Understanding what the downside of your clients financial plans look like is crucial. That’s the first question a client will usually ask – “What happens if it doesn’t work?” inStream’s Shortfall Analysis can answer that question.
The Shortfall Analysis describes the failure mode of a financial plan. It looks at all of the simulations that failed, and tells you what happened. From here, there are two important things to understand: how we generate the numbers, and how to talk about them with your client.
Understanding the Analysis
The Shortfall Analysis is pretty straightforward from an analytical perspective. Let’s assume that we have a plan that has a 90% probability of success. Since 900 of the simulations succeeded, that means that 100 of the simulations failed, or did not meet the goals laid out in the plan. The Shortfall Analysis only cares about the 100 simulations that didn’t work.
There are two results in the shortfall analysis – the Average Age of failure and the Median Shortfall Amount. The average age of failure is pretty straightforward, we just take the average of the age that the portfolio ran out of money in each of the failed simulations.
The Median Shortfall Amount is a little bit more complicated. Not that much more though. For each of the failed simulations we look at how much more would have been due for each of the goals in the plan. So for instance let’s say we have a plan where the only goal is a retirement goal of $100,000 per year (with a 0% inflation rate), and the goal runs until 2020. If the simulation were to fail this year there would be 6 full years of missed goals (2015 – 2020), as well as however much we were short by this year. So let’s say that we were short by $50,000 this year. That means that we were short by $650,000 for the simulation. The complicating factor is the discounting – we show everything in real terms, so the effect of the goals further out will be less than the goals closer in.
Once we do this for each failed simulation, we will take the median shortfall amount, and shockingly, that’s the Median Shortfall Amount.
Talking about the Shortfall Analysis
Now that you understand how we got the numbers that we did, how do you talk to your clients about it? I like to think of the Shortfall Analysis as a quality check on the plan, or more accurately, a gut check for your client. I’ve seen plans that have a very high probability of success, but a really nasty shortfall analysis, and vice versa. Just like everything in this business there is no “right” answer. Every client is different, and every advisor is different. Everyone will react differently to the numbers, and it really comes down to what works for you and your client.
The actual conversation is pretty straightforward – “In the event that this plan doesn’t work, here’s what would happen.” For clients, the age is generally going to be much more important. That is something that they can understand. They get what it means to run out of money at 87. They can make decisions off of that information, and understand the tradeoffs that that implies. And with financial plans, that is the goal – to help your clients understand what the tradeoffs are and decide how to proceed.