How to fix financial planning

I always look forward to and enjoy reading Michael Kitces’ blog posts. If you are not familiar with his work, you should check out his blog Nerd’s Eye View.

Recently, Kitces has taken on financial planning software and financial planning itself and raised some important questions about how it is commonly practiced.

In “Is Financial Planning Software Preventing The Growth Of Real Financial Planning Advice?”, Kitces questions whether the product-centric focus of traditional financial planning software is getting in the way of real planning.

In a subsequent post, “Reimagining Client Meetings With A More Client-Centric Financial Planning Process”, Kitces proposes a more client-centric process for doing financial planning with clients.

I have been in financial services for the better part of 40 years and began my career, like many advisors, selling products for a commission.

For the past 20 years, my focus has been on comprehensive financial planning as both a financial advisor and a software designer/developer. Ten years ago I realized that the “generally accepted process” for delivering a financial plan was not working for me or my clients. Clients were not properly engaged and I was not adequately compensated for my time.

After much soul-searching I realized the problem was not me or the client, it was the software tools we had at our disposal.

My financial planning software manifesto

So, I set out to re-envision the financial planning process based on these six principles:

1. Financial planning software is NOT a financial plan

To borrow a Harley-Davidson tagline, “It’s not the destination that matters, it’s the journey.” A financial plan should address the needs of the client and support implementation of the recommendations made.

2. Financial planning software must be client facing

I do not have the time to do anything more than once, so the client needs to be present when preparing the analysis and constructing the financial plan.

3. Real-time data entry should take no more than 15 minutes

To do this, the amount of information gathered in the first meeting would need to be minimized. The 80/20 principal states that 80% of our productivity comes from 20% of our efforts. This is equally true for financial planning: 80% of a financial plan comes from 20% of the client’s information. This approach gives us a very good sense of the plan while contributing to engaging the client in a much easier up-front information gathering process.

4. No “what-if” scenarios

To eliminate the need for what-if scenarios, the system has to automate all routine elements of the financial analysis. Implementing strategies to minimize tax and maximize returns should be done with intelligent algorithms instead of manual data changes. In simple terms, the system would need to automate the calculations that any competent advisor would perform, but without requiring input from the advisor.

5. Financial planning should provide simple answers to common questions

“How much can I spend?” “When can I retire?” “How much do I need to save?” and, “What rate of return do I need?” In any situation, no matter what the outcome of the analysis, an intelligent algorithm should automatically provide the above answers.

6. No shortcuts in business logic

The analysis must be robust and accurate, providing proper tax calculations and flexible assumptions that can be controlled by the advisor.

Simplification is valued over complication

I felt so strongly that advisors needed to ‎spend more time interacting with clients and less time on computers crunching numbers that I decided in 2010 to create a software tool that lived up to these principles. ‎

To give this new financial planning software program a name, I looked to Occam’s razor, a problem-solving principle that states “the simplest explanation is usually the correct one”. Over the years I also noticed that “the simplest recommendations are usually implemented first”, so it seemed only logical to call this new tool “The Razor”.

In February 2016, Razor Logic Systems Inc. will launch our 4th version of The Razor, completely rebuilt on a state-of-the-art HTML5 platform to make it more compatible with today’s mobile computing. Although initially available only in Canada, we have plans to offer a US version later this year.

The Razor embraces simplicity and automation, without sacrificing precision, helping to engage clients interactively in the financial planning process.

To learn more, visit razorplan.com or register today for a FREE 30-day trial of The Razor.

 

Benefits of the Human Capital method in calculating insurance needs

Determining how much and what type of life insurance one should purchase can be a daunting task. Buy too much and you waste hard earned money on unnecessary premiums. Buy too little and you run the risk of leaving your family financially strapped should you die.

The traditional approach to calculating one’s insurance needs involves answering questions such as “How much is your mortgage?”, “What lifestyle do you need to maintain?”, or “What school will your kids go to?” Based on the answers provided, this approach calculates a dollar amount of life insurance coverage you should have.

The problem with this Needs Analysis method is that it is limited to your needs should you die today. How much insurance you may need in the future, say 10, 20 or even 40 years from now, is outside the scope of most traditional Needs Analysis calculations. The risk of not taking future needs into consideration is that it can leave you with hefty increases in premiums when your term coverage renews or no coverage at all when you can no longer qualify due to a change in health.

Today, many insurance agents and financial advisors are embracing a relatively new approach that calculates insurance needs using a person’s Human Capital value. In simple terms, a person’s Human Capital is the present value of all their future earnings potential.

When compared directly, the Needs Analysis and Human Capital methods have a strong correlation. They both calculate the value of a loss, but from different ends of the spectrum. The Needs Analysis method looks at the effect of earning an income, whereas the Human Capital method looks at the value of income earned.

Think of it this way: You go to work each day, earn a salary, and pay taxes. The amount you have left over will allow you to qualify for a mortgage, save for retirement, and establish a lifestyle. If we then calculate the value required to replace your lost income in the event of death, we will get a Human Capital value that is consistent to the amount provided through a Needs Analysis approach.

Advantages of using the Human Capital method

The Human Capital method offers a number of advantages over a traditional Needs Analysis approach:

  1. Faster and easier to calculate – It requires very little information, so there is no need to provide exact amounts to questions on debts and income needs.
  2. Better for changing needs over time – It suggests a new value each year, so that you can purchase the type of coverage that better matches your future insurance needs.
  3. Broadly applicable to many insurable risks – It is not just for life insurance needs; it can also be used to calculate disability and critical illness needs.
  4. Not limited to lost earned income – It can also calculate lost pension and government benefits in retirement.

How Human Capital and traditional Needs Analysis work together

Bill and Mary earn $100,000 and $35,000 per year respectively. Both plan to retire in 20 years at age 65. Assuming 3 percent inflation and an investment rate of return of 5 percent, Bill’s future earnings potential over his lifetime has a present value of $1,746,000 and Mary’s is $708,000. This is their Human Capital.

As Bill and Mary age, the value of their Human Capital declines over time (see chart #1 below, blue lines). By age 65, Bill and Mary’s Human Capital is less than $400,000, which represents the value of lost government benefits from age 65 to age 90 (assumed life expectancy).

Using the grid lines, determining how much insurance is needed and the term is a relatively simple exercise. When done as part of a comprehensive analysis, Human Capital can also be compared to future liabilities and deferred taxes (red line).

human-capital-chart1

Using the more traditional Needs Analysis method, we ask Bill and Mary how much is needed to cover lump-sum needs such as debts, children’s education and final expenses. We also ask them to estimate how much additional income each survivor would need in order to maintain their lifestyle.

In Chart #2 below the “Capital Needed” is compared to “Available Capital” from all sources including creditor, group and individual life insurance policies and any liquid investments they may have.

human-capital-chart2

This Needs Analysis approach determines that Bill requires $1,560,000 of life insurance in the event of his death, compared to Human Capital of $1,746,000. Mary requires $550,000 compared to Human Capital of $708,000. Human Capital will usually calculate a slightly higher need when including lost income to life expectancy.

In the end, although Human Capital and traditional Needs Analysis are calculated using differing methodologies, the results are very similar. When used together, these two insurance needs calculations can be seen as providing an upper and lower limit to help one choose the right amount and type of insurance coverage that meets their needs and budget.

Note: The above analysis was done using The Razor, a financial planning software program that takes minimal time to complete and is centered on engaging clients through meaningful discussions and analysis. In addition to the core analysis, The Razor also includes a library of concepts and calculators.

Automation offers efficiency, saves time and can reduce the cost of providing financial advice

When properly implemented, automation can provide huge benefits.

In 2010, when I set out to design the next generation of financial planning software, I had two simple goals in mind:

  1. It had to take less than 15 minutes to enter client data in real-time.
  2. It had to analyze the client’s financial situation in such a way as to eliminate the need for time consuming “what-if” scenarios.

Given the options for financial planning software at the time, a unique approach had to be adopted in order to achieve these goals. Continue reading

Betterment offers automated planning, does this signal the end for human advisors?

Betterment, a US-based automated investing service, or “Robo Advisor” as they are commonly referred to, recently announced the release of RetireGuide™ – an advice engine that creates a free personalized retirement plan for account holders. While this move confirms the importance of financial planning in the investment management process, Betterment’s RetireGuide isn’t going to render human advisors obsolete any time soon.
Continue reading

Defining the Problem

Albert Einstein once said, “If I was given one hour to save the planet, I would spend the first 55 minutes defining the problem and 5 minutes solving it.”

Although there is some debate on whether Einstein is truly the source of this quote, it illustrates an important point: before jumping right into solving a problem, you should take a step back and invest your time and effort into understanding it first. Continue reading