How to test your financial security

Flickr user 401(K) 2012

(MoneyWatch) Timothy Noonan and Matt Smith are financial professionals with over five decades of combined experience working in the asset management business. They've written an excellent book, "Someday Rich," that takes an atypical approach to the issue of financial security. Though the book is written for financial advisors, most investors will learn a great deal from their work.

Noonan and Smith define financial security as "the ability to always have enough assets to annuitize to meet essential needs." As the authors point out, having that ability doesn't mean one should necessarily do so, as avoiding annuitization preserves options. Once you buy an annuity, you fix the amount you'll have to spend and pay fees to get that guarantee. Of course, in addition to the benefit of the guarantee, you also get to pool your longevity risk. That allows you to earn what are called mortality credits.

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The authors use what they call the personal liability model to help determine your financial security. The starting point, as it should be with any investment plan, is to ask the right questions. They provide a list of three key ones:

How much do I need?

To determine this, you need to know how much you actually spend and what you actually buy. You also need to be able to separate essential needs from lifestyle desires (such as travel, entertainment, club memberships, and of course one person's desires might be another's needs). A third category is estate spending -- the desire to leave wealth to heirs or donate to charity either during your lifetime or upon death. The authors focus on having sufficient financial assets to purchase an annuity that would meet all your essential needs. Once that goal is achieved, you can tailor your investment strategy with the surplus capital.

Will my money last?

To answer this question, you just need to know if you have sufficient assets to purchase an annuity to fund your needs. However, even this isn't a perfect answer because even with an annuity you'll still face inflation and credit risk. You also lose some financial flexibility.

What can I do?

If you haven't met the 100 percent funded level, you'll need to consider working longer, delaying social security benefits, saving more or lowering your spending goal. The good news is that you have control over these issues. The other alternative is not as prudent, because it entails taking more investment risk, and you have no control over the outcome. Those who have achieved the 100 percent funded level have better choices.

A well-developed financial plan will identify not only spending and saving needs, but also insure against risks that can undermine your goals. Failing to address how much life, disability, health, liability and long-term care insurance you need can ruin even the best investment plans.

In addition, an investment plan must be persistently monitored to adapt to unexpected events -- both life events and investment returns that are above or below expectation. It's important that plans be persistently updated to reflect the current reality. Even the simple passage of time impacts plans. For example, during the accumulation phase, the value of your labor capital decreases as time passes, and during the decumulation phase your longevity risk decreases as time passes.

As another example, during the accumulation phase bear markets can be viewed as opportunities to buy low, while in the decumulation phase withdrawing assets to provide for spending needs has the opposite effect.

If you're either working with a financial advisor or considering working with one, Noonan and Smith point the way to determining if you're receiving good advice. First, it should be tailored to your personal situation, not cookie-cutter. Second, it should cover not only investments, but also overall financial planning, lifestyle planning and retirement planning. finally, it should be both strategic and adaptive as circumstances change and tactical adjustments are needed.

Image courtesy of Flickr user 401(K) 2012

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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