Financial Geekery

On the importance of "Plan B"

September 8, 2019

Risk mitigation is an important part of any good financial plan: funding emergency savings, diversifying the investment portfolio, setting an asset allocation appropriate to your risk tolerance and risk capacity, purchasing appropriate insurance, preparing the proper estate planning documents, etc. etc. Bad things happen, and it's important to shore up your defenses against them.

 

Here's the thing, though: "shoring up your defenses" doesn't mean "making yourself invulnerable".  Sometimes it's not possible, like building a portfolio that captures 100% of market growth without any downturns. (Anyone who says differently is (quite literally) selling something.) Sometimes it's just not wise, like purchasing long-term care insurance when it makes more sense to pay for care out of pocket. Regardless, it's important to consider the situations when the dice come up snake eyes, despite the odds being in our favor. Remember: part of "being the casino" is "don't take bets you can't afford to lose"!

 

This is where "Plan B" comes in. I mentioned it earlier when talking about the gift of uncertainty, but let's take this opportunity to go into more detail.

 

What's "Plan B"?

 

The concept of Plan B is fairly straightforward: it's simply a plan of record for What To Do If The Bad Thing Happens. It's extremely useful for two main reasons, either of which may be more important depending on what kind of person you are.

 

On the one hand, if you're a happy-go-lucky risk-taker, Plan B helps determine whether you're overextending yourself. Sure, you say you're OK with no disability insurance -- but what would you do if you got a debilitating autoimmune disease? By thinking through the scenario, you can determine whether you're really OK with the potential consequences of a negative outcome, or whether you should determine some way to pare down your risk. There's a difference between being okay with the bad outcome and simply not considering it in the first place!

 

On the other hand, if you're a planner who's prone to analysis paralysis and just outright fear, Plan B can help you sleep at night. By coming up with a plan to address each of the scenarios that flits through your mind at 3AM, you can help calm that part of you that (not unwisely) wrestles with potential negative outcomes. And yes, I know it's tempting to just try not to think about it, but I can tell you with near-certainty that the more you try to shut out that part of you, the louder it will yell. In my experience, it's far better to listen and come up with a plan!

 

So: what might Plan B look like?

 

Bear market Plan B

 

Unsurprisingly, one of the most common questions I hear from clients -- especially as of this writing in mid-2019 -- is whether there's an impending market downturn. Like many good financial planners, my Magic 8-Ball answer is "Yes." But when you ask me when, it's "Answer Hazy". (That sound you just heard was my fellow planners chuckling as they read this. It's true!) The market is just so darned efficient that by the time all the market indicators line up with a clear answer, stock and bond prices have already changed to indicate this now-certainty. (Sure, there are generally-reliable predictors like the Shiller CAPE ratio, but they're (a) long-term, and (b) only generally reliable!)

 

But that doesn't mean we just throw up our hands and give up. Rather, we do our best to mitigate the effect of a downturn, by diversifying our portfolios and building an asset allocation of non-correlated asset classes. We don't stop there, however: we also create a Plan B to take into account a market downturn during the worst possible time(s).

 

The most obvious Bad Timing scenario is a bear market that occurs the year you retire -- statistically speaking, those first few years post-retirement are a "window of vulnerability" during which a downturn could seriously damage your financial plan. There's only so much that good portfolio design can do; running Monte Carlo, it's pretty common for me to see a retirement bear market reduce the success rate by 20% or more! Therefore, it makes sense to develop a plan B in case a downturn strikes during that window. There are several options that you might consider:

 

  • A more conservative portfolio during the "window of vulnerability"

  • Delaying retirement (assuming the downturn occurs immediately before retirement)

  • "Semi-retirement" - taking on part-time work like consulting

  • Reducing large discretionary expenses (e.g. giving, vacations) for a few years

  • Reducing general living expenses for a few years, or even holding them steady rather than increasing with inflation

  • Tapping the equity in your home, either by downsizing or taking on a reverse mortgage

 

This is by no means an exhaustive list; rather, the object is to come up with a combination of actions that you'd be okay with undertaking in the event of a bear market scenario. And if you're not okay with any of them, then maybe you need to revisit the rest of your plan -- perhaps reducing your expenses now, or planning for a delayed retirement as your base case.

 

And of course, given the fact that a bear market could happen at any time, you should be extra cautious with non-retirement funds, particularly your emergency savings!

 

Life and disability Plan B

 

While clients often come to me worried about the market, I find that it's generally my job to worry about risks such as untimely death and debilitating injury or disease. We're all immortal until proven otherwise, right? But as painful as it is to think through these scenarios, it's vital. 

 

Thankfully, life and disability insurance provide us a means to mitigate that risk. Term life insurance is particularly well-crafted: by levelling the premium and having the term end around your retirement age (at which point you hopefully will no longer need life insurance), you can get a lot of insurance for not a lot of money. 

 

Disability insurance is another matter -- because you're a lot more likely to be disabled during your career than to die prematurely, the premiums can be quite a big higher. Unfortunately, because you're a lot more likely to be disabled during your career than to die prematurely, that makes disability insurance all the more necessary!

 

The first-order analysis for both of these is to take a look at your current financial plan, calculate how much disability and life insurance you would need in order to make your plan work even in the event of premature death or disability, and purchase that much insurance. However -- particularly with young, well-paid professionals -- I often find that this results in a truly gobsmacking amount of insurance. 

 

This is where Plan B comes in again. How might your family's goals and expenses change in the event of premature death? Would they continue going on the same vacations? Would they downsize the home? And in the event of long-term disability, what would you do? Would your expenses go down? Would you perhaps go into "early semi-retirement", taking on a different occupation to supplement insurance payments? It's worth iterating on this a few times until you end up with both a Plan B you're reasonably comfortable with and insurance premiums that don't make your head hurt.

 

Leave room for the unknown!

 

Of course, there are only so many Plan B's you can come up with -- while it's good to prepare for the Big Known Risks, there are lots of unknown risks, both big and small. This is why it's important to embrace uncertainty in general: build buffers into your plan, set a high threshold for your Monte Carlo success rate, place a premium on flexibility and liquidity, etc. 

 

 

Want to read more about risk mitigation? I recommend starting with "be the casino" and "wise decisions v. good outcomes" for a mindset check, then "the gift of uncertainty" for some more practical tips. If you're particularly interested in portfolio design, check out "the theory behind smart investing", as well as the article on Monte Carlo simulations.

 

 

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

Please reload

Subscribe

RSS Feed

Recent Posts

October 20, 2019

Please reload

Archive

Please reload

Tags

Please reload