Executive Summary
It is a common financial planning challenge: just how much time and effort should be spent trying to make the numbers in your financial planning projections as precise as possible? How much research should you put into refining the growth rate assumption for each asset in the portfolio? And its volatility? And its correlation? What about client spending? Should we build a detailed cash flow for retirement, year by year, or is it sufficient to just provide a rough guesstimate of how much money will go towards retirement outflows? Many planners have a strong tendency to fine-tune these numbers and make them as precise as possible, but that in turn begs the question... in a world where the future itself is so uncertain, are the results really more accurate, or is an effort for greater precision just an exercise in futility?
The inspiration for today's blog post comes from a great conversation I had with David Jacobs, a financial planner, great thinker, and owner of Pathfinder Financial Services in Kailua, Hawaii. In our conversation, an extension of a discussion about my recent blog post on a plan's sensitivity to its assumptions, David highlighted a great point that I too have spent a lot of time thinking about: we spend a great deal of time and effort trying to make our projections as precise as possible, and to model the uncertainty of markets (e.g., Monte Carlo) as effectively as possible... yet we seem to give short shrift to the fact that our long-term income and cash flow assumptions are so radically uncertain - and high impact - in the first place.
In essence, what we're talking about here is the difference between precision, and accuracy. A measurement could be done very precisely - spending is estimated through a comprehensive process that determines anticipated spending down to the last dollar and cent - but that does not necessarily mean it will be an accurate reflection of reality.
For example, I may expend a great deal of effort trying to determine whether my client's current employment income of $60,000/year should be increased at an inflation rate of 3% or 3.5%, because I want to be precise in determining how much future income will be available to save and invest; in 20 years, 3% inflation results in $108,367 of nominal income, but 3.5% inflation leads to $119,387 of income. If I'm trying to determine how much my client can save in the future, that $11,020 difference in available income is really important, so I want to be as precise as possible!
However, if it turns out that next year my client gets a significant promotion and her income jumps to $82,000/year, the numbers I just spent a lot of time analyzing will be completely wrong! Whether I enter 3% or 3.5% inflation for the remaining 19 years, my client will actually have future income between $143,788 and $153,800 now! I may have expended a lot of effort ensuring that my inflation estimate was precise - down to the last dollar - yet the entire projection was horribly inaccurate because of a change in the client's base income due to circumstances beyond the inflation projection. In other words, I focused on the $11,020 impact of a 0.5% difference in inflation over 20 years, and in the process missed the $35,000+ impact of my client getting a job promotion next year!
So what is a planner to do? Should planners delve into the deep details of a client's cash inflows and outflows? Should retirement spending projections be built from the bottom up, estimating a precise cost for each anticipated expenditure, year by year? Or is it sufficient to just make a rough top-down estimate of about how much cash flow goes towards spending, and focus on other details? Should we eschew the detail of the last 0.5% difference in inflation as shown above, because its impact is trivialized by a material job promotion at any point during the next 20 years anyway?
Without a doubt, it's a difficult balance to strike, and the above example is a good case in point. Although the impact of a job promotion far outweighed the last 0.5% swing in inflation, it is nonetheless still true that the 0.5% inflation difference would likely be material relative to the client's overall plan. It was still a difference of nearly 10%/year in nominal income in the future that could be directed towards savings. And this is true for many of the assumptions for financial planning, where small deviations can have significant impacts because they are compounded over so many years. So I don't think that means we can or should just completely ignore the finer points of financial planning projections and accept less precise results because we're afraid a change in circumstances will make them inaccurate anyway. But we probably should be more cognizant of what factors deserve a lot of time - because they have a material impact -and what deserve less time, because they're likely overwhelmed by other changes. To say the least, as the example above highlights, maybe we need to spend more time looking at the trajectory of our clients' career paths and potential earnings, rather than just focusing on the growth rate of their income in a steady straight line.
So what do you think? Have you been focusing on the precision of your projections when in reality it may contribute little to their ultimate accuracy? Do you have any thresholds you apply where you decide a difference isn't material enough to count because the "extra precision" isn't necessary?
Michael et al: Just as a planner must not get to caught up in the “right” asset allocation, “right” cost of college, and “right” of anything, the same is true of inputs. Yes, one wants to be precise with the inputs to avoid as much as possible the concept of “garbage in, garbage out”. Even when the inputs are as accurate as possible, the planner needs to be careful not to create either false hopes, or the dashing of dreams. Things change. The plan is not a static document. Financial planning is a dynamic process and that is one of the many reasons that financial plans need to be updated from time to time. If the planner assumes it is static, then having absolutely, positively the most accurate inputs possible with all of the best assumptions one can make given the current conditions and facts and circumstances makes it worthwhile to overdo the time and effort that comes with this approach. On the other hand, if it dynamic process and the plan is constantly refined, then being somewhat “wrong” with the initial projections in twenty years shouldn’t be a big deal. Explain all of this to the client. Help them to understand the process as much as the plan. Concentrate on the big stuff like saving money for the various goals, not overspending, developing a sound investment plan, having the client understand the values around money, etc. are far more important than worrying too much about the inputs which will change, for better or worse, in the future. As a financial planner, you should enbrace the financial planning process and not the finite details of a plan that are going to be unknown.
The investment process should be about probabilities and sensitivities, not false precision, yet most of the investment business is build around single-point forecasts.
Easy answers make for easy sales, but the complexity of markets will continue to make for disappointed and disillusioned clients if they have been fed simplicity.
I don’t think it is valuable to spend too much time on the details, particularly as you start to project far into the future. (On the contrary, accounting for every dollar in the current budget to help increase savings today is very useful).
The whole financial planning/projecting process has a sizeable systemic error. After all, the only thing I can pretty much guarantee you about interest rates, market returns, inflation etc. over the next 20-30 years is that whatever you think it will be, it will be something different. As Michael pointed out, evena 0.5% difference in an inflation rate can be material. Now imagine your market returns and inflation both also vary 0.5% from your input levels. Now your original projections are completely off and whatever precision you included in spending projects has been completely overwhelmed.
Now, since you are essentially guaranteed not to have accurate inputs, as nobody can predict things like market returns, interest rates, and inflation with any reliability, we are left with substantial uncertainty in every plan we do. It seems to make sense not to focus too much on things whose impact will be less than that overall uncertainty.
This uncertainty also suggests an important best practice – review financial plans and projections frequently (annually at least, although I would also suggest redoing the whole process from scratch every 3-5 years). If everything went as you planned, great, but if it didn’t (the more likely scenario) you can make whatever changes to address the new situation and chart an action plan that will take the client through – not to retirement, but to the next review.
Agree with M Sherman that we need to keep perspective regarding long term plans. It’s an ongoing process that requires annual updates and planning for a broad range of outcomes. No one predicts the future with any accuracy even a couple of years down the road.
Back to the broader question of input accuracy, though, I’d recommend simple sensitivity analysis. What would happen to the plan if we changed the inflation assumption by +/- 2% or the income assumptions by $20K? This not only tells the planner where to spend his time honing inputs, it tells the planner and the client how important each assumption s.
Michael, I think our profession, when well-executed, is a combination of science and art. Inputs should be based on a combination of history, current conditions, and the assumptions of both planner and client. No matter what you use for your inputs, the client should be aware that whatever the output indicates will not happen. It’s an estimate, reasonable and educated, but still an estimate. As time passes, reviewing and adjusting the assumptions is very necessary based on what actually occurs.
Great post!