Goals-Based Planning
Goals-based planning is a financial strategy that aligns an individual’s financial resources with their unique goals and circumstances. Unlike traditional methods that primarily focus on portfolio performance, goals-based planning balances personal spending with income and aligns investments with risk levels and future needs.
Planning and Human Capital
In the field of wealth management, planning and human capital play a pivotal role. This section delves into the concept of goals-based planning in wealth management, its correlation with Asset and Liability Management (ALM), and the importance of an extended balance sheet.
- Goals-based planning in wealth management is akin to the strategies employed in pension fund management. For instance, a company like IBM would use ALM to identify, measure, and evaluate risks associated with their pension fund.
- Assets in a pension fund include explicit assets like stocks and bonds, and implicit assets such as expected future contributions from employers and employees.
- Liabilities encompass explicit liabilities like the accrued pension obligation (APO) and implied liabilities such as the projected pension obligation (PBO).
- The primary objective of pension fund management is to manage risks to the net asset value or surplus capital, ensuring sufficient assets to balance liabilities and meet long-term pension obligations.
$$ \textbf{Pension Fund Balance Sheet} \\
\begin{array}{l|l}
\textbf{Assets} & \textbf{Liabilities and Surplus} \\ \hline
\text{Traditional assets} & \text{Accrued pension obligation (APO)} \\ \hline
\text{Alternative assets} & \text{Projected pension obligation (PBO)} \\ \hline
& \text{Projected employer contributions} \\ \hline
& \text{Projected employee contributions} \\ \hline
& \text{Surplus}
\end{array} $$
Goals-based Planning and ALM
- Goals-based planning can be viewed through an ALM lens. For most families, non-liquid, implicit assets like human capital, expected pension, and retirement benefits are significant but challenging to quantify.
- Implicit assets also include expected inheritances, which can significantly influence a family’s financial situation.
- Liabilities include explicit ones like mortgages and loans, and implicit ones such as lifestyle expenses.
- Wealth managers evaluate discretionary wealth, the difference between the sum of explicit and implied assets less the sum of current and implied liabilities.
The Extended Balance Sheet
- The extended balance sheet provides a comprehensive view of assets and liabilities, helping to assess risk exposures. For example, a high-net-worth individual would have a different asset and liability structure compared to a middle-income family.
- The size of the surplus, or discretionary wealth, is what matters and differentiates how assets and liabilities are managed to achieve financial goals.
Goals-Based Financial Planning
Goals-based financial planning is a strategic process that aligns an individual’s financial resources with their unique goals to achieve financial success. This process involves several key steps, starting with defining the goals of financial planning.
Step1: The Defining Goals of Financial Planning
In this initial step, the advisor and the client work together to identify and describe each financial goal, outlining the time frame for achieving them and the minimum probability of success that the client finds acceptable. The risk involved in this context refers to the significance of the goal and the risk of not being able to realize it, which is not synonymous with the traditional volatility of returns.
Classification of Financial Goals
The goals-based planning approach differentiates between short-term (under 5 years), intermediate-term (between 5 and 15 years), and long-term (over 15 years) financial goals. These goals are further categorized as either discretionary or non-discretionary. For instance, a discretionary financial goal could be a vacation to Europe, while a non-discretionary goal could be paying for a child’s college education.
Behavioral Portfolio and Goals-Based Wealth Management
It is important to note that not all goals can or should be pursued simultaneously. Meeting essential goals like housing, education, and healthcare is crucial, while other goals are discretionary and less critical to the client’s lifestyle. The concept of a behavioral portfolio was formulated by Hersh Shefrin and Meir Statman in 2000, drawing inspiration from Abraham Maslow’s hierarchy of needs. They posited that since individuals possess multiple financial goals and varying risk profiles associated with each goal, these aims should be addressed through a series of subportfolios tailored to the specific goals and risk profiles.
Building upon their research, Jean L. P Brunel, in “Goals-Based Wealth Management” (2015), advocates for establishing high-level financial goals, each with its own distinct portfolio featuring unique risk and return characteristics. Each goal corresponds to a portfolio with its own unique risk, return, and other characteristics. Most investors easily understand this approach, and it aligns with behavioral decision making. However, it often neglects the interactions between different investment goals, leading to inefficiency. Despite this, many find the trade-off acceptable for a simpler framework, and various methods can usually address the inefficiency.
Step2: The Prioritizing and Quantifying Goals of Financial Planning
The second phase in financial planning involves wealth managers identifying and quantifying both explicit and ambiguous goals. These goals are then translated into specific asset allocations that cater to lifestyle, philanthropy, and legacy objectives. It’s crucial to understand that essential lifestyle expenses can trigger strong emotional reactions in affluent families, particularly the fear of lifestyle reduction. Unforeseen expenses such as inflation can also lead to emotional impulsivity, especially during market downturns, which can strain the relationship between the manager and client.
Understanding Growth Needs and Limitations
According to Brunel (2011), there are five key questions to help families understand their growth needs and limitations. These questions address concerns about:
- Unexpected inflation,
- Protection against generational fragmentation,
- Potential lifestyle changes,
- certainty about future needs, and
- The need to keep score.
For instance, a family in Venezuela, a country with a history of sudden hyperinflation, might be particularly concerned about unexpected inflation. Similarly, a family with a large inheritance might be worried about generational fragmentation and the equitable distribution of wealth. These questions are crucial in helping families navigate their financial planning process.
Non-Lifestyle Related Goals
Goals not related to lifestyle form part of the family’s discretionary wealth, and excess assets should be allocated to a long-term growth portfolio. Wealth managers play a crucial role in linking diverse financial goals and fluctuations in human capital, tailoring their advice to align with their clients’ changing needs and aspirations. This includes addressing philanthropic aims, wealth transfers, entrepreneurship, and retirement.
Step3: Structuring Portfolios to Meet the Goals of Financial Planning
Financial planning is a multi-step process, with the third step involving the calculation of assets required for each financial goal and the structuring of portfolios to meet these objectives. This process may involve financial calculations such as discounting expected cash flows, for instance, calculating the present value of future retirement income, or assigning lump sums for goals without specific forecasts, like setting aside a fixed amount for a child’s education. The choice of asset classes, such as stocks, bonds, or real estate, must align with the goals, considering factors like liquidity requirements. The time frame and success probability for each goal guide capital allocation, ensuring that the financial needs and objectives are met with appropriate subportfolios.
Strategy for Subportfolios
A robust strategy involves calculating actuarially adjusted cash flows for each client goal to create distinct subportfolios in terms of return and volatility. These subportfolios should cover a wide range of market options and have their own success probabilities. For example, a subportfolio for retirement might have a different risk and return profile than a subportfolio for a vacation home.
Types of Subportfolios
Subportfolios can be categorized into:
- Short-term lifestyle,
- Long-term lifestyle,
- Capital preservation, and
- Growth.
$$ \textbf{Portfolio Success Probabilities} \\ \\
\begin{array}{l|l|l}
\textbf{Objective} & \textbf{Portfolio Characteristics} & { \textbf{Minimum} \\ \textbf{Probability} \\ \textbf{of Success}} \\ \hline
{\text{Short-term} \\ \text{lifestyle}} & {\text{Low-risk subportfolio} \\ \text{allocated to:}} & {\text{More than} \\ \text{95%}} \\ \\
& { {\small \bullet} { \text{ liquid cash and cash} \\ \text{equivalents;} } \\
{\small \bullet} {\text{ liquid short and high}\\ \text{-quality medium-term debt.}} } & \\ \\ \hline
{\text{Long-term} \\ \text{lifestyle}} & {\text{Moderate-risk, income} \\ \text{producing, subportfolio} \\ \text{allocated to:}} &
{\text{More than} \\ \text{80%}} \\ \\
& { {\small \bullet} {\text{ riskier medium- and} \\ \text{long-term debt;}} \\
{\small \bullet} {\text{ dividend paying public} \\ \text{equity.} } } & \\ \\ \hline
{\text{Capital} \\ \text{preservation}} & {\text{Higher-risk, income producing,} \\ \text{subportfolio allocated to:}} & {\text{More than} \\ \text{75%}} \\ \\
& { {\small \bullet} {\text{ riskier medium- and} \\ \text{long-term debt;}} \\
{\small \bullet} {\text{ balance of dividend} \\ \text{paying and non-dividend} \\ \text{paying (growth) equity.}} } & \\ \\
& {\text{Increasing portfolio allocation} \\ \text{Equity and other growth} \\ \text{assets allocated to the} \\ \text{portfolio Varies}} & \\ \\ \hline
\text{Growth} & {\text{Very high risk subportfolio} \\ \text{allocated to:}} & \text{Up to 75%} \\ \\
& { {\small \bullet} {\text{high risk debt;}} \\
{\small \bullet} \text{growth equity; and} \\
{\small \bullet} {\text{alternative illiquid} \\ \text{investments}} } & \\ \\
& {\text{Increasing the portfolio} \\ \text{allocation to equity and other} \\ \text{growth assets allocated to the} \\ \text{portfolio.}} & \\
\end{array} $$
Each category has its own risk level, time horizon, and success probability. For instance, a short-term lifestyle subportfolio might include low-risk assets like treasury bills to cover the next five years of expenses, while a growth subportfolio might include high-risk assets like private equity to achieve long-term goals.
Application of Goals-Based Planning
Goals-based planning can be applied to various objectives such as retirement, education, vacation homes, and business goals, concluding with philanthropy and legacy aims. The overall asset allocation will adjust based on the capital set for each specific goal and its corresponding subportfolio.
Step4: Managing Portfolios to Meet Financial Goals
Financial planning culminates in the creation and management of goal-specific subportfolios, which are then combined into a single, custom-made portfolio. This process involves balancing lifestyle needs with philanthropic and dynastic goals. The crucial decision here is determining the amount of capital to allocate beyond essential spending, taking into account each goal’s risk profile and asset suitability. For instance, a philanthropic goal might involve setting up a scholarship fund, requiring a different risk profile and asset suitability than a lifestyle goal such as buying a vacation home.
Surplus Assets and Growth
Contrary to popular belief, surplus assets should not always be directed towards growth. In goals-based financial planning, wealth managers need to maintain discipline due to the constraints placed on asset allocation within the subportfolios. This discipline becomes particularly important during the annual rebalancing or tactical asset allocation.
Goals-based financial planning simplifies discussions by focusing on the calculation of assets required to meet spending expectations. This approach could minimize the risk that the client overspends and depletes their savings.
If there is enough capital for long-term investment, these goals-oriented plans can be supplemented with more strategic portfolios to possibly meet dynastic needs. Goals-based portfolios are designed to be optimal in satisfying the client’s specific needs, ensuring financial protection for their important goals.
Optimization and Customization of Portfolios
While the overall portfolio may not be optimized for mean variance, individual subportfolios can be, effectively balancing risk and return. Goals-based portfolios can be further customized to match each client’s unique financial conditions and objectives.
Subportfolio Self-Liquidation and Rebalancing
Each subportfolio, designed to meet a specific goal or subgoal, self-liquidates over time, and the overall portfolio adapts to changes in the client’s financial situation. Depletion of a subportfolio does not automatically trigger reassessment of the financial goals and plans. Shifts in capital market expectations, market conditions, and the individual’s spending habits may necessitate rebalancing at various points in time.
Alignment of Financial Goals, Human Capital, and Life-Cycle Stages
In the early career phase, individuals focus on short-term financial goals like paying rent, buying groceries, and commuting. For instance, a recent graduate might prioritize paying off student loans and saving for a car. Simultaneously, they are developing their human capital, which is essential for achieving financial goals. Intermediate-term goals, such as establishing an emergency fund, may also be considered. However, long-term goals like retirement savings might not be a priority.
Career Development Phase
As individuals progress into the career development phase, the focus shifts towards long-term goals like wealth building and retirement planning. For example, a mid-career professional might prioritize investing in a 401(k) or buying a house. This phase is the peak phase for capital accumulation, covering both short-term and mid-term needs.
Pre-Retirement Phase
Approaching pre-retirement, the emphasis shifts towards short-term goals like debt repayment and asset consolidation. For instance, an individual might focus on paying off their mortgage or consolidating their investment portfolio. While capital accumulation continues, spending on items like vacation homes may initiate capital decumulation.
Retirement Phase
During the early retirement phase, individuals generally focus on short-term goals like maintaining their lifestyle and medium-term goals like generating income from retirement assets. For example, a retiree might focus on managing their retirement savings to maintain their lifestyle. Wealth managers play a crucial role at this stage by advising clients on optimal cash withdrawals during the decumulation phase. Long-term objectives like estate and wealth transfer strategies, considering available financial resources and philanthropic aspirations, are also considered.
As a crucial part of financial planning, wealth managers play a significant role in guiding clients through the process of wealth accumulation and spending during retirement. They are responsible for setting goals and timelines, ensuring sufficient funds for retirement and legacy plans, accounting for extra income sources to minimize early withdrawals, and adjusting plans for negative returns or income changes while monitoring inflation and portfolio performance.
Monte Carlo Simulation in Financial Planning
Monte Carlo simulation is a powerful tool used in goals-based financial planning. It provides valuable insights into the likelihood of meeting set financial goals by simulating various real-world scenarios such as different investment returns, market conditions, spending needs, and financial goals. This simulation generates a probability distribution for the success of a financial plan, helping wealth managers and clients gauge the probability of achieving goals. By running simulations for different portfolios, strategies that align best with risk tolerances and financial goals can be identified.
Resiliency Assessment and Withdrawal Strategies
Monte Carlo simulations also play a vital role in assessing the resiliency of financial plans. They simulate extreme market events and their influence on meeting financial goals during shifting economic conditions, volatility in interest rates, or unexpected changes in spending habits. This simulation helps fine-tune withdrawal strategies to balance income needs with capital preservation. It identifies optimal approaches to minimize the risk of exhausting available financial resources. An integral factor in this simulation is the life expectancy used for the client(s).
Family Support and Wealth Transfer Considerations
Family support and wealth transfer are integral parts of financial planning. They involve managing resources to meet immediate needs, plan for future expenses, and ensure the financial well-being of future generations. This involves a delicate balance between supporting family members and achieving other financial goals.
Family Support
- Family support is a key element of financial planning, covering a range of needs from immediate emergency expenses like medical bills to long-term plans such as estate planning. For example, a sudden illness in the family may require immediate financial support.
- It’s crucial to understand the potential impact of supporting family members on other financial goals. For instance, financing a child’s education may interfere with retirement savings.
- Goals-based financial planning is a strategy that helps balance these priorities. This could involve setting aside a specific amount for emergencies while also regularly contributing to a retirement fund.
Short-term Support
- Short-term support for family members may involve addressing unexpected expenses such as emergency repairs. For example, a sudden breakdown of the family car may require immediate financial support.
Intermediate-term Support
- Intermediate-term support could involve helping aging parents with their living expenses. This could include costs for healthcare, housing, and daily living expenses.
Long-term Support
- Long-term support may involve wealth transfer to ensure the financial well-being of future generations. This could involve setting up a trust fund for children or grandchildren.
- This can be achieved through estate planning and establishing foundations and, where legally recognized, trusts.
Practice Questions
Question 1: John is a financial planner who is considering different strategies to manage his clients’ portfolios. He is particularly interested in a method that aligns an individual’s financial resources with their unique goals and circumstances, rather than focusing solely on portfolio performance. This method should also balance personal spending with income and align investments with risk levels and future needs. The success of this method should not be measured by the portfolio’s performance against a specific benchmark, but rather by the achievement of the individual’s financial goals. Which financial planning approach is John considering?
- Traditional financial planning
- Goals-based planning
- Performance-based planning
Answer: Choice B is correct.
John is considering the Goals-Based Planning approach. This method of financial planning is centered around the individual’s unique financial goals and circumstances. It is a holistic approach that takes into account the individual’s income, spending, risk tolerance, and future needs. The success of this method is measured by the achievement of the individual’s financial goals, rather than the portfolio’s performance against a specific benchmark. This approach is particularly useful for individuals who have specific financial goals, such as saving for retirement, buying a home, or funding a child’s education. It allows the financial planner to tailor the investment strategy to the individual’s specific needs and circumstances, rather than focusing solely on maximizing portfolio performance. This approach also encourages the individual to take a more active role in their financial planning, as they are required to identify and prioritize their financial goals.
Choice A is incorrect. Traditional financial planning focuses primarily on portfolio performance and often measures success against a specific benchmark. While it does take into account the individual’s financial resources, it does not necessarily align these resources with their unique goals and circumstances.
Choice C is incorrect. Performance-based planning is primarily focused on maximizing portfolio performance. While this approach can be effective for individuals who are primarily concerned with maximizing their returns, it does not necessarily align the individual’s financial resources with their unique goals and circumstances. It also measures success based on the portfolio’s performance against a specific benchmark, rather than the achievement of the individual’s financial goals.
Question 2: Sarah is a financial advisor who is looking for a personalized approach to financial planning for her clients. She wants to take into account her clients’ income, spending habits, risk tolerance, and future needs to create a financial plan that is tailored to their specific goals. The success of this approach should be measured by the achievement of the individual’s financial goals, rather than the portfolio’s performance against a specific benchmark. Which financial planning approach is Sarah considering?
- Performance-based planning
- Traditional financial planning
- Goals-based planning
Answer: Choice C is correct.
Sarah is considering the Goals-based planning approach. This approach is a personalized method of financial planning that takes into account an individual’s income, spending habits, risk tolerance, and future needs. It is designed to create a financial plan that is tailored to the individual’s specific goals. The success of this approach is measured by the achievement of the individual’s financial goals, rather than the portfolio’s performance against a specific benchmark. This approach is more client-centric and focuses on achieving specific financial goals, such as saving for retirement, buying a house, or funding a child’s education. It is a holistic approach that considers all aspects of a client’s financial situation and aligns the investment strategy with the client’s personal goals and risk tolerance. This approach is becoming increasingly popular as it allows financial advisors to provide a more personalized service to their clients.
Choice A is incorrect. Performance-based planning is an approach that focuses on the portfolio’s performance against a specific benchmark. This approach is more investment-centric and does not take into account the individual’s specific financial goals or personal circumstances. While it can be useful for comparing the performance of different investments, it does not provide a personalized financial plan that is tailored to the individual’s needs and goals.
Choice B is incorrect. Traditional financial planning is a more general approach that provides a broad overview of an individual’s financial situation. It typically includes elements such as budgeting, saving, investing, and retirement planning. However, it does not provide the same level of personalization as the goals-based planning approach and may not take into account the individual’s specific financial goals or risk tolerance.
Glossary
- Goals-based planning: A financial strategy that aligns an individual’s financial resources with their unique goals and circumstances.
- Traditional methods: Financial strategies that primarily focus on portfolio performance.
- Portfolio performance: The return on an investment portfolio.
- Financial goals: The specific financial targets that an individual aims to achieve.
- Asset and Liability Management (ALM): A process of managing risks that arise due to mismatches between assets and liabilities.
- Accrued Pension Obligation (APO): The amount that a pension plan has promised to pay out in the future.
- Projected Pension Obligation (PBO): The present value of all future pension liabilities, considering factors like salary increases and employee turnover.
- Discretionary Wealth: The difference between the sum of explicit and implied assets less the sum of current and implied liabilities.
- Goals-based financial planning: A process that aligns clients’ financial resources with their unique goals to achieve financial success.
- Discretionary financial goals: Non-essential objectives that are desirable but not critical for maintaining one’s lifestyle.
Private Wealth Pathway Volume 1: Learning Module 3: Wealth Planning;
LOS 3(a): Formulate goals-based financial plans and recommend appropriate strategies to achieve an individual’s goals-based financial plans