An Asset Manager Embraces Financial Planning

I have been investing other people’s money for over 36 years. As most of my clients are either saving for retirement or living off of their retirement savings and/or trust accounts, my overriding goal has been to build durable, income-producing portfolios that will enable my clients to live off of the income from their investments during the entire “withdrawal phase” of their lives, and hopefully have something left to pass on to future generations. I have the same goals for my own investment portfolio.

Our investment philosophy has focused on investing in expanding businesses which are led by good management teams who maintain strong balance sheets. We have a preference for dividend payers and dividend growers. Despite periods of financial and economic turbulence, our investment portfolios have proved rather resilient and have served their purpose. For many of our clients, especially those whose withdrawals have been in line with the returns produced by their portfolios, the investment portfolios have supported them through their retirement or period of withdrawals, often leaving much of the remainder available for the next generation.

Given my personal experience of witnessing decent historical returns, I probably should have plenty of optimism as I peer into the future and plan to start living – at least in part – off of savings in the next 10 plus years. However, many industry experts believe that stock and bond returns may be lower over the next decade or two compared to historical averages. Volatility could increase as well. Lower expected returns and heightened volatility could have an adverse impact on people planning their retirements. I sense a greater level of concern from investors these days about planning for the future based on historical average return assumptions.

Investors have always had to endure economic and financial issues that adversely impact their returns and thus their standard of living. In the past, such issues have included periods of accelerated inflation which reduced the purchasing power of their investment income. At other times, these issues have involved the collapse of prices of housing and financial assets. Currently, we are witnessing bonds with negative interest rates, coupled with explosive growth in the cost of health care and education. We are also faced with local, state and federal government taxing authorities taking a bigger share of our wallets. Add to that a rise in violent crime, a breakdown of respect for “authority,” and the spread of terrorism around the world. These factors, coupled with stock valuations currently trading above historical averages, all lead to investor anxiety and a concern that returns from our investment assets may vary widely from the mean, and not match the average returns we have enjoyed in the past.

If we assume that portfolio returns in the future might be lower on average and more volatile, what can a beleaguered investor do to have greater confidence that their retirement years will be free of financial stress? Rather than fly blindly into retirement, investors need to get the facts and have a plan that maps an achievable path to success, identifies the changes or strategies that may need to be implemented, and lets them monitor how they are doing.

When I am asked to look at household budgets of clients entering retirement, I sometimes see a level of expenses that can only be sustained if returns match the higher historical returns of the past 20 years. If we are not confident that we can rely on historical return assumptions to estimate our income as we contemplate retirement, it is important to perform a deep dive analysis on the expense side of the equation. Managing expenses is where the rubber meets the road for most households.

Ten years ago, risk-free money market funds yielded 5%. In those days, you could comfortably assume that your financial assets invested in a moderate to moderateaggressive risk portfolio could generate 8-10% over extended periods of time. These days, risk-free money market funds are yielding barely above zero. It’s no surprise that returns on risker assets are also correspondingly lower. With potentially reduced expected income, there is a greater need to be more precise with estimated expenses.

For most of my career, my role as an investment advisor was that of an “asset manager,” and my focus was on the underlying securities that comprised a portfolio. I strongly believed (and still do) that investing in the public markets over long periods of time is the best way to save and grow financial assets. Assuming client withdrawals are “reasonable,” (4% of the portfolio value annually has long been considered a “safe” withdrawal rate), building portfolios with high quality securities was pretty much all that was necessary to achieve financial success in retirement. Basically, as an asset manager, my role has been to focus on the Balance Sheet of our clients. The household Balance Sheet is, in my view, primarily comprised of investment and retirement portfolios. I exclude residential real estate because even though it might be an asset, it is a personal-use asset with negative cash flow. Thanks to decent historical returns, investors nearing retirement could safely rely on their Balance Sheet to produce the funds necessary to finance retirement.

Recently, however, I have been giving greater attention to the Cash Flow statements of our clients. The household Cash Flow statement is a report that details the income (inflows) and expenses (outflows) that annually flow through a family budget. Perhaps due in part to interest rates being so low, and perhaps due in other part to household expenses rising at a greater rate than income, I am seeing a greater need to assist clients with their cash flow analysis than ever before. I have come to embrace that we asset managers need to understand the household budgets of our clients as we are crafting investment portfolios.

Financial planning tools are now available to help investors answer the question of how much they need to save for retirement, and as they near retirement, how likely it is that the income from their retirement assets will allow them to maintain their lifestyle and household budget. Our own financial planning software aggregates all of the financial assets, sources of income, and budgeted expenses into a report that sheds light on how long the assets will last based on current expenses and historical asset returns. We can modify all of these inputs to see how the plan might change as we change the assumed rates of returns and estimated withdrawals. We can even “stress test” the plan with a Monte Carlo analysis that calculates the likelihood of success based on thousands of different return environments.

By performing this in-depth analysis, we can make better decisions about the investment choices that fall within our clients’ tolerance for risk, and recommend expense controls that will yield a higher chance of success in retirement within various return assumption environments. Because all the information is stored online and is accessible through a web browser, the plan can be reviewed and updated periodically to keep up with changes in asset returns and budget assumptions. I personally have my own Balance Sheet, Cash Flow, and projected household budget organized in such a dynamic “living” plan, and it gives me great comfort to monitor my progress and know the “levers” available to me to keep me on track.

When performing retirement planning analyses, we no longer concentrate exclusively on client portfolios. We now take into consideration client income and expenses since the household budget might influence not only how we build investment portfolios, but how clients manage their withdrawals. With the use of financial planning software, investors can now have a much better understanding of where they stand as they seek to define and fulfill their savings and spending goals.