portfolio. To illustrate the point, consider the Rule of 72 (i.e., the time required for an amount to double when a fixed annual interest rate is applied). To use the rule of 72, divide 72 by the annual interest rate. At 3 per cent, it will take 24 years to double an amount At 3.5 per cent, it will take 20.6 years 5 per cent requires 14.4 years 7 per cent, 10.3 years 10 per cent, 7.2 years With seven per cent inflation, purchasing power cuts in half in 10.3 years, and at 10 per cent, it only takes 7.2 years. Meaning, if a client enters retirement with Rs.50,00,000 in their hand or long-term bucket, that they CFP Level 2: Module 1 – Retirement Planning Page5
don’t plan on touching for 10 years, and inflation is 7 per cent per year over those 10 years, that Rs.50,00,000 will effectively only buy Rs.25,00,000 worth of goods and services after 10.3 years. At 10 per cent inflation, the same will happen after just 7.2 years. As a result, the retiree will experience a reduction in lifestyle. This is a good reason to suggest that a client save for retirement on their own, in addition to any government plan. It’s also a reason to include inflation-sensitive investment vehicles, like equities, in the portfolio mix. Many financial advisors suggest having at least 50 or 60 per cent of investment assets in some type of equity (e.g., stocks) or real estate for a large portion of retirement to help ensure the client’s assets and income at least keep pace with inflation. A Financial advisor should review inflation history in his country. What trends are forecasted by economists? Is the government making plans to impact inflation rates (either up or down)? These are all good considerations that will help you make correct projections. Goal Classification and Funding Retirement funding has to be based on the goals defined by client. You cannot apply rule of thumb as every plan has to be customised as per the needs of investors. It is helpful to recognize that goals can be classified to help the advisor and client with developing a retirement budget. We will use four classifications to help with the process: Fixed and terminable Fixed and permanent Variable and terminable Variable and permanent Let’s explore each category more completely. Fixed and Terminable Fixed goal amounts do not change during the funding period. A fixed home mortgage is a good example of making payments that do not change throughout the loan term. When an individual agrees to a mortgage, the plan is often to time the mortgage repayment period so that it is paid off prior to, or early in, retirement. Of course, an individual could make extra payments during the mortgage term, but just considering a regular repayment amount over a regular repayment period, illustrates a terminable goal or expense. As a general rule, the fewer on-going payment commitments a person has during the retirement period, the easier it will be to fund cash flow needs. Payments for any loans that cannot be fully repaid prior to retirement will need to be included in the retirement budget. As the loans are retired related payments can be put to other uses, such as paying off additional on-going commitments. CFP Level 2: Module 1 – Retirement Planning Page6
Fixed and Permanent Some goals keep going even after retirement. Related financial arrangements will also not end at retirement. The potential problem is that, while payments remain at pre-retirement levels, retirement cash flow reduces after retirement. In at least some situations retirement cash flow is greatly reduced from pre-retirement levels. One on-going financial commitment may not create a problem. However, if the client has several commitments that will not end during retirement the financial burden can overwhelm the retirement budget. This is a good reason to discuss entering into on-going financial commitments long before retirement is scheduled to begin. Quite a few retirement-related concerns involve lifestyle decisions, many of which are made prior to retirement. Purchasing a bigger, better house or car fits into this category. What can be done when a client realizes that financial commitments exceed the ability to continue making required payments? There is no standard solution that works in all situations. Each case has to be considered on its own. However, it is possible that the client may have to sell the house and downsize to something more affordable. If finances are weak, the client may have to begin renting, which is often worse, because there is no opportunity for rental payments to cease, rather than pursue on-going home ownership. The expensive car may need to be sold and replaced with one that is less expensive. Perhaps the solution is to forego owning a car and instead use public transportation alternatives. The decision to sell a home, car, or other asset is not confined to people with limited financial resources. It can also be a proactive choice made by clients with reasonable resources, but want to improve their lifestyle options by reducing expenses. It is important to remember that most goals require money and have financial consequences. As such, it is important for the financial advisor to work with clients to review long-term goals and financial decisions as part of early retirement planning discussions. Fixed, permanent financial decisions have the greatest long-term impact on retirement planning and budgeting. Variable and Terminable Some of the long-term goals may have variable funding requirements as there may be some goals of shorter duration. When interacting with clients, financial advisors have the most flexibility in this area. For example, a client may want to fund a grandchild’s education. This is an example of a goal that is variable and terminable. Financial advisor can discuss about various expenses related to tuition, fees, housing and related costs. The costs will vary depending on the University and place also. On-going support for dependent children, aging parents or other family members is another scenario that may exist. Here, the expenses are going to be less certain than with education and the client may not know for how long the funding need will continue. Discussions around this goal can be thoughtful. The client will likely feel a sense of responsibility to support their dependents. Providing this support can involve a lot of expense if healthcare costs are included in addition to housing and other regular expenses. This is an area that requires careful consideration because of its potential to reduce retirement funds. CFP Level 2: Module 1 – Retirement Planning Page7
Some of the clients may be willing to cut support for dependents. If possible, this is an expense for which the client can set aside a contingency fund and look into the possibility of insurance cover that can help pay expenses. If insurance cover is an option, the client may be able to help make premium payments prior to the time of need. If that’s not possible, having a discussion with the parents (again, prior to the time of need) about carrying beneficial insurance cover can provide a solution. The whole arena of dependent care for children or other family members who have special healthcare needs is often financially and emotionally difficult. The advisor cannot do much to address the emotional issues, but supporting a sensitive discussion of the financial requirements along with possible solutions can be helpful. A good time to encourage this discussion is long before the need presents itself, and if there is never a need, the client will have that much more money to put toward other goals. Variable and Permanent Monthly household expenses are the best example of a funding need that is variable, but will continue throughout retirement. Although these expenses are permanent but will keep changing over time. Some of the changes will come as a result of economic fluctuations. Prices increase and decrease. Necessary services almost always increase in price over time. Food, clothing, utilities and similar expenses also generally increase in price. The client does have some control in this area, but no control over actual costs. This is why, when formulating financial projections, the advisor should always include a reasonable inflation factor. Inflation will be there throughout the life of a person. Funding Requirements Once we have set and defined goals, funding is one of the most important steps in the retirement planning process. Developing a budget is important throughout life’s stages, and it is the most important during retirement. Always remember, the assets with which someone begins retirement are only going to decrease as he is using money from these investments. In few cases, it may not happen as a person may have enough retirement corpus that he is only using return on those investments. Let me explain it with the help of an example: Mr. Khurana has Rs.2,00,00,000 as retirement corpus. He has invested 50% in equity and 50% in fixed income getting an average return of 10% p.a. The expenses in the first year after retirement are Rs.9,00,000 p.a. If you feed the values in CASIO FC200 V calculator to know, how many years the money will last, it will show error. You can try this because money will last even if he is alive 40 years after retirement and also leave enough legacies for children. Return @10% will give him Rs.20, 00,000 p.a. but he started spending Rs.9, 00,000 p.a. Although the inflation will increase the amount required buy the remaining amount of Rs.11, 00,000 (20, 00,000-9, 00,000) will also remain invested at @ 10%@ p.a. leading to increase in corpus. CFP Level 2: Module 1 – Retirement Planning Page8
As long as a person has a job and earns an income, there is always the potential to increase financial assets. Once work (for pay) ends, the asset base does not get bigger, except for whatever is added from investment returns. After considering all this, we can begin exploring the amount required to fund a client’s retirement, and also any changes in goals that might result from the funding determination. Let’s assume a client, who wants to retire in 30 years, has an annual budget today of Rs.5,00,000. We are in an economic environment where eight per cent is a reasonable long-term (e.g. 20-plus years) investment return, and inflation averages three per cent. If we are also able to assume that the client’s basic budget will not change (which is unlikely, but OK for this example), except for inflation, how do we determine the amount needed to fund the client’s retirement cash flow needs? We do this with a three-part calculation: 1. Inflate the current cash flow amount for 30 years to determine the first year’s retirement cash flow need. This step uses the rate of inflation only. 2. Calculate the amount needed at the beginning of retirement (i.e., not today) to fund the inflation- adjusted cash flow required for the client to maintain purchasing power throughout the anticipated retirement period (in this case, let’s use 25 years). This step uses the real (i.e., inflation-adjusted) rate of return, and is almost always calculated as an annuity due (i.e., in BEGIN mode on financial calculators). 3. The third step can be either solve for a (PV) lump sum amount or (PMT) annual payments needed today to accumulate the retirement fund. As this step only involves the investment return, we will use the investment, or discount rate. Given our scenario, what is the first year’s retirement cash flow amount, and how much would be needed at the beginning of retirement to allow the individual to maintain purchasing power over the 25-year retirement period? The following steps allow us to determine the amount. 30 N 3 I 5,00,000 PV P/Y =1, C/Y=1 FV = 12,13,631 The client’s annual budget today is Rs.5, 00,000, which will be Rs.12,13,631 (rounded) in 30 years. If the client’s annual cash flow need does not change, in 30 years he or she would need Rs.12, 13,631in the first year after retirement to have the same lifestyle as today. How much money would the client need to accumulate by the beginning of retirement (At the time of retirement 30 years from now) to fund 25 years of inflation-adjusted cash flow? CFP Level 2: Module 1 – Retirement Planning Page9
25 N 4.8544 I(Real rate of return) 12,13,631 PMT 0 FV P/Y=1 C/Y=1 PV Solve = 1,81,99,865(BEG) The client must have a fund of around Rs.1,81,99,865 in 30 years to provide the desired retirement cash flow. How much will the client have to save to reach that goal? The process to calculate a lump sum needed today or periodic annual payments over the next 30 years is the same with one difference – whether you solve for PV or PMT. 30 N 8 I (Rate of return) 0 PMT 1,81,99,865 FV P/Y=1, C/Y=1 PV = 18,08,654 Or for payments PMT = Rs.1,48,757[BEG] The client would need to either deposit Rs.18, 08,654 today, or agree to make annual level payments of Rs.1, 48,757. That amount of annual savings may seem high at the beginning, but is less likely to seem so high in the future (especially with regular salary increases). Even so, most clients will not be able to save that exact amount every year. It may be more realistic to begin with a smaller amount and increase it annually as income increases. What does the client envisage doing during retirement? If the individual were to continue working in some capacity and earning a cash flow, he or she might be able to offset the required investment. Let’s change the scenario and say that the client wants to fund their grand children’s education but has not yet accumulated any money to put toward the goal. Let us take an example to understand this We can work with a four-year tuition amount of Rs.5,00,000 (future cost i.e., when tuition payments begin). To accumulate the money to pay for tuition would only will require an additional Rs. CFP Level 2: Module 1 – Retirement Planning Page10
30 N 8 I 5,00,000 FV P/Y=1, C/Y=1 Solve for PV = 49,688 Of course, if the tuition amount is stated in today’s terms, rather than the cost upon reaching retirement, we would have to inflate the tuition amount over the next 30 years, with the required amount changing to Rs.12, 13,631. 30 N 3 I 5,00,000 PV P/Y=1, C/Y=1 Solve for FV = 12,13,631 Doing a quick present value calculation on that amount means the client must deposit an additional Rs.1, 20,607 today to have enough money to fund the future tuition. 30 N 8 I 12,13,631 FV P/Y=1, C/Y=1 Solve for PV = 1,20,607 We can easily see the impact changes can make in the amounts required to fund future retirement-period goals. As an advisor, you will need to consider the various changes to develop a retirement plan. Keep in mind, too, that it’s better to keep assumptions conservative, because you would rather the client accumulate a little more money than needed instead of not enough. Also remember that there is no way to accurately predict the future, so you should review earnings rates, inflation amounts, and all other inputs each year. Making changes annually will be easier than waiting five or ten years to make changes – especially if the required amounts have increased substantially. Also, don’t forget about additional expenses, such as those for healthcare. If we were to add the anticipated amount needed based on the Fidelity study, we would need an additional $260,000 in today’s dollars. You can expect the amount to change, but it is not clear whether it will increase or decrease (the amount periodically has gone in both directions). Let’s look at the planning we have done to evaluate it for reasonableness. Remember, we have not included any government-provided or other benefits, nor have we taken into account any amounts the client may already have accumulated. Both of these items can help reduce the client’s funding requirements. This would be good, because if we add the health-care costs to the original amount needed, plus money needed to fund the inflated tuition costs for grandchildren, the client would need to accumulate a larger amount to fully fund retirement cash flow needs. When we include additional expenses for travel and other goals, the funding requirement will further increase. CFP Level 2: Module 1 – Retirement Planning Page11
We will make an assumption that the client does not have the money available to fully fund their retirement needs. The real question is whether the client has the discretionary cash flow to meet the required annual funding amount. That amount could be difficult for some individuals. If so, what path would you suggest for the client? We will explore possible answers to this question below. Insurance and Other Benefits We need to consider insurance and other benefits that can impact retirement planning. First, some employees may be getting government guaranteed pension income; some employers also give the benefit of pension. We discussed previously about the financial advice rule; “Plan for the best, but develops strategies in case the best doesn’t happen”. Where government or employer benefits are concerned, this means an advisor should be cautious when helping a client plan for retirement, because the advisor cannot guarantee the anticipated benefits will be available when needed. Even when the benefits get paid, the recipient never knows whether they will continue, or at what level they may be paid in the future. As a result, good planning should not ignore potential benefits, but neither should it depend 100 per cent on them being available. The client and advisor should discuss this, and together determine the degree to which they feel comfortable including government / employer benefits, and at what level. In situations where the individual has few years remaining prior to retirement and has not saved enough money to fund any sort of lifestyle, depending on potential benefits may be the only real option. Insurance can also play a part. Part of good financial advice is to consider how you might use different types of insurance or other products, such as annuities. An advisor cannot simply consider the potential benefits, but must also compare them to their cost. Working through a cost-benefit analysis is a good process. Health or medical (including long-term care) insurance and annuities are the two primary products that come to mind for retirees. Life insurance may or may not be valuable, depending on things such as outstanding debts (e.g., home mortgage), need for estate planning purposes, taking care of dependents: parents, children living at home, or those with special needs requiring on-going care Health insurance –Is an important part of good planning. Even when the government or an employer provides some benefits, many people find they are more comfortable with at least a supplemental benefits policy. Such a policy can fill the gaps in government and other programs. At the same time, be careful not to have the client duplicate benefits and pay for something that he or she doesn’t need. As always, careful analysis pays. Example Question We know that people are living longer than ever before. Assumptions that a financial advisor and client make regarding the client’s longevity will have a big impact on the retirement plan. Your client has a first-year retirement cash flow need 20 years from now of $75,000 (future value that has already been CFP Level 2: Module 1 – Retirement Planning Page12
Correct adjusted for inflation 41,526 PV in today's dollars). This will be paid out of the Answer account at the beginning of every year. Your client also wants their retirement income fund amount to be fully funded upon retirement. Assuming an Explanation investment return rate of 8% and inflation at 2.5%, what is the difference in the investment fund inflation-adjusted amount required if the longevity Distractor #1 assumption moves from retiring for 25 years to retiring for 35 years? The Distractor #2 purchasing power of the $70,000 has to be maintained. Distractor #3 a $154,028 b $73,485 c $162,292 d $79,363 C Step 1: Q is asking inflation-adjusted retirement cash flow. ((1.08/1.025) −1) ×100=5.36585. Step 2: Calculate amount needed in fund for 25 years Longevity Mode = BGN, P/Y = 1, N = 25, I/Y = 5.36585, PMT = 75,000, FV = 0, CPT PV =1,074,047. Step 3: Calculate with longevity at 35 years: Mode = BGN, P/Y = 1, N = 30, I/Y = 5.36585, PMT = 75,000, FV = 0, CPT PV =1,236,339.37 Step 4 Calculate the difference: 1,236,339 - 1,074,047 = 162,291.95 a Calculator in END mode for steps 2 & 3 b Calculator in END mode for steps 2 & 3 & I/Y = 8 for steps 2 & 3 d I/Y = 8 for steps 2 & 3 Goal Development Client goal should form the foundation of every engagement between client and financial advisor. We have discussed various retirement goals. Now, we want to review goal development, and then look into how a client can prioritize goals. Financial goals need to be specific that are tied to specific life cycles. Not only does this help identify financial priorities, but it can further define associated time lines and help establish more realistic and effective financial goals. Well defined goals share three characteristics: CFP Level 2: Module 1 – Retirement Planning Page13
A defined purpose A specific timeframe A monetary amount Establishing Goals and Timelines The investment time horizon is the period available until money is needed for a financial goal. A financial goal with a high degree of certainty and a short time period requires a focus on capital preservation, and therefore a selection of assets that remain stable in value (most likely interest-bearing instruments). The money in this category fits well into Bucket 1. For example, an investor who plans to make a down payment for a house six months from now would want to keep that money in an asset with minimal risk, like a six-month bank fixed deposit, flexi deposit account or liquid fund of a mutual fund. Longer time horizons (e.g., Buckets 2 and 3) can allow for investments that, though they will fluctuate in value, offer increased appreciation potential. For example, if the investment goal is accumulating Rs.1 crore for retirement 25 years from now, investments with higher long-term expected returns i.e. equity either directly or through mutual fund route will be appropriate. Investment once done needs to be monitored and reviewed regularly. SMART Goals Goals should be considered in relation to each other, because many (if not most) will have an impact on the others. Goals could be: Short-term (two years or less) Intermediate-term (from two to ten years) Long-term (more than ten years) (These tenures are as per global standards) Categorisation of goals as per time horizon will be useful as it will help the financial advisor make appropriate recommendations as to how to allocate financial resources to achieve the goals and to see that right amount of money is available at right time to meet goals. Goals need to be SMART . Specific Measurable Attainable Realistic or Relevant; and Trackable or Time-bound CFP Level 2: Module 1 – Retirement Planning Page14
How would a financial advisor turn a client’s wish for a comfortable retirement into a SMART goal? After having advisor and the client’s initial communication, the advisor would have to ask some clarifying questions. What information does the financial advisor need to develop a useful retirement planning goal? The client’s current age and status (i.e., single, married, etc.) The age at which the client wishes to retire The client’s desired retirement lifestyle This would require a determination of how much money would be required to fund the desired lifestyle. Available financial resources Government or employer-provided pension Money already accumulated Discretionary funds available for application to meet this goal Competing goals and uses for available funds Anticipated longevity (how long should we plan for the retirement period?) Expected rates of return and inflation This will also require an understanding of the client’s risk tolerance and any investment-related limitations Let us understand some SMART goals. Specific: The client wants to maintain same lifestyle in retirement as she is maintaining now, except for the possibility of moving into a beach house. She is 40 years old and, even though she really enjoys her work, wants to retire at age 65. Longevity runs in her family, so she wants to plan to live in retirement for 35 years. Measurable: Current annual living expenses = Rs.4, 50,000; annual inflation is expected to average 4.5 percent, and her portfolio rate of return should average 9.00 percent. The inflated equivalent of Rs.450, 000 in 25 years is Rs.13, 52,446. That’s the first year’s cash flow requirement. If we were going to carry out the process, we would need to determine the amount needed to fund the inflation-adjusted annual cash flow throughout the entire retirement period. Without going through the calculations here, the client would require a portfolio at the beginning of retirement valued at slightly more that Rs.2.53 crore. Attainable: The client has already accumulated Rs.5, 00,000, which will grow to Rs.43, 11,540 by age 65 (at 9 percent per annum). Assuming no pension benefits, this leaves her with having to accumulate Rs.2.09 crores. The client can easily afford the required annual contributions of Rs.2, 26,500, so her goal is attainable. Realistic: Based on her continuing to earn at the same general rate, with no unanticipated large expenses, and assuming she follows through with annual contributions, and that both inflation and her rate of return meet expectations, the goal is realistic. CFP Level 2: Module 1 – Retirement Planning Page15
Time bound: Given that the financial advisor and client know the amount required at age 65 and the periodic payments needed to fund that amount, the goal is trackable/time bound. Annual reviews would allow client and advisor to determine the degree to which the plan is on track and any adjustments needed. The retirement goal of a client will look like this “The client wants to retire in 25 years at age 65 and wants to have an annual cash flow in retirement that is the inflation-adjusted equivalent of her current annual cash flow. The retirement cash flow period will last for 35 years.” The goal statement would not include the financial particulars (e.g., the inflation-adjusted annual cash flow or portfolio amount needed at retirement). However, to determine whether the goal fits the SMART criteria, the advisor would need to evaluate each of those details. As a result, it may be that the initial goal would need to be modified somewhat, based on funding requirements and the client’s ability to satisfy them. The discovery process needs to be robust so that financial advisor is able to get a greater understanding of the client’s desires, it would be easy for the goal to be expanded. As we complete the SMART goal process, we included several steps in the process required to determine whether the goal will be achievable. After identifying the client’s general wishes, we focused on quantifying the goal statement with both financial constraints and timeframes. Then, we checked existing resources and determined whether additional resources would be needed. If the financial advisor were to take the next steps in the process, he or she would need to consider potential strategies, along with any potential funding constraints or limitations. Then, the financial advisor would make recommendations for the goal-achievement strategy, and advisor and client would then work to implement the strategy. The advisor would round out the process by regular review, with possible adjustments based on economic and personal changes. Determining Goal Priorities We have understood how to help clients determine retirement goals. One question an advisor can ask that can be helpful when trying to determine goal priorities is: “What does a fulfilling or satisfying retirement look like to you?” Retirement is different for different people as we have discussed in earlier paragraphs. Can you imagine about you, how retirement means to you. For me it is lot of traveling, helping society with money and knowledge. 1) The first step in the goal-prioritization process is discussing and determining how the individual views retirement. How does he or she hope to shape the retirement period. Within this discussion, the advisor should help the client understand the need to build a strong financial foundation. An individual’s financial foundation usually includes items such as sufficient types and amounts of health insurance cover, adequate savings – especially emergency funds, enough money to meet monthly living expenses CFP Level 2: Module 1 – Retirement Planning Page16
and on-going debt repayments if any (although debt should have been paid off before retirement), focused savings for large purchases. 2) For many retirees, a secondary level of goal priorities includes items such as education funding for grandchildren, saving for a house, funding for a wedding (or more than one), money to start a business, or for other large goals. Funding the client’s ideal retirement may fit into this second priority level, or it may stand on its own. The retirement funding category can be misleading, because it can incorporate many existing goals. For example, financial security goals will continue throughout the retirement period. These can include things such as insurance premium payments, having enough money to live independently throughout retirement, money to cover potential emergencies, etc. The primary difference in funding these goals is that during retirement, no new work-related income is being generated. This may not have much impact on funding goals if the individual has sufficient assets to produce their desired cash flow. However, for many retirees, with the exception of investment earnings (e.g., rental receipts, stock dividends, bond income), new sources of cash flow are limited. This can impact goal achievement and prioritization. The best time to prioritize goals and make plans to fund these goals is much long before retirement begins. If we accept that the foundational goals already mentioned automatically have top priority, all remaining goals have to be prioritized in a secondary position. How can this be accomplished? Even an excellent discussion between the client and financial planner will not prevent inadequate financial resources from obstructing goal achievement. This means that within the prioritization process, the client must allow the one or two most important (non-foundational) goals to rise to the top of the list. When asking clients what a fulfilling retirement looks like to them, it will be important for the advisor to allow enough time for the clients to reflect and carefully consider the answer, and understand that it may change as retirement gets closer. This may mean suggesting the clients think this through on their own time and return with an answer. One way to consider the question is to turn it around and ask what would make for a negative retirement experience if it was missing. As an example, if the client wants to travel to see grandchildren annually, what difference in their satisfaction would it make if they could not do the traveling? Sometimes there is value in taking away options to help clients recognize what is most important to them. It can also be helpful to frame the decision in the context of asking, “If money was not a concern, and you had all the required financial resources, what would you like to achieve?”This type of conversation can be difficult for some clients, and some advisors, too. It may open areas the individual has kept closed for many years. A good financial advisor will recognize this possibility and proceed accordingly. Eventually, as we have seen, goals must be funded. This means that without funding goals are unlikely to be achieved. Some clients will have such limited financial resources that their ability to achieve goals will be reduced to those in the financial foundation. For others, especially when planning begins early enough, there will be enough money to achieve at least one additional goal in retirement perhaps several. As a financial advisor, one of the top goals should be helping the client accumulate enough funds so he or she can achieve as CFP Level 2: Module 1 – Retirement Planning Page17
many high-priority goals as desired. To do this will involve building an investment portfolio. We will look at this next. Selecting and Administering Long-Term Investment Portfolio We need to first review some key factors in determining optimal retirement investment (cash flow) portfolios. As we have discussed earlier also, people today are living longer, longevity is increasing. While the percentage of increased life span seems to be slowing in some areas and increasing in others, it is clear overall that people are living longer. This must be factored into any long-term retirement planning. Whether it remains level, increases, or decreases, we can be certain that inflation will continue to be a factor. As we have seen, the loss of purchasing power due to inflation can be the cause of considerable difficulties for retirees with a three per cent inflation rate, over 24 years; the cost of living comes close to doubling. This means that a Rs.5, 00,000 annual budget today will need to be Rs.10, 00,000 in 24 years, with no increase in purchasing power. We can conclude from this that retirement portfolios must be structured to, at the least, keep pace with inflation. This means incorporating equity in the portfolio. Equity provides growth to the portfolio and debt gives stability. However, with equities comes volatility and when structuring a portfolio, especially for someone close to retirement, you have to consider volatility, and choose asset allocations accordingly. Asset allocation is one of the most significant factors in portfolio success. A mostly fixed-income/cash-based retirement portfolio is rarely the best idea for most people. While investment risk discussions often focus on market risk, especially for retirees, loss of purchasing power represents an equally, if not more significant risk. This being the case, most retirement portfolios should include equities or real estate investments that keep pace with inflation. The percentage will vary based on client goals and risk profile. For our purposes, let’s suggest a 65 per cent equity allocation at the beginning of retirement, recognizing that this percentage may need to be adjusted based on current economic and market conditions, and the individual’s risk profile. We have earlier discussed about bucket strategy. The portfolio also needs to allocate from one to three years’ worth of cash flow/budget requirements to a cash or cash equivalents bucket (i.e., Bucket #1). This will fund each year’s withdrawal needs. It would also be prudent to allocate a percentage of assets to an emergency fund. This money should also be held in cash equivalents or at least something stable and liquid. How much should be allocated to an emergency fund? That will vary from person to person. We do not have to cover regular expenses from this fund, so there should just be enough to cover any emergencies, such as repair of laptop, LED, need to fly to another country for a family emergency, without negatively affecting the overall retirement portfolio. What’s the best way to invest funds in the equity allocation? As you know, not all equity investments are equal. For example, a significant difference exists between buying 100 shares of a new start-up company stock and 100 CFP Level 2: Module 1 – Retirement Planning Page18
shares of Toyota, Siemens, Sinopec Group, or Alibaba. Further, there is a big difference between buying shares of those four companies directly, and holding them in a mutual fund or other collective investment scheme. Let us assume Sameer is among the many people for whom owning equities in the form of mutual or exchange- traded funds (ETFs) makes the most sense (for this example, we will not include options, commodities, or direct ownership of real estate). Let’s build a portfolio (Bucket #3) around shares of funds, recognizing that, depending on the individual and the size of the portfolio, direct ownership of company stocks (or other securities) can be a viable option. The real question for Sameer is what types of funds are most appropriate? This question refers to options such as index or non-index (i.e., passively or actively managed), domestic, international, global, large-cap, mid-cap, small-cap, emerging markets, growth, value, growth and value, etc. There are 44 Mutual Funds (AMC’s) in India having variety of schemes to choose from. The bigger problem is deciding what percentage of the various categories to use, and then selecting the actual funds within each category. As Sameer’s financial advisor, what allocation would you suggest? Is there enough information to do more than a basic allocation? Recognizing that we could discuss actual allocations for days, we will use the following asset classes: Large-cap domestic Small-cap domestic Broad-based international (Few schemes of MFs investing in US markets) Emerging markets (international) (Not available in India as of now) REIT (real estate investment trust) (Not available in India as of now) Let’s also assume that the list moves from lowest market risk to highest (realizing that the REIT category is somewhat of an outlier). How would you determine the percentage of each asset class for Sameer’s portfolio? Further, would you recommend keeping it the same throughout retirement, or would you shift the allocation over time? Since we are looking at a portfolio during retirement, the overall market-risk level needs to be considered in that context. While we have agreed on a 65 per cent equity exposure (in this example), we should bias that exposure to the lower end of the risk spectrum. At least part of that exposure might include dividend-producing assets. However, because the other looming risk is the loss of purchasing power, and Sameer may live for another 30 years or more, we should allocate some portion of the equity portfolio to more risk-aggressive assets. In addition to large-capitalization domestic equities, Sameer could benefit from international assets (both large and small cap) to help diversify any purely domestic risk. Also, it could be good to include a small percentage of REIT ownership for diversification and potential cash flow generation (when available) Sameer’s long-term equity portfolio allocation might look something like this: (As per Global content), it will vary in India. CFP Level 2: Module 1 – Retirement Planning Page19
Large-cap domestic: 50 per cent Broad-based international (large and small cap): 25 per cent REIT: 10 per cent Small-cap domestic: 7.5 per cent Emerging markets (international): 7.5 per cent This portfolio is designed to provide growth and income, along with reasonable domestic and international diversification. The small-cap and emerging-markets exposure is significant, but not too great for the initial retirement portfolio allocation (around 15 per cent of the equity, and 10 per cent of the total portfolio allocation). This higher-risk allocation should give the portfolio extra growth potential, which may be needed to offset higher periods of inflation. The REIT exposure amounts to around 6.5 per cent of the total portfolio allocation, with the remainder (35 per cent) of the portfolio invested in fixed income. This is only one example of a potential retirement portfolio. However, this sample allocation can serve as a starting point for thinking about how to initially invest the client’s retirement portfolio. Regardless of the starting point, the question becomes, should the initial allocation remain the same throughout retirement or should it be changed over time? In India, many of the options discussed as per global standards are not available, we suggest financial advisors to create a portfolio as per the time horizon and risk appetite of investors. If you feel more exposure to equity than desired by client should be done, make your client understand the importance of more equity in the portfolio. In India, most of clients wish to deposit the entire retirement corpus in debt which provides fixed income. As we all know, impact of inflation cannot be ignored while planning for any goal and retirement is amongst the most important goals. Variety of schemes with different objectives is available in mutual funds. Financial advisor can select the best schemes out of many better performing schemes for their clients and keep monitoring the retirement portfolio once every 6 months and if need be rebalance by selling non performing schemes. As a young investor may be 100% of retirement investment in equity and as age increases, slowly keep shifting money to fixed income and at retirement, keep around 30-40% in equity, rest in debt. Equity portion will again vary as per risk appetite of investors. Education the clients about risk and return can help investors increase their risk appetite. You would probably agree that the allocation should not remain constant throughout retirement. As Sameer moves closer to the end of his life, cash flow needs—including those for healthcare expenses—will likely increase, requiring a greater allocation to income-producing investments (e.g., high-dividend equities and fixed income). Additionally, from a psychological standpoint, many, if not most, seniors grow more conservative and fearful as they age. The fear is based on reality. They are no longer generating new income, and they need to have confidence that their existing asset base will last as long as they do. This usually results in a gradual decrease in their risk-tolerance threshold. CFP Level 2: Module 1 – Retirement Planning Page20
By the time Sameer reaches age 75 or so, he might be more comfortable with an allocation closer to 20 per cent equities / 80 percent fixed income. Over the following 10 years, he may want to continue reallocating the portfolio to a more conservative, cash flow-generating mix. Sometime in his final decade, Sameer may want to adjust his portfolio allocation to nearly 100 per cent in fixed income comprised of short-term bonds and cash equivalents. Remember though, neither Sameer nor anyone else knows exactly how long they will live. If all of a client’s planning focuses on only 25 or 30 years in retirement, and they actually live for 40 years, they could be in financial distress at life’s end. This advanced planning and scenario testing is where the value of financial advice and client’s working with a financial advisor comes in. We cannot create “best” portfolio-allocation plan. The optimal retirement portfolio allocation for each client will depend on their individual needs, goals, risk tolerance and time horizon. Instead, we have looked at creating an overall flow and built a potential foundation for a sustainable retirement portfolio. Each individual’s situation will determine optimal investment allocations to meet their retirement goals. Risk, Return and Implications for Retirement Planning Before making strategy for investing to accumulate retirement corpus, financial advisor needs to gain an understanding of a client’s risk appetite. Risk Profiling is very important part of planning process as asset allocation will depend on client’s risk appetite. As the individual approaches and enters the retirement period, risk capacity (i.e., the ability to sustain a loss and still achieve investment goals) and time horizon may become even more important than risk tolerance. As an extension of this process the advisor must explore some general considerations about investments and their risk-adjusted return potential. Then, the task becomes combining the two areas to determine whether the individual’s return expectations are consistent with their risk tolerance. This must also be compared with the client’s risk requirement, or the necessity of earning a minimum return to support retirement cash flow goals. Portfolio construction and asset allocation decisions will likely be at least a little different prior to retirement than within the retirement period. People tend to develop a more conservative risk tolerance as they progress through retirement. Also, their risk capacity generally decreases, because they need to ensure continued availability of funds and cannot afford as much volatility as they may have in preceding decades. If a client has enough funding for his comfortable retirement, there is no need to take excess investment risk. There is no need to incur greater volatility in an attempt to increase available funds. Most clients will not be in this situation and will need to at least explore the possibility of increasing portfolio risk in an attempt to increase investment return. Remember that there generally is no way to increase investment return to any degree without also increasing investment risk. Also remember that increasing risk is not a guarantee of increasing return. Doing so just opens the door to potential increases. The average person investing for retirement and in retirement will likely require accepting an increased level of investment risk. If we embrace the bucket concept in retirement and place enough money in the first cash bucket to fund around two years of cash flow, it will be a little easier for clients to accept an increased CFP Level 2: Module 1 – Retirement Planning Page21
level of risk for the third bucket (longer term investments). Prior to retirement, accepting portfolio risk is almost mandatory if the client is going to accumulate enough money to fund retirement goals. The degree to which this is true will depend largely on the amount the client needs to accumulate and the timeframe in which to do so. We can illustrate this using return averages for different asset classes. Over the 20 years from 1997 to 2016, here are average annual returns for a few asset classes (Blackrock, 2017). Cash 2.30 per cent Fixed Income 5.30 percent REIT 11.04 percent Large cap value stocks 8.30 per cent Int’l stocks 4.20 percent Small cap stocks 8.20 percent Depending on the resource consulted, you can find variations on historical return figures, but the preceding list will serve our purposes. The list is ordered according to relative risk levels (although you can find different ordering in various lists). Notice that REITS have a return greater than the stocks, but often are considered to be less risky. Part of the reason is that different asset classes exhibit different returns over different time periods. Another part of the reason has to do with the type of real estate the REITs hold. When a fund holds actual properties, there is always the potential to sell the properties and recover lost funds. This is less likely with any type of stock (although a company could sell assets in liquidation). When we developed a portfolio for Sameer, we used the following allocation: Large-cap domestic: 50 percent Broad-based international (large and small cap): 25 percent REIT: 10 percent Small-cap domestic: 7.5 percent Emerging markets (international): 7.5 percent The question you have to ask as a financial advisor is whether this allocation is appropriate, and if so, during retirement, pre-retirement or both? Further, as we mentioned above, how should Sameer’s portfolio be adjusted as he ages? The answer to the first question is yes, the portfolio is at least potentially appropriate before, as well as during, retirement. The answer to the second question hinges of how long Sameer lives, how much money he has accumulated relative to retirement funding requirements, his risk tolerance and to what degree does Sameer become more risk averse over time. If a client starts investing early, investing even a small amount per month and taking adequate amount of investment risk will lead to accumulation of huge corpus. May be the client does not wish to take more risk but he has more surplus available to invest which when invested at moderate rate of return can accumulate so much corpus that his retired life can be taken care of perfectly. A can invest Rs.6,00,000 p.a. for next 25 years at a return of 10% p.a. (moderate risk), he will be able to accumulate Rs. 6,49,09,059 (6.49 crore) that is fair CFP Level 2: Module 1 – Retirement Planning Page22
enough amount to take care of his needs. B is having a surplus of Rs.300000 p.a., if he invests at a return of 14.25% p.a. he will be able to accumulate the same amount Rs.6,49,09,059 You can see how available time and funding requirements influence portfolio risk decisions. This fact will have to enter into discussions with the client around goal achievement realities. Sometimes, as we have seen, the client will not be able to accumulate the required amount of money within the available timeframe, given the amount of investment he or she can make. Other times the client can probably accumulate the funds, but only by assuming a relatively higher degree of risk. These decisions continue throughout the retirement period. Recall the potential problems associated with increased longevity and inflation. If the client is unwilling to accept a moderate risk level during retirement, he or she may have to accept a lower standard of living, because funds will be depleted over time. The financial advisor should educate clients about the different types of risk, including purchasing power, and the potential impact on portfolio development considerations. We now have a fundamental understanding of retirement goals, their development and portfolio funding solutions. In the next chapter we will look at sources of retirement cash flow, many of which are provided by the government and do not require personal savings and investments. CFP Level 2: Module 1 – Retirement Planning Page23
Search
Read the Text Version
- 1 - 23
Pages: