The Probability of Success vs. the Consequence of Failure

In reality, absent the occurrence of a significant risk event, people don't abruptly run out of money. Instead, they change their lifestyle little by little and year by year to account for their updated situation. They get more stressed every year, and in turn, make further decisions that add to stress, like taking on debt.

I advocate for a lifetime financial planning process that regularly revisits a reasonably conservative expected path, but also multiple possible personal and economic futures that could produce dramatically different results. Three of the most common alternate economic futures are: a significant market decline early in retirement, a long-term care event, and an early death. A variety of others could be considered, including but certainly not limited to: high inflation, boomerang children and extreme longevity.

Most of the Monte Carlo-related conversations I see advisors having are solely focused on variation of the path of market returns, with the resulting conversation solely focused on improving the probability of success, without thorough consideration of the consequences of failure under a variety of personal and macroeconomic futures. The result is often a recommendation of a more aggressive portfolio to try to make up for the potential of a shortfall, which may increase the probability of success while additionally increasing the consequences of failure.

Should advisors instead focus solely on the consequences of failure? Absolutely not, except for possibly the most conservative clients. Doing so would eliminate significant upside potential that could have accrued either to the client's lifestyle or to the client's heirs. Instead, it is a balancing act for every client with a reasonable definition of what is an acceptable consequence for failure.

It is dangerous to advocate for client plans with zero visible consequences of failure. Minimizing the consequences of failure inevitably means pursuing more conservative strategies. Pursuing conservative strategies, whether investment- or insurance-oriented, eliminates significant upside potential that can accrue either to the client's lifestyle or to the client's heirs, and gives clients a better ability to deal with risks that you can't even fathom at the beginning of a retirement.

Instead I would argue that the central dashboard for financial planning decision-making should include a base case with a reasonable, but realistic, estimate of long-term returns. Couple this with a variety of stress tests that demonstrate the impact or consequences of a risk event with clear explanations of the base case and the risk events tested. If there is a realistic possibility of failure, then we should discuss the consequences of that failure and adjust the plan to bring those consequences into an acceptable range. None of these conversations happen with a focus only on the probability of success.

— Related on ThinkAdvisor:

• Roth IRA Conversions: How Much Is Too Much?
• Think You Know the Capital Gains Tax Rate? Think Again.
• Beware the Social Security 'Tax Torpedo'

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Joe Elsasser, CFP, RHU, REBC, developed his Social Security Timing software in 2010 because, as a practicing financial advisor, he couldn't find a Social Security tool that would help his clients make the best decision about when to elect their benefits. Inspired by the success of Social Security Timing, Joe founded Covisum, a financial tech company focused on creating a shared vision throughout the financial planning process.