Financial planning gone wild

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Yesterday I wrote a piece about the upside of good planning. I wrote about the powerful psychological effects a formal financial plan can have on a client. Well, I slept on it and completely changed my mind!

I think if you throw darts into the financial section of the WSJ you have a better chance of putting together an investment portfolio that works for the long haul. Just kidding, joke joke haha.

If you’ve been reading CFTPM, then you know by now that I’m a huge believer in the planning process. But my objective here is not to paint this overly rosy picture of how financial planning is the answer to all of life’s mysteries. My objective is to tell it like I see it and share some insights based on my experiences.

Which got me thinking about the downside to poor planning. So I racked my brain and decided to share one of the few negative experiences that I can remember. But before I go on I think it’s important to reiterate that the benefits of planning far far outweigh the drawbacks. With that said, it’s also fair to say that there is always room for abuses no matter how good something is.

Plan assumptions

There are a lot of assumptions that go into a formal financial plan. Often you’re modeling scenarios for a client that can span the course of 30 years or more and the engine that powers the plan (more often than not) is the client’s investment portfolio. Here’s a list of some typical investment rate assumptions you might find in a financial plan:

• Inflation- 3%
• Cash- 3.8%
• Tax Free Bonds- 5%
• Taxable Bonds- 6.5%
• Equities- 8%*

* the S&P 500 Index ( a widely used barometer for stock performance) has averaged close to 11% a year since its inception in 1926

A financial plan is chock full of quantitative information that you’ve gathered in step 2 of the planning process, like the size and style of a clients investment portfolio. For example, a clients’ investment portfolio may consist of $200,000 in equity mutual funds and $100,000 in taxable bonds.

So using the above ‘assumed’ rates of return, the planning software will model the future value of those investments and see where we stand in relation to the clients’ stated goals. Now I’ve oversimplified the planning process for the sake of making a point and tying it into my story.

Unrealistic assumptions

It’s very easy to go in and change the ‘assumed’ rates to something unrealistic. Changing the assumed rate of return by 2% (over a 30 year period) can have a profound effect on the outcome of a financial plan; i.e. raising the assumed equity rate from 8% to 10%.

Right around the time of Y2K it was not unusual to come across stocks and equity mutual funds that had average annual returns of 20% throughout the decade of the 1990’s. These kind of dizzying returns had a gluttonous effect on many people including some financial advisors. People were no longer worried about protecting against downside risk and maintaining balanced portfolios; they were positioning themselves very aggressively.

A sad story

I inherited a new client in the fall of 2002 (this client had had their first financial plan performed in 2000 by another planner who left the business in the summer of 2002). By this point the markets had turned and the S&P index was into its third down year in a row and the Nasdaq was just plain awful.

The client’s asset base was down significantly from their starting point in 2000 and it took me quite a while to gain their trust; in fact, when I first got involved they wanted to throw in the towel and quit the markets all together.

One of the first things I did was ask to see their financial plan and what I saw shocked me. The previous planner had helped them to dream up all these unrealistic goals (i.e. retiring within 3 years, buying a lavish mansion overseas, showing them around the world trip brochures etc.)

Abuse of power

The reason the financial plan could support the goals that the planner dreamed up for these client’s was because he was using an assumed annual rate of return for equities of 16% +.

The euphoric market returns of the previous decade had gone to his head and it seemed to me like he developed a godlike complex. He projected his own fantastical goals onto the clients and used the financial plan as his accomplice… a very dangerous combination.

I think you can see why these clients were shell shocked and why the planner left the business and moved far far away from NY. A financial plan is a wonderful tool when used properly, which is the overwhelming majority of the time, but like anything else in the wrong hands it can be misused.

This planning disaster had all the ingredients for the perfect storm: a new client, irresponsible ego maniac advisor, scant diversification, unreasonable assumptions, peaking market and plain bad luck, just to name a few.

The client will never fully recover from the first “financial planning” impression they had, it left a bad taste in their mouth. Inheriting that client was like adopting an abused pet from the animal shelter. Everything had to be re-learned, it was hard to get close to them, trust had to be re-established in the planner (me) and the process.

Well we redid the plan completely, reassessed the goals, plotted a new course and things have improved considerably. In the end, these days they are happy to have a more realistic financial plan as their guide and see the merits of it.

So the morals of the story are:

1. Make sure to have checks and balances. A formal financial plan is like a high quality automobile but you can run into problems if the driver is irresponsible;
2. The plan needs to be monitored (step 6 of the process) periodically, constantly gauging the progress being made towards achieving the client’s objectives, insuring against the car swerving off the road.
3. Always make sure the plan assumptions are in line with reasonably conservative historical return rates. There’s no reason to drive 90 mph when you know driving 55 mph will get you to your destination in plenty of time.

Tags: Financial Planning Retirement and Now!, Psychology Behind Financial Planning