A Goals-Based Approach to Financial Planning

Adviser Massi De Santis offers a step-by-step guide to identifying retirement goals and building a plan to meet them.
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By Massi De Santis

One of my children reminded me of an efficient way to solve a maze: work back from the end to the start. In economics, we use a similar approach to solve planning and strategy problems, called backward induction. Backward induction is a process that starts from the end of a problem and works back in time to determine the sequence of optimal actions, a plan. The process can be applied to solve virtually all problems in finance, including portfolio selection and savings versus consumption decisions.

Applied to retirement planning, backward induction means that to design a good retirement plan, you need to start from what successful retirement means to you. Assume you are there. What does success look like?

Retirement planning questions like How much do I need to save? How much of my current income should I replace? And How much can I safely spend from my savings each month? all need to start with your end goal. Only by defining your goals you can create a strategy to achieve them.

Start with Goals Meaningful to You

The first thing I ask my retirement planning clients is this: "What does a successful retirement look like to you?" Usually, when someone is serious about retirement planning, they know what is important in life to them.

So, our conversation helps us define measurable objectives that are aligned with those values. For some, this can mean retire at age 60 and spend the first five years sailing around the world before moving closer to their children. For others, it can be a partial retirement for a few years, then increased travel.

Different goals have different implications for saving, spending, and investing, as we will see. To be useful, goals always have two elements: the dollar amount and the time horizon. Goals can be lump-sum, like buying a boat in five years, or recurring, like monthly retirement income, or buying a car every five years.

The first benefit of this approach is that once goals are defined, you can prioritize them. Goal prioritization is based on the importance and flexibility of each goal. Here is a list of common goals and some prioritization considerations.

Retirement Income: This goal can have two parts -- necessary and desired incomes. The first income goal covers your basic needs, like food, clothing, utility bills, etc. You don't have a lot of flexibility with these expenses. Desired income is income used to provide for your recurrent discretionary spending, including club memberships, entertainment, dining out, etc. You may have some flexibility with this part of your income, and you can cut some of the spending if you need to.

Safety Net: You may want to set a buffer for unexpected expenses, like healthcare costs or home maintenance.

Big Purchase(s): This includes big-ticket items like vacations or other purchases, such as a new car every five years. You may have some flexibility in both dollar value and timing for these goals. For example, you may decide to delay the purchase of your next car or select a less expensive model. You should list out and prioritize each big purchase separately.

Bequest: This is similar to a big purchase. You may set a goal for how much to leave to your children, loved ones, or your favorite charity. Flexibility in the bequest amount can be expressed as a range of values, like leave between $700,000 and $1 million to children.

Long-Term Care: If you have long-term care insurance, the premium you pay can be part of your income goal. If you don't, you may decide to create a nest egg for covering the potential need for long-term care toward the end of your planning horizon.

The Clarity of Quantifying Goals

Your goals make it clear what you are working toward. Once you set your goals, financial software can make it relatively effortless to see the cost of achieving each goal and the likelihood of achieving it with your current plan (calculators for different goals are available on the web, including investor.gov). When you first design your plan, you can use information about the cost and likelihood of your goals to refine and prioritize them. For example, you may feel comfortable about your desired income goal and decide to devote more savings toward your bequest.

But the real benefit of this information is in reviewing it periodically. The cost and the likelihood of your goals can help you put portfolio performance into perspective, stick with your plan, and make better decisions.

For example, while you may be unsure how to interpret the impact of a 10% return, knowing that you are 80% done toward your income goal can make you feel pretty good about your progress. Similarly, a rough patch in the stock market or changing interest rates may be scary, but you may find that these events have a limited impact on your ability to meet your goals.

Even if you find that you need to make adjustments, you have the information to evaluate which goals need adjusting, and how to better direct your savings after a setback. You might decide to postpone a big purchase until you feel more comfortable or scale it down a bit.

Aligning Your Investments

Use your goals to build a purposeful asset allocation from the bottom up. Each goal should have a dedicated investment portfolio. For example, your safety net portfolio should be quite conservative, with stocks at 20% or less. Your allocation to a minimum or essential income goal should also be conservative. But, because you plan to draw a regular income for a long period of time, the fixed-income investment for this goal should be of longer maturity than in the safety net portfolio.

In contrast, you can take more risk with the portion dedicated to lifestyle goals, like big purchases or expensive vacations, because you may be able to delay them or make adjustments. The increased risk exposure can help reduce the amount of savings required for the goals. Similarly, longer-term goals like a bequest can warrant a greater allocation to stocks.

After building a dedicated portfolio for each goal, you derive your overall asset allocation by adding up each asset class. At the end of the process, your split between stocks and bonds may be in the 40%/60% range, an assumption often made in retirement planning studies.

The key difference is that with the goals-based approach, you know exactly the role that each investment plays for your goals. Each piece of the allocation works in sync with your goals. And as you review and revise your plan over time, your allocation changes with it. Not because of market timing or irrational behavior, but simply because it is adapting to your current plan, increasing the likelihood of achieving your goals while managing key risks.

Better Risk Management

Besides helping you choose the mix of stocks and bonds, your goals help you highlight key risks and design the best way to manage them.

Consider your retirement income. How can you protect your income portfolio from the risks of inflation, market, interest rates, and longevity? One way to manage these risks could be to purchase an inflation-protected annuity, at least for the portion of your necessary income. For your desired income, you may opt to self-manage these risks. If you decide to do that, your fixed-income portfolio should take into account the effect of inflation, the long term nature of the desired income, and changes in life expectancy. For goals with a greater stock allocation, uncertainty can be managed using a glide path approach (reducing equity exposure as the goal approaches). A two-level approach similar to the retirement income goal can be used for this and other types of goals as well.

A Dynamic, Adaptable Approach

A goals-based approach can be summarized in three steps:

  • Set meaningful goals characterized by both dollar amounts and time horizon.
  • Prioritize and quantify the cost of each goal.
  • Identify key risks and set a purposeful asset allocation.

Keep in mind this is a cycle. You have to repeat the steps regularly because life gets in the way of your plan. Your goals change and your progress will be different from what you expected; your plan should reflect this. By committing to the process of reviewing 1, 2, and 3 at least annually, you can increase the likelihood of achieving your goals.

Now you may think, "OK, this sounds great but it seems like more work than a simple 4% rule, and so will I stick with it?" Give it a try. And think about this, how many people do you know stick to the 4% rule? Research in behavioral economics shows that the key reasons for not sticking to a plan or process are a failure to consider personal motivations and lack of coaching. You are more likely to stick with a goals-based approach because it starts from goals that are meaningful to you and makes it clear how the plan helps you achieve them.

About the author: Massi De Santis, Ph.D., CFP, is an Austin, Texas-based fee-only financial planner and founder of DESMO Wealth Advisors, LLC a company designed to help people live better lives through enhanced financial health and wellness. Desmo Wealth provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives.