How risky is a person's lifestyle is in relation to their investment portfolio?
In last month's article we reviewed the fourth and final behavioral investor type, the Active Accumulator. You should now have a solid foundation of knowledge from which to understand the thinking and behavior of your clients. In future articles we will be discussing how to modify an asset allocation recommendation based on a client's BIT. But before we do that, however, we need to discuss a very important subject: standard-of-living risk, which will be discussed in the next few articles. Often advisors will recommend an investment program to a client based purely on their risk tolerance questionnaire. One element that is rarely captured in a risk-tolerance questionnaire (or anywhere else for that matter) is the idea of how risky a person's lifestyle is in relation to their investment portfolio.
Suppose you only have two clients, Mrs. Jones and Mr. Smith. Mrs. Jones is 70 years old, has $1,000,000 in assets, is unsophisticated about investing, and her only income is what her portfolio earns plus social security. Mr. Smith is 50 years old and divorced, has $5,000,000 in assets and is a sophisticated investor making $350,000 per year in annual compensation. Based on this fact pattern, on the surface most advisors would assume that Mr. Jones can tolerate substantial more volatility in his portfolio than Mr. Smith. But let's now add some facts. Mrs. Jones has no mortgage, no dependents, no other debts, and lives a very frugal lifestyle involving little to no travel and modest entertainment. She only spends 3% of her portfolio a year. Mr. Smith on the other hand has a high-spending lifestyle. He has a $1,000,000 vacation home that is almost completely mortgaged, has a $3,000,000 home that is 60% mortgaged and $1,000,000 in an investment portfolio. He has three children, one of whom attends an expensive private college and the other two are in fancy private high schools which he fully funds. He pays alimony and child support and is dating a super-model who demands a very cushy lifestyle. Mr. Smith, in short, is a job-termination away from potential financial disaster while Mrs. Jones' assets will likely outlast her lifetime. Mrs. Jones does not have a standard of living risk; Mr. Smith does. Advisors need to take this concept into account when designing an asset allocation strategy for their clients. In this article I will review some guidelines as to determining standard of living risk. In subsequent articles we will discuss strategies for dealing with SLR vis-a-vis certain BITs and also modifying an asset allocation incorporating the concept of SLR.
Why Standard-of-Living Risk Matters
To advise clients properly, financial advisors need to assess the financial responsibilities of their clients and determine if clients have ample assets to cover these responsibilities. As we saw in the previous example, in some circumstances $1,000,000 may be a substantial amount of money. In other cases, $1,000,000 may not be a substantial amount of money. The following is a 3-step assessment mechanism that can be used to determine if a client has a standard of living risk. Readers should recognize that the numbers used in this analysis are open to adjustments based on the specific views of the advisor and/or the client.
Step 1: Where Are They in Life?
The first step in assessing SLR is to determine what stage of the investor life cycle the client is in. Although there are several ways to categorize clients by their age, I use the following for purposes of this analysis.
Accumulation Stage: age 20-35
Consolidation Stage: age 36-50
Spending Stage: age 51-65
Gifting Stage: older than 65
Step 2: Is the Client Employed?
The next step in the SLR assessment process is to determine if the client is employed. If the client is employed, then, obviously the client has a lower risk of having his or her standard of living reduced. If the client is not employed, the client needs resources available to sustain standard of living. Step 3 is the methodology to assess SLR depending upon employment status.
Step 3: Assessing SLR
If the Investor Is Employed:
For those who are employed, the first question to ask is: What percent of your income is discretionary? Put another way, for every dollar you earn after taxes how much could you save if you had to?
Accumulation Stage: 25% or more If yes, no std of living risk. If no, see next question
Consolidation Stage: 25% or more If yes, no std of living risk. If no, see next question
Spending Stage: 30% or more If yes, no std of living risk. If no, see next question
Gifting Stage: 35% or more If yes, no std of living risk. If no, see next question
If the client answered no in the first question, the next step is to determine the ratio of non-discretionary (living) expenses to total assets (the inverse of the answer given in previous question divided by the client's total net assets). The following is the assessment for each stage of the investor life cycle.
Accumulation Stage: 16% or more If yes, standard of living risk
Consolidation Stage: 14% or more If yes, standard of living risk
Spending Stage: 12% or more If yes, standard of living risk
Gifting Stage: 10% or more If yes, standard of living risk