I have worked as a financial advisor for almost 15 years, and one of the best things about the job is seeing clients achieve their long-term goals. Our focus in planning is to help clients control what they can while handling the unexpected in a financial plan, and that approach has worked well for us and our clients.
The risks are varied as are the ways in which we address them. A few of the more common ones – and how we protect against them – are as follows below.
Poor Market Returns. The downturn from 2007 to 2009 was one of the worst on record, well below the average return we assume in our plans. But we don’t just build plans based on average returns – we also stress test our plans. The stress tests examine how plans are impacted by an unfavorable sequence of returns, including returns similar to what we experienced from 2008 to 2009. However, the tests assume that returns will mean-revert – that is, over time the markets will achieve the average return. In order for this to happen, periods of abnormally bad returns will be followed by periods of abnormally good returns and vice versa.
Returns might be below par for a number of years, but historically, mean reversion has always come into play in and returns have bounced back. We saw this clearly during and after the financial crisis. Thus, while 2007 to 2009 was uncomfortable for clients – particularly those who depended upon their portfolio for income – they ultimately weathered the downturn fine because their plans were designed to weather such a downturn.
Loss of Income. Over the course of a plan, loss of income can take several different forms. For clients who are working, job loss or disability are the most common drivers of income loss, while premature death is less common until the latter part of a working career. We address job loss by establishing an emergency fund, while disability can be covered by disability insurance assuming it is available for an affordable premium. Lastly, we use term insurance as a reasonably priced tool to cover the risk of premature death. Depending upon how long the loss of income lasts, it may be necessary to rework a plan by pushing retirement back a few years, increasing savings rates once income is back to the normal level or some similar change.
For clients who are retired, loss of income may be related to the death of a spouse and subsequent loss of pension or social security income. Household expenses generally decrease in this situation, and the surviving spouse may ultimately be okay financially if this decrease is paired with sufficient assets. If we have any concerns, we run a survivor plan to confirm that the surviving spouse will be in good financial shape. If the plan results aren’t sufficiently favorable, typically the best option is to pare back on expenses while both spouses are living so that either spouse would be financially secure should the other pass away unexpectedly.
Overly Optimistic Budgeting. As I’ve written before, not everyone wants to budget. In many instances, budgeting isn’t necessary as clients have a very good grasp on what they are spending. For those that don’t, we provide a few different options to build a budget, but even for clients who know their spending to the penny, a budget can be upended by one-time expenses. The problem with one-time expenses is that they may change from year-to-year, but as a group, they happen every year. A few years back, we began building in a one-time expense category to handle this and the amount is typically a percentage of overall spending. The approach has worked well, and has helped clients avoid having to figure out how they’re going to fit dental work or home repair or some other one-time expense into their carefully thought-out regular budget.
Handling the unexpected in a financial plan is a key part of what planners do. Given that plans often span decades, it isn’t unreasonable to think that external risks may well manifest themselves at some point. Without a plan to address them, they can undo years of discipline and work that is the foundation of a successful financial plan.
Micah Porter, CFP®, CFA is a financial advisor in Decatur (Atlanta). Feel free to contact him with questions related to this post.