To refresh your memory, the diagram below depicts the goals based planning (GBP) process.

As you can see, GBP is a collaborative and iterative process designing to help client’s design their lifestyle plan based on striking a combination of tradeoffs that are right for them.

The levers available to them in designing their plan include:

• What they are spending on day to day living costs (and the savings that may or may not result)
• Lifestyle spending on their planned big ticket items such as cars, holidays and the children’s school fees
• Their planned retirement age
• Their existing asset base
• The investment returns they generate.

Many of you will immediately think to yourself…hey…wait a minute…where is the clients risk tolerance?

Well spotted if you did…back to school if you didn’t.

As stated earlier, the GBP process STARTS by getting the client to design their lifestyle plan representing as it does the combination of tradeoffs that suit them and their circumstances.

Once this plan is agreed, the planner needs to then stress test it for the client by showing them where their lifestyle plan might end up if they invested in accordance with their risk tolerance.  This stress testing often leads to what I call the client’s investment risk gap.  Identifying this gap and getting the client to take responsibility for it is absolutely pivotal to the GBP process and to protecting advisers in the new FoFA world.

The investment risk gap is explained in more detail later in the article.
GBP in action
Now, for many clients, the single greatest value you can provide them with in the early stages of your relationship with them happens NEXT.

Without going into too much detail regarding their current circumstances, the 1st cut of the lifestyle plan for Dick and Dora appears below. This projection is based on an annual living cost today of $75k ($70k pa in retirement), almost no annual savings, retiring at age 60 and earning inflation plus 1% from their asset base.  Let’s call these items their benchmarks.

As you can see, Dick and Dora are heading for a crisis with their funds estimated to last only until age 79.

Why is this a crisis?…because the longest average life expectancy for this couple is Dora’s at age 85.  Based on her life expectancy, she has a 10% chance of living beyond age 96.

So the prudent planning objective for them is to plan to have their funds last to at least their 1st goal post (Dora’s life expectancy).  And in order to build some safety margin into the plan, aiming to get their assets to fund them as close to their 2nd goal post as possible (or even slightly beyond) would make sense.
Now for the tradeoffs
With the right modeling tool at hand you can now walk Dick and Dora through an iterative process that helps them to understand the relative impact of changing one or all of their benchmarks in a way that makes sense to them.

For the sake of brevity lets say that by reducing their current living cost by $100 per week and by $200 per week in retirement AND increasing the target returns on their investments to inflation plus 4% today and plus 3% in retirement AND delaying their retirement to age 62 respectively we get the following projections.

While these changes appear to achieve a terrific outcome for Dick and Dora, when they add the following plans into the mix, their projections unfortunately come crashing back to earth.

• A car replacement every 3 years at a  cost of $25k for each changeover
• A family holiday of $10k every 2 years for the next 30 years
• Uni fees for their daughter of $30k each year for 4 years starting in 5 years time.

The impact of these big ticket items is devastating with Dick and Dora losing around 21 years lifestyle funding.

Finally we can see that Dick and Dora can get their plan back on track by making the following adjustments:

• Reducing their annual living cost now and in retirement by a further $5k
• Delaying their retirement to age 65
• Reducing the cost and frequency of their car replacements.

Now apply their risk tolerance
With their 1st lifestyle plan agreed and the tradeoffs decided, their adviser then decides to stress to test their plan by recalculating it using a return target that corresponds to the lowest risk tolerance between Dick and Dora.  In my example Dick’s risk tolerance has been assessed as “low” which I attach a target return of just inflation plus 1% for this calculation.  This change produces the following projection.

‘
In the above example, this last graph shows in clear, unadulterated terms what I call the clients investment risk gap.

Put simply the clients investment risk gap occurs when a client’s target return (in combination with their other benchmarks) is higher than the target return associated with their lowest risk tolerance.

In my example, an investment risk gap exists because Dick and Dora are:

• Targeting a return of inflation plus 4% and 3% which helps fund them to age 95; which is higher than the
• Target return of inflation plus 1% which equates to their lowest risk tolerance.  Using their risk tolerance they might only fund their lifestyle to age 82.

By expressing the investment risk gap in years (13 years in this case), clients can instantly see the impact on their lifestyle should they decide to invest in accordance with their risk tolerance.

So…what to do about this gap you might ask?
Well there are really only too courses of action available to the client.

Firstly they can continue to trade off their lifestyle goals by reducing their living cost yet again or perhaps they could both agree to pay for their daughter’s books at uni but she might have to use the HECS system to fund her tuition.   Both these tradeoffs would enable Dick and Dora to reduce their target return to a number closer to their underlying risk tolerance.

Or…secondly…they could live with their investment risk gap.

Taking responsibility
If Dick and Dora still have an investment risk gap after making all the tradeoffs they are prepared to make, they must take responsibility for it.

In my world, I don’t even start to draft an SOA for a client until I have on file a signed declaration from the client stating that they:

• Know they have a gap
• Know what the gap is and why their gap exists
• Know the consequences of maintaining a gap; and that they
• Take responsibility for it.

Conclusion
In my view, a goals based planning process that incorporates a risk tolerance stress test is simply the most robust and sustainable process to attract, engage and retain long term fee based clients.

Over the last 30 years as an industry we have been guilty of selling at various times tax, super, Centrelink and investment arbitrage as the basis of our value proposition to our clients.

While all of these elements are critical to the overall financial planning process, GBP is real planning.   GBP helps the client to articulate WHAT THEY WANT to achieve as a result of their planning.  Investment strategy, tax, super and Centrelink planning reflect HOW WE IMPLEMENT their plan.

In my final article on the planning process for Adviser Voice, I’ll provide a detailed account of the staggering commercial consequences of uniformly adopting GBP across a planning business by calling upon my experiences at IPAC Securities back in the late 90s.

9 July 2012

The post Goals based planning – more than just a label appeared first on AdviserVoice.

AdviserVoice should be commended for resisting the current trend among the financial press to editorialise the content on the site, and for that reason alone, AdviserVoice deserves our support.

It’s the process stupid!
Forgive me for my “loose” use of the phrase used by the Clinton presidential campaign crew in 1993 (i.e…the economy stupid) to describe what I think is an absolute truth that can be applied to the financial planning industry.

When I received my first proper authority in 1985, I was taught that the financial planning “process” starts by asking the client what their attitude toward investment risk is. Armed with the clients answer, the planning process that followed was straight forward enough.

Now any thinking financial planner knows that this approach is fundamentally flawed.

In the first instance it clearly isn’t a process in the strict sense of the word. Processes generally contain feedback loops to continuously feed outcomes back into the process to check and verify results along the way. None of that exists in this straight line approach.

To put it bluntly, this “process” is nothing more than an expedited portfolio picking approach designed to get products in front of clients as quickly as possible.

The second flaw embedded in this approach is that few advisers actually do the detailed cash flow modelling required to work out whether the client’s risk decision is going to generate sufficient returns to fund the their lifestyle over the long term.

Failure to do this modelling was one of the deficiencies cited by ASIC following the recent shadow shopper trials.

Risk based decisions
Who in the industry…be they advisers, dealers, institutions or regulators…honestly and truly believe that a client can make an informed decision about their attitude toward investment risk following a 30 minute discussion with the planner and a questionnaire.

Following this discussion, how many clients really think to themselves…?

• Time not timing and diversification
• Two standard deviation measures of return based on rolling five year periods
• The relationships between risk, return and lifestyle funding.

The truth is almost none of them.

In my experience, when clients hear the word “risk” almost all of them think about the chance of losing their capital and it takes time, patience and repeated sessions and lessons before they gain a more sophisticated view of what risk really is.

From the client’s perspective, an approach that starts with an unknown…risk…and ends in an unknown…funding lifestyle…is simply doomed to fail and to ultimately play itself out in the courts with monotonous regularity.

Divergent risk tolerances
In addition to these fundamental problems, another flaw of the “straight line” risk approach relates to how advisers manage the very common situation where couple clients have divergent risk tolerances. See the diagram below.

And how do most advisers manage this situation? They recommend a compromised risk position. In the example above, lets say both partners are convinced to adopt inflation plus 3% as a compromise risk position.

In doing so, the adviser has now put themselves, their dealer and their business at risk!

How? In the first instance the adviser has recommended this risk position to the client rather than the client arriving at this decision by themselves, with the full knowledge of the impact this decision will have on their future.

When the client’s investments go pear shaped in the future and they decide to drag the adviser and their dealer into court, all they need to say is that they didn’t understand the risk.

Let me ask you…what evidence do most advisers have on file to present in court in defence of their assertion that any reasonable person should have understood the risks.  Remember, a defence based on a “buyer beware” argument is unlikely to succeed in an environment where the regulator and the courts are moving toward a fiduciary standard for the industry.

The other problem that emerges from adopting a compromise risk recommendation relates to the advisers business.

Often, the consequences of adopting a compromise recommendation are to all but guarantee that 50% of the adviser’s client base is going to be upset with them.

When markets move up, the more aggressive partner will be thinking to themselves “…if only they listened to me” we would be getting all these higher returns. When markets move down, the more conservative partner will be thinking to themselves “…if only they listened to me” we wouldn’t be suffering all these losses.

What’s the alternative?
As an absolute minimum, a robust financial planning process must have the following two elements.

Firstly it must have a feedback loop which enables clients to iteratively see the dynamic relationships that exist between:

• what they want out of life
• the return (and savings in some cases) needed to fund their plans
• the length of time they need their financial resources to last.

Secondly, the process has to get the client to understand the impact that their risk decision will have on these lifestyle outcomes…and to own this decision!

What I am referring to here is goals based planning process…an often referred to process, but one which is so often misunderstood.

In my next contribution, I will describe goals based planning in detail, explain how it deals with the shortcomings of a “straight line” risk based approach and then finally explore the legal, commercial and compliance benefits of using this process with your clients.

The post What’s in a name? appeared first on AdviserVoice.