Source Bruce Sheppard NZ in Stirring the Pot | 2:27 pm 19 August 2008

Financial advisers are not universally bad. In fact most of them are honest, well-intentioned and competent people who do a good job selling a stupid product that they honestly believe in. The product is the fund management industry and modern portfolio theory. The sales wrap for this is financial planning. While the product is suitable for some it is not suitable for most. Now the base principles of financial planning are so basic that it would be hard to get people to pay for advice, which is why financial planners are so hell-bent on getting control of other people’s money and then executing a plan. It is the activity of execution that makes them money though annuity fees to monitor the stuff they invest in, and the commissions and front end fees charged on initial execution. Because the advice is so basic, how do they encourage otherwise intelligent and successful people to part with their money? Two ways, either they say that investment is really complex and you need to be a professional to do it well, or they say to do it properly requires so much work that you need to spread the cost over a large pool thus reducing the cost to each investor.

Shall we start with the basics of preparing a financial plan.

The first step is a bit of self-realisation. This being that you won’t be dead anytime soon and that you likely will outlive your ability to work and earn. Therefore the quality of your life when you get nearer to the grave will be predicated on the resources you accumulate now. Now this might sound obvious, but for sub 30’s nothing could be further from their minds, either because they think they are immortal, or because they think they will die some time soon anyway. Now as we are also breeding later in life this mentality is creeping up the age scales. Some high earners believe that they can just do nothing until later because their earning capacity can fix it in a year or five, so why not have fun all the way up to age 60? This is true…. provided they don’t lose their job or capacity to work. Most in this category do have the intellect to take out loss of income insurance. But what you can’t insure is the drop off in your capacity to work or your desirability to an employer. While I suspect this will change over the next 15 years, the reality is that once you hit 50 if you lose your job you are going to struggle to get another one.So the time to start thinking about your future is when your last child is hitting their teenage years, because until then your future is subservient to your children’s. For most this is the mid forties, and despite what financial planners say this is not too late provided you have a reasonable income. So much for self-realisation, and mid life crisis.

The basis of a financial plan is pretty simple. To start with you just have to answer these questions:

1. What sort of life do I want when I stop working, and what roughly would it cost in today’s dollars?
2. How long do I intend to work and what income do I hope to have?
3. What costs will I have to fund while I am working, what sort of life do I want to live, and what can I save?
4. How much have I got available to me right now and where is it?

These are the numbers and may well be as far as you have to go. Take an example. A couple in their 50’s, $2,700,000 in financial assets, a home worth another $1,500,000 with no debt, income will exceed expenditure for the next 10 years by another $300,000 in total and in 10 years time they would like to retire and have in today’s equivalent buying power $100,000 pa tax paid.

Now it doesn’t take a rocket scientist to work out that reinvesting bank interest on maturity for the next 10 years net of tax will probably out strip inflation, so likely ignoring inflation the retirement capital of this couple if they retired today in today’s dollars will be not less than $3,000,000, so long as nothing happens to the planned saving. If the wheels fall of that plan then they should still have $2,700,000.

Now on a pretty conservative basis, the long-term interest rate at the bank should be 6% or more and a long-term tax rate of 33%, this capital will earn them $108,000 tax paid, so they do not need to take any risk at all.This couple need do nothing; they can just leave the money in the bank and sleep peacefully.

So why would a financial planner advice such people to put funds in a basket of finance companies or equity and property managed funds? Of course in the hope that the return will be an extra percentage point or two.But why would this couple give a toss about that, their financial future is certain, they don’t need to take risk at all? Now of course they are sold risk on the basis of greed for extra return, so greed is what drives it. But how do financial planners sleep at night when they use greed to sell people product they don’t need? Now if the maths is less compelling some further questions need to be examined.

1. How secure is my income between now and when I retire?
2. What might go wrong with my life that reduces my income or increases my expenditure?
3. Is my home a saleable asset, or have I over capitalised?
4. What will tax rates, interest rates and inflation do over the rest of my life?

Now these questions are only relevant to a family that looks like they might get to enough but it is too close to call and the short terms risks to health, job security and economic volatility need to be mitigated. The mitigation is pricing in insurance where possible, and spreading the asset allocation between growth and non-growth assets, mostly to mitigate tax and inflation risk.

Now for most people, the home is the growth asset, rental properties are the next growth asset, often with tax advantages attached to mitigate tax, and to the extent that non growth is even considered, it will be a bank or finance company deposit. Now obviously this is an extreme risk concentration on country and on property, and over the next decade is unlikely to do the goods.

In short a classic a family with less than $25 in assets for each $1 of income that they aspire to have at some point in the future, will need to consider taking on some risk just to mitigate personal and macro economic risks, and could do with some advise from a financial planner.Then you have the dreamer group, those who want heaps, but have little and are not prepared to do much either. I am sure financial planners get many who think they are rich.

Another example: Couple with $500,000, and a home worth $1m which they intend to keep until they die, who want $100,000 pa tax paid when they retire, and intend to do this in 10 years time, but have no intention of saving.

 

For them the financial planner has to ask some really hard and unpleasant questions:

1. Do you really need to own your home; could you trade down or better trade into a rental situation?
2. If you really had to what could you save?
3. How much risk are you prepared to assume to make your money work harder? By the way, I doubt that the client will understand risk even if it is explained to them.

Or the end result is, sorry team you will only have $25,000 pa to retire on, and at this level you won’t be able to afford to own the house anyway.

The purpose of these two little case studies is to point out that people should only take risk with their investment capital because they need to or want to. Those who need to take risk are those who do not have a clear proposition that they can have the life they want from the resources they have now. But before they consider taking risk, which will involve both work and the prospect of loss, they should consider the alternative of saving more or wanting less. If having reduced their expectations and increased their savings effort they still do not get a result that works then they must set about making their money work harder, i.e. taking on board risk. For those who need to take risk, they only have two choices, do it themselves or pay someone to do it for them.
If they choose to do it themselves that can be very rewarding, but that will keep for another blog. If they choose to pay someone to do it for them then they at least have to do some work, and that is picking the right adviser.

So here is a list of questions for any potential adviser.

1. What are the fixed costs, how do you charge for your time?
2. If you invest in managed funds what are the costs structures of each and what if any commissions do you receive?
3. Where do you invest your money?
4. How long have you been in this business?
5. How many clients do you have and how much do you have under management and how have these clients fared?
6. How often have you and or your firm been subject to litigation regarding your advise over the last 10 years and if at all how much was involved and if settled where did the liability sit. Now others will suggest that you should ask about qualifications. Forget that nonsense, track how they make money and where they put it, look at their scale of operations and the size of the cock up factor.