The primary goal of retirement planning is to accumulate enough financial capital to last throughout retirement while funding all of one’s goals and objectives. Unfortunately, retirement planning in today’s environment has become more difficult than ever for a variety of significant reasons. First, private employers have been shifting away from defined benefit retirement packages (such as pension plans) and into defined contribution plans where employees bear all of the investment risks and are responsible for managing their own retirement accounts. Unlike pension plans, which guarantee a certain payment every year, defined contribution plans create more uncertainty as to how much will be available during retirement. Furthermore, the average life expectancy has risen dramatically over the last two decades, increasing the risk that retired individuals will outlive their financial assets. Finally, the volatile equity market over the past 15 years and the persistent low interest rates in the fixed income market over the past five years have significantly affected the values of investors’ portfolios and may have negatively impacted their retirement plans.
Based on these challenging issues, retirement planning is more difficult and more important than ever. Although individuals cannot control these challenges, they can take certain steps to place themselves in the best position to meet their goals. One effective tool every investor should consider is putting their current financial assets through a capital sufficiency analysis.
A capital sufficiency analysis is the process of determining the likelihood that an investor will have enough financial resources to last his or her entire life. More specifically, the analysis is used to evaluate whether an investor’s current and future financial capital will allow for the achievement of all financial goals and objectives, which can include everything from meeting basic lifestyle needs and health care costs to leaving a legacy for heirs and philanthropic bequests.
The process of completing this type of analysis starts with a current balance sheet, an estimate of all cash flows in current and future years (including everything such as taxes and modest social security estimates), a retirement age and life expectancy, and overlaying capital market assumptions, such as the rate of inflation and the expected rate of return on the portfolio (this will include a distinction between retirement accounts and non-retirement accounts, which have different return expectations due to different tax considerations). When projecting these variables into the future, one can see how stable his or her balance sheet is and whether or not it is projected to run out early.
Of course, the variables involved in estimating events in the distant future mean the results of an analysis should only be used as a general frame of reference, as capital market expectations often do not materialize as projected and the expected return used in a forecast may not accurately reflect volatility involved in the markets (i.e., a portfolio may significantly underperform in certain years but will statistically average a certain return in the long run). Most of the inputs used are only assumptions, such as life expectancy, living expenses and tax rates, so a capital sufficiency analysis can only provide a base case framework since there is no way to know all of the variables precisely.
The results of a capital sufficiency analysis allow investors to make more educated and thoughtful financial and wealth planning decisions. It creates the opportunity to plan ahead for any potential cash shortfalls and to design an appropriate strategy to mitigate risks. Recommendations will be identified depending upon the outcome of this forecast, such as the need to save more or spend less, to stay employed longer, or to revise the allocation of one’s portfolio to take on more or less risk in hopes of earning a return more in line with the financial plan. The earlier these types of changes are made, the more impactful they can be over the long run.
The analysis should be re-evaluated periodically. This will measure the effect of improvements that have been implemented following a previous forecast. It will illustrate what progress has been made and if anything has changed significantly that should be addressed.
A capital sufficiency analysis can also be used to address questions such as how much spending one can sustain on an annual basis given the individual's current portfolio size and strategy, or alternatively, what rate of return is needed in order to achieve a target annual spending rate. The forecast can be customized to show a variety of different solutions.
By providing a clearer picture of one’s financial plan, a capital sufficiency analysis can result in more peace of mind. Many delay focusing on their retirement plans as they are preoccupied with the demands of everyday life. Some may even be apprehensive of what this type of analysis might reveal. However, whether the results of the analysis are pleasing or disconcerting, it should resolve a lot of the uncertainty about one’s financial plan and identify strengths and weaknesses, providing opportunities to modify behavior and expectations. For those who have been diligent in their planning, it is quite possible that this analysis shows that sacrifices today are disproportionately outweighing success in the future. Investors often find that they are in a much better position than they originally thought and that they may be taking on more risk in the portfolio than needed.
In conclusion, a capital sufficiency analysis can be a very helpful tool in financial and wealth planning decisions. It provides an estimate of how prepared investors are for meeting all of their financial goals and objectives, and the results can reveal any necessary changes that should be implemented to put themselves on the right track. It is never too early to start planning for retirement, and a capital sufficiency analysis is a great first step to taking control of one’s future.
WTAS routinely provides capital sufficiency analyses and recommendations for clients. If you have an interest, or if you have any other questions relating to this article or your investment portfolio, please contact your WTAS investment consultant.
Adam Levy, Director, leads the WTAS Investment Consulting Services practice in the New York office, providing comprehensive investment consulting and wealth management services to high-net-worth individuals, corporate executives and family business owners. He serves on the WTAS Investment Committee and is both a CFA® charterholder and a CERTIFIED FINANCIAL PLANNER™ certificant. Michael Ford is a Senior Associate at WTAS.