How much buffer do you need? (Or: four things I agonise over when providing financial advice)

Sonnie Bailey

12 July 2019

I have clients worth tens of thousands of dollars, and clients worth tens of millions of dollars. I find it much easier to advise clients with millions rather than thousands.

First up, I’ll admit to sampling bias, which impacts this blog and my world view in general. For the most part, my clients and the people in my personal orbit are in a good financial position.

In most of the reports I prepare for clients, I’m able to use the words “You’re in an enviable position compared to most Kiwis, especially at your age and stage”.

In fact, most of the time, my discussions are oriented towards asking clients why they don’t spend more, rather than encouraging them to save more.

As a general rule: the wealthier the client, the easier it is to provide investment advice.

(Which flies in the face of what most advisers in the past have told me, in part rationalising why they charge asset-based fees which are calculated as a percentage of their clients’ investment portfolios. But I digress.)

The reason for this is because, in my view, clients don’t just want advice on how to invest their money.

We want to know that we’re going to be okay. Specifically, we want to know if we’re going to be able to support a reasonable quality of life over the course of our lives, no matter what happens.

With very wealthy clients, it’s easier to give them that assurance.

The wealthier you are, the bigger your buffer in case things don’t go to plan.

It’s one of the reasons I spend so much time working on “flawcasts” for my clients, and tailoring them to their specific circumstances. It gives them a sense of their financial trajectory and helps answer this important question as to whether they’ll be okay.

(For some clients, I may only have half a dozen variables on the spreadsheet I prepare for them. For others, I might have up to two dozen variables. For the flawcast I’ve prepared for my wife and myself, I’m up to 26 variables – and yes, some variables relate to when I buy a Porsche Cayman and how much I pay for it; it also includes the timing and cost of major renovations for our home; and even the prospect of buying a bach (and selling it at some point during our retirement: that’s a topic for another day). But I digress.)

I AGONISE over these flawcasts. Part of my patter with clients is to specifically state that “the only guarantee I can give is that these flawcasts WILL be wrong“.

Below is standard text in my reports, when I discuss my clients’ financial trajectory:

“In this section of your report, I will try to make some forecasts – or more accurately, “flawcasts” about your financial future.

One caveat in terms of making forecasts: It’s impossible to make precise predictions about the  future, especially the distant future. For example, we can’t:

  • predict what will happen with your health and how long you’ll live;
  • accurately predict what returns you’ll generate from your investments [as I discuss elsewhere];
  • predict changes to Government policy which might have a significant financial impact  (including, for example, policy relating to NZ Super over the long-run); or
  • predict social, technological, economic, environmental, and political changes that might have profound implications on our way of life over the course of decades.

And of course, there are always “unknown unknowns”.

We can make “best guesses”. But that’s all they are: guesses. (Or: flawcasts.)

The only thing we can guarantee when it comes to these guesses is that they’ll be wrong.

However, they are valuable in terms of providing some context for the investment and lifestyle  decisions you might make in the foreseeable future. It provides a valuable backdrop for the advice in this report.”

I reiterate these disclaimers at the end of the flawcasting section, in case I haven’t made myself clear enough. I repeat it during our conversations.

But even with these disclaimers, I agonise over this flawcasting process.

I think it’s an essential part of my advice process. It’s one thing to look at someone’s financial position as it stands now. But I don’t think I can provide appropriate advice without trying to look at their financial situation within the broader context of their financial trajectory.

Even if I can’t predict their trajectory in exact detail.

Because if you’re keen reader of this blog, you’ll know that I’m not a strong believer in crystal balls. (See my writing on: Future babble. Or Are we on the road to ruin. Or The folly of predicting market downturns. Or any one of a dozen or more other articles that touch on this point; it’s a major theme in my worldview and why this blog is about wealth and risk – or to put it another way, uncertainty.)

One of the things I agonise over is what level of buffer is necessary when preparing a financial plan.

Part of this comes down to my determination that my advice doesn’t end up being a personal Rorschach test (where I project my own values and priorities onto my clients).

(A confounding challenge is that the majority of my clients seem to have similar values and priorities to me, which is why they reach out to me – it’s hard to work out where the line is.)

(I’ve also wanted to refer to this article by Scott Alexander titled “Different worlds” for a couple of years now – so here’s an excerpt which is at least tangentially relevant:

“People self-select into bubbles along all sorts of axes. Some of these bubbles are obvious and easy to explain, like rich people mostly meeting other rich people at the country club. Others are more mysterious, like how some non-programmer ends up with mostly programmer friends. Still others are horrible and completely outside comprehension, like someone who tries very hard to avoid abusers but ends up in multiple abusive relationships anyway. Even for two people living in the same country, city, and neighborhood, they can have a “society” made up of very different types of people.”

Read the article!)

Part of the reason I agonise over flawcasts also comes down to the fact that I’m quite far down the “agreeable” spectrum (in the context of the “big five” personality traits). Which is good in some respects – I seem to be good at maintaining long-term relationships, and not burning bridges. But it’s challenging in other respects, because I don’t enjoy conflict, even when it’s necessary, and I can find myself spending a lot of time and emotional energy trying to work out ways to “frame” challenging topics that might elicit negative responses. (Ultimately, this ability to frame things is probably an adaptive trait, and it’s good in the sense that prevention is often better than a cure. It’s probably why I’m good at being a devil’s avocado (advocate). But it can also be tiring – for myself and others.)

Changing variables can have an enormous impact on long-term outcomes. I was recently working with some clients with about $10 million in investment assets, and even with a portfolio of that size, you can make assumptions that will make them second-guess themselves about their financial security.

Is there a degree to which I play with variables to get the outcome I want, and my clients will want? I’m confident I don’t. But I’m constantly second-guessing myself.

Anyway. I digress again.

Specific scenarios I agonise over

Health issues

If I make standard assumptions over the course of someone’s lifetime – such as steady income, savings rate, and relatively steady expenditure – then I’m not factoring in the impact of major health issues.

If someone has a major health issue during their working life, it means they might not be able to generate an income. (Their partner may also have to reduce their income as they need to accommodate to the illness and its fallout on their household.)

Whether or not someone is working, a major health issue might increase their expenditure, as they incur additional costs associated with the fallout on their lives.

Some things can offset the negative financial impact. To be really morbid, if it is a major health issue, it might reduce your longevity, and this might reduce the time frame you need to support yourself with the capital you have.

Alternatively, insurance can go a long way towards dealing with these scenarios. For example, income protection insurance can help make up for some portion of lost income. Trauma insurance can provide a lump sum to cover additional costs and provide some buffer.

Whether these insurances will be enough are hard to predict ahead of time because it will really come down to the diagnosis, your situation, and Government support you receive.

How much buffer do you need to accommodate potential health issues?

Without a crystal ball, I don’t have an answer.

Relationship breakdowns

I have a number of clients who are going through the process of adapting to a “new normal” after separating from a partner of many years.

In some ways these clients are easier to advise, at least from a technical perspective. (Having said this, it involves more emotional and social skills, and an ability to communicate effectively and tactfully.) One of the big question marks – the possibility of separation – is known. They’ve already suffered the “worst” (in the sense that they’ve often lost roughly half of their previous combined level of wealth). On top of this, there’s even potential upside at some point in the future – of entering into a relationship with someone else who is financially secure, which might make their cost of living lower and improve their financial situation substantially.

When preparing a financial plan for a couple, should I explicitly plan around the possibility of a separation?

Because we all know the probabilities. The divorce rate is higher than we would like to admit.

If someone came to you for advice, and there was an event that impacted, say, 40% of people you advised, you might want to plan for this possibility.

(I’d like to think that people who come to an adviser for advice might have a lower probability of separation than the general population in the first place – because they have a willingness and ability to discuss financial matters in a reasonable way. And I’d really like to think that for the sample of people who come to me the probability is even lower – a la Scott Alexander’s “Different worlds” article. And I’d really, really, really love to think that my advice process might improve relationship quality and the likelihood people will stay together and improve their relationship. But who knows?)

I’m still unsure of this. I usually mention this as an aside, for clients to consider or discuss further if they want.

Sometimes I touch on this in the context of considering the potential implications if one client passes away before another (which might reduce expenditure but might also reduce household entitlement to NZ Super, for instance).

And: If you plan on the basis that a separation is possible, does this make a separation more likely? Not only because you’re opening the door for this – but also because you have to accumulate substantially more wealth, which means you might have less time and emotional energy to focus on maintaining and cultivating your relationship in the first place?

Should you include a buffer for this possibility? I don’t think there’s a right or wrong answer, and there’s a lot of room for good faith debate on the matter.

Career twists and turns

When flawcasting someone’s financial future, I have to make assumptions about their future income. But realistically, no one can predict the exact twists and turns of their professional life.

My wife and I have variable incomes, for example. I couldn’t predict to the nearest $50,000 or more what our household income will be in any given year. I honestly don’t know what our net worth will end up being – to the nearest $1 or $2 million. We might be an extreme example. But it’s true for most people.

What will you be doing professionally in five years time? How do you perceive the stability of your income?

Might you take one step back to take two steps forward?

Might your career be impacted by automation, as software eats the world, turning labour into capital?

Will you be able to – and want to – work into your eighties, or will “retirement” be a euphemism for displacement from the workforce?

I circle around these topics, and discuss them with clients. But to what extent can we really predict these things, and to what extent do we need to build in a buffer?

Sequencing risk

I can’t predict the future any more than anyone else can.

As I’ve discussed elsewhere on this blog (ad nauseum),can predict that a downturn is coming. But I can’t tell you the timing of the downturn, its magnitude, and how long it will take before a recovery occurs.

The prospect of recommending that a client switch from a defensive investment approach to a significantly more aggressive approach, always terrifies me. Because there’s always a prospect of a significant downturn immediately after they follow my advice.

This possibility is referred to as “sequencing risk”. It may seem like you’re on the right track to achieve your financial goals, but the wrong downturn at the wrong time can significantly impact this.

(Think of it in Bayesian terms: you might have, say, a 95% likelihood of your capital surviving until you hit the age of 100 (as measured by historical back-testing and/or a Monte Carlo analysis – preferably both, as both has their own unique advantages and disadvantages). A 95% probability is pretty good, for reasons I will probably discuss another time. If you retire into a couple of excellent years of market returns and all of your other assumptions stay the same, your likelihood may rise to, say, 98% or 99%. But if your first year of retirement coincides with a major market downturn, this probability might reduce substantially and it may be necessary to recalibrate your expectations and make different decisions. (In much the same way that a couple of unexpectedly good or bad overs in a cricket match can completely turn the tables.)

(For what it’s worth, even if this happens, this doesn’t stop the advice from being appropriate. A financial plan should be based on YOUR circumstances, needs, and objectives, after all.)

There are various ways of addressing this. For example:

  • I tend to recommend that clients shift into a more aggressive asset allocation gradually, over time. As I explain, the most likely scenario is that they’ll end up in a slightly worse position. But a possible scenario is that it will stop from being in a worse position if you experience a downturn – which can be bad for all sorts of reasons (including impacting your relationship to investing, which might make you too conservative over the long-run, which is often worse than short-term volatility).
  • I emphasise the importance of investing according to your cash flow needs. When I calculate a suitable asset allocation, I usually use a “bucket strategy” approach, which emphasises the importance of cash flow needs. This tends to help deal with market volatility. When you know a decent portion of your investment assets are earmarked for decades into the future, you can feel a lot more confident about your financial future in light of the ebbs and flows of the market.

Scenario testing, stress testing, and resilience

The reason I provide most of my clients with a “flawcasting” spreadsheet is because it makes them aware of the trade-offs involved with their immediate decisions. It also makes it clear that their long-term outcomes are extremely sensitive to certain variables.

It enables clients to go through something resembling a “stress testing” exercise, as they test out different scenarios, and see the impact of certain events and decisions on their long-term outcomes.

This feeds into one of my reasons for being sceptical about being too specific about goals and targets. Having a goal of a mortgage-free home and $1 million in investment assets by age 65 might be all well and good. But it’s often more important to make sure you’re going in the right direction – and that you have some degree of resilience to deal with the worst, as well as an ability to take advantage of opportunities, without getting too attached to a precise outcome.

I’m not a fan of aiming towards one specific figure – but instead I prefer flexibility and being adaptable and making sure you live a wealthy life by your own personal definition.

There is a financial aspect to this. Having a financial buffer is important. There’s room for good faith debate and discussion about the level of buffer that’s suitable for someone in light of the risks I’ve mentioned, and more.

Different people have different philosophies and risk tolerances, and these are embedded into their own broader circumstances, which means that the buffer that’s suitable for one person will be different to the buffer suitable for someone else.

I’ll finish up by adding: having a financial buffer isn’t the only type of buffer you can have. For example, being resourceful can be just as important as having a financial buffer.

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