Investment Planning

Capital Sufficiency

Capital sufficiency (or capital needs) analysis enables private wealth managers to determine the likelihood of their clients being able to meet their financial objectives. This analysis can be performed using deterministic forecasting and Monte Carlo simulation.

Portfolio growth in a deterministic model occurs in a “straight-line” manner. When using this approach, the wealth manager needs to establish the following inputs:

  • Current value of the investment portfolio.
  • Investment horizon.
  • Annual return assumption (this should be based on forward-looking capital market assumptions rather than the simplistic use of historical returns).
  • Contributions into the portfolio and cash flows out of the portfolio over the investment horizon.
  • Impact of taxes, inflation, and investment management fees.

While deterministic forecasting is easy to understand and implement, its main disadvantage is that the use of a single return assumption is not representative of the actual market volatility.

Monte Carlo simulation allows a wealth manager to model the uncertainty of several key variables and, therefore, the uncertainty or variability in the future outcome. Monte Carlo simulation generates random outcomes according to assumed probability distributions for these key variables.

Instead of assuming linear portfolio growth, Monte Carlo simulation would assume a simple average return and a standard deviation of year-to-year returns for the portfolio. The portfolio’s expected rate of return in a given year is determined randomly from this predefined distribution of possible returns.

Monte Carlo simulation generates a large number of independent “trials,” each of which represents one potential outcome for the client’s investment horizon. By aggregating the outcomes of these various trials, the wealth manager is able to draw conclusions about the probability that the client will reach his or her objectives. It should be noted that such conclusions are sensitive to underlying assumptions, which may be subjective in nature.

Wealth managers tend to use a 75%–90% probability of success as a rule of thumb when advising private clients.

When the probability of success falls below an acceptable range, potential solutions include the following:

  • Increasing the amount of contributions toward a goal
  • Reducing the goal amount
  • Delaying the timing of a goal
  • Adopting an investment strategy with higher expected returns

Retirement Planning

Private wealth managers work with their clients to establish how much they should save toward their financial goals and to determine when they will be financially able to retire.

An overview of the following financial stages of life provides some context:

Education –  The private client gains knowledge and skills through formal and informal education and apprenticeships. The emphasis in this stage of life is on developing human capital rather than saving for retirement.

Early career – The individual enters the workforce, often starts a family, and assumes other personal responsibilities. Saving for retirement usually begins at this stage, although there are many other competing financial goals.

Career development – After becoming established in a career, job skills can continue to expand and upward mobility increases. Financial obligations often increase to fund the college education of children.

Peak accumulation – Financial capital accumulation is typically greatest in the decade before retirement as human capital is converted into financial capital. Earnings and the need to accumulate funds for retirement are high. The private client also reduces liabilities, such as mortgage debt.

Pre-retirement – Emphasis continues to be on accumulating financial capital for retirement and reducing liabilities.

Early retirement – Private clients depend on cash flows from pension income and their investment portfolio to fund their retirement lifestyle.

Late retirement – Expenses on leisure activities generally decrease, but uninsured health care expenses could increase, putting more pressure on financial resources.

A private client’s retirement goals can be analyzed using mortality tables, annuities, and Monte Carlo simulation.

Mortality tables. A mortality table shows life expectancy for an individual at different ages and enables a private wealth manager to determine the probability that a client will survive to a given age.

Annuities can be used to analyze a client’s retirement goals. A relatively simple way of calculating the present value of a client’s desired retirement spending is by pricing an annuity. Annuities provide a series of fixed payments, either for life or for a specified period, in exchange for a lump sum payment.

Monte Carlo simulation can also be used to analyze a client’s retirement goals. One advantage of Monte Carlo simulation is its applicability to the client’s actual asset allocation. Monte Carlo simulation can be used to analyze the likelihood that the client’s actual portfolio will meet anticipated retirement needs.

Behavioral considerations are relevant to retired clients and/or retirement planning. The following are some examples:

  • Heightened loss aversion. Some studies suggest that retirees are much more loss-averse than younger investors.
  • Consumption gaps. Due to loss aversion and uncertainty about future financial needs, many retirees spend less than economists would predict, resulting in a gap between actual and potential consumption.
  • The annuity puzzle. While annuities can help to mitigate longevity risk and, in some cases, may improve the probability of retirees meeting their spending objectives, individuals tend not to prefer to invest in annuities.
  • Preference for investment income over capital appreciation. Behavioral economists have noted that individuals distinguish between income and capital when making spending choices.

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