It’s safest to underrate returns, overrate inflation

Recent market vicissitudes have proven that clients and their portfolios can be severely impacted by the twists and turns of economic circumstances. And I’m sure no advisor has been immune to the concerns of clients in the last 12 months; or exempt from the numerous handholding meetings.

As a fee-only financial advisor, I’m also registered as an investment counsellor and, therefore, clients who have investments through our programs receive an investment policy statement (IPS) replete with an established structure of the portfolio, ongoing asset mix and key risk elements. We provide fee-only personal financial planning services even to clients who don’t have portfolio assets, and in this context we have typically focused on very conservative rates of return for investment assets and an overall game plan that depends on steady long-term asset accumulation.

Preparing clients for bad news and the potential risks in their portfolios or financial circumstances provides the best buffer against the severe shock when the inevitable downturn does happen.

Many times when economic circumstances turn soft, advisors need to reinforce the need to handle the truth. The truth may well be that the portfolio is down 10% or 15% since the last quarter report but it also means the asset mix is tilted toward the more conservative side of the portfolio (likely the fixed income side in the most recent markets), which means rebalancing is required.

It’s tough to help clients understand how their portfolios fared against swooning indexes, and then go on to recommend that the very asset class (fixed income) that has been the salvation of the portfolio be trimmed back—and some of the funds reallocated to asset classes that did all the damage to the portfolio. Clearly, this is the correct thing to do. Portfolio management has shown us that when markets rebound, rebalanced portfolios recover significantly quicker than portfolios that haven’t been rebalanced.

The truth can certainly be painful.

For some near-retirement clients faced with recent markets the message has certainly been tough: With the viability of their pension income cash flow, and the value of their house, if they really want to achieve an effective retirement with cash flow that meets or exceeds their expenses, they may need to sell that house and downsize fairly soon. For a client contemplating early retirement, your job as an advisor might entail focusing the client on reality and telling him he can’t afford to make that change today.

On a more reassuring note, for clients depending on their portfolio for retirement income, the balance of the asset mix can help avoid selling equities at depressed prices. For example, if a client were withdrawing 4% to 5% of a portfolio for lifestyle expenses, having 40% of assets in fixed income would provide many years of value to fund these withdrawals—while equities are left to recover.

We have a duty to our clients to help them understand the truth and to handle that truth. As such, we cannot afford to be simply fair-weather advisors.

A Pollyanna attitude towards investment returns and pooh-poohing any aspects of risk is not doing your clients or you any favours. Communicate clearly and don’t gloss over the risk issue in the portfolio. Your services being provided should be set out very clearly in writing with your client. Any recommendations made should be made in writing to the client and documented at your end as well. And, keep all your meeting notes from discussions with all your clients.

It’s our duty to provide clients with the most effective advice, even if it involves delivering some tough messages: Such as the need to cut back on their lifestyle today in order to establish a more stable lifestyle in retirement.

I follow a six-step process which helps me reflect on other financial needs or goals. When clients are concerned about the value of their portfolios and engaged in cash-flow discussions, for example, we can focus on budgeting strategies, income tax management and income splitting techniques that could help determine alternative structures and maintain financial security.

Curbing Client Criticism

We are frequently faced with some argument or other about the extremely conservative assumptions we use on the rate of return and the rate of inflation. Recent market assumptions have used 7% as an excellent rate of return, but then these are highly unusual circumstances. We do, though, routinely argue against using more aggressive rates of return such as 10% or 12% when making long-term projections.

In similar vein, assuming 3% as the long-term rate of inflation seems rather high right now, but we find it’s generally best to be conservative on this particular assumption. But projections are just a guide and we need to help our clients understand that the safe approach is to underrate returns and overrate inflation. I’ve experienced the flipside of this structure and it’s dreadful: A financial plan showing an unfettered 18% compounding ROI along with a 2% CPI into retirement is destined to fail.

We also must broach the risk issue with our clients. They need to comprehend not only the potential for long-term returns but also the volatility that comes with investing in the markets. Providing this reinforcement on a consistent basis will ease the stress for both you and your clients during tough market conditions. Some advisors and group plan sponsors use our services to provide basic financial plans for clients. This creates a hands-on opportunity to consider longer-term horizons and integrate them with an overview of their entire financial structure.

The equity asset mix structure of a portfolio is another area we’re we’ve been forced to rein in some reactionary aspects of client behavior. When the U.S. market is doing poorly and the loonie rising against the greenback, it’s hard to argue in favor of moving assets to U.S. equities. However, investments in the U.S. market during the recent turmoil paid off when a robust rebound of the U.S. dollar added to some of the value protection in client portfolios.

Compensation Explanation

To be fair, an advisor’s compensation structure can sometimes add additional stress to client relationships during tough economic times. Lately, a fee-only advice model does suffer some pressure, but the reduction in fees is not as dramatic as the downturn in the markets. Since fee structures are often tiered, the reduction in the value of the portfolio does not translate into an equal reduction in the overall fee revenue from that portfolio.

In addition, many clients may be paying a fee simply for advice and planning guidance and the fee doesn’t change based on any change in the value of their portfolios.

On the other hand, in a more traditional commission-based structure, where income arises from new sales or ongoing trailer commissions, the reduction in advisor income can be dramatic when markets turn ugly. Clients, both new and old, are reluctant and sometimes downright opposed to investing in any new products, and trailer commissions may also decline due to redemptions and/or reduction in the value of portfolios.

Clients sometimes criticize advisors for continuing to take fees during market downturns. Ironically, we as advisors have to remind clients it’s during turbulent times that we spend the most time discussing portfolios with clients. We’re called upon to do more of the work that adds value to the client experience when markets are negative. We take more phone calls, do more analysis, schedule more meetings, and basically do more to earn our keep when things get rough.

That’s not to say it’s all smooth sailing and very little work during the good times; working hard with clients in the good times sets a solid platform of understanding and expectation management for all aspects of investing and setting financial goals. But this allows clients, as well as their advisors, to react comfortably with one another when the good times turn.

1. Clarifying your present situation

The professional financial planner will gather all relevant financial information from you, such as details of assets and liabilities, income and expenses, tax returns, insurance policies, employment benefit and pension details and estate planning documents.

2. Identifying personal and financial goals and objectives

In order to provide appropriate recommendations to you, the planner must help you clarify your specific goals and objectives. Such goals may include retiring at age 55, buying a house, ensuring that your children’s education funding needs are met, or even taking that once in a lifetime trip.

3. Identifying financial problems and opportunities

With knowledge of both your personal goals and your current financial position, a professional financial planner can determine whether there are any impediments to reaching your goals. They will also identify opportunities that will allow you to meet your goals. For example, you may not be taking advantage of all the income tax deductions and credits available, or may have too much or too little insurance.

4. Providing written recommendations and alternative solutions where appropriate

The recommendations provided will be specific to your goals and will vary with the complexity of your individual circumstances. In some cases, alternative solutions may be included. The professional financial planner will meet with you to determine which recommendations you are comfortable implementing and who will be responsible for implementation.

5. Implementation

This is a key step to ensure that you reach your goals and objectives. Your financial planner may assist you with implementation, or refer you to other appropriate professionals.

6. Periodic review

Last but not least, your financial plan needs to be reviewed and revised periodically, in order to take into account changes in your personal circumstances or the economy. For most individuals, an annual review is appropriate.

Source: www.iafp.ca

Warren Baldwin, CFP, R.F.P., CIM, a fee-only financial advisor in the Toronto office of T.E. Wealth, a national firm of fee-only personal financial advisors and investment counselors.