Be goal-based in retirement planning

When preparing clients for retirement it is essential to look closely at their longevity, finances and how comfortable they are about investing.

A need for short-term emotional comfort makes clients reluctant to invest, so they hold on to their cash, which comes at a price. The long-term benefit of investing compared with holding cash can cost clients up to 5% annually in returns.

Irrational behavior

Clients may sacrifice returns for comfort by investing in familiar asset classes or managers, foregoing the investment returns they may earn if they diversify their portfolios across different assets and managers.

There is also the fear of losing out, which is called loss aversion, where clients join the herd and invest more actively. This, however, can lead to excessive investing, where clients constantly adjust their portfolios to take advantage of perceived market trends, unknowingly increasing or decreasing their risks.

The cost of emotional comfort is an estimated two to three percent loss in returns annually. This loss, or behavioral gap, stems from clients’ financial decisions which are optimal in the long-term, but are uncomfortable to endure in the short term.

Driving past comfort
The current investment challenges clients face include low investment returns, market volatility, negative sentiment and the questionable role of benchmarks.

These require a new investment approach in diversified portfolios, an approach that focuses on:

• goal setting rather than beating benchmarks,
• reducing the risk equities bring,
• providing acceptable risk levels,
• moving away from conventional growth and defensive assets, and
• employing a more dynamic approach to asset allocation that counteracts low returns, market volatility and the reduced correlation between bonds and equities.

Overcoming the behavioral gap

As an adviser, your approach should be to recognise the human need for comfort. You understand your clients and the challenges they face to achieve their financial goals, and you can offer practical and individually targeted advice to give them comfort and overcome the behavioral gap.

This means you need to challenge the conventional idea of looking for the best risk-adjusted returns that are only concerned with long-term financial goals.

As an adviser, you can improve returns by focusing on achieving the best anxiety-adjusted returns, i.e. the best returns your client can achieve for the level of stress he or she is going to experience during his or her investment journey. Some of this stress comes from taking risk, and a great deal arises from the client’s emotional responses to fluctuations during the journey.

A degree of accuracy

This boils down to Goal-Based Investing (GBI). With GBI, the focus shifts from achieving the best investment returns to managing personal financial goals. It helps to prevent irrational investment decisions by providing clear goals, i.e. retirement planning, and choosing investment strategies to achieve these.

GBI attempts to foresee and understand clients’ future liabilities and immunise their portfolios against such liabilities. Advisers consider investment products and strategies after understanding what their clients want and how they can get there. It is more about focusing on consistently achieving clients’ goals with an appropriate investment strategy.

This approach enables an adviser to look ahead with a high degree of accuracy so that his or her client is able to save enough for a comfortable retirement.

This is not to say that a conventional approach to managing diversified portfolios is wrong, or that a high allocation to equities is not appropriate for the long-term. In fact, managing funds to a pre-agreed benchmark makes it easy for an adviser’s clients to know the risk and return they are likely to encounter. Growth and defensive assets are still easy to understand and there is no evidence that equities have lost their long-term ability to deliver.

What is suggested, however, is that if an adviser’s clients have specific needs or income requirements, it is worth considering an absolute goal-based approach.