Earning a benchmark rate of return or beating a market index may feel good at the time, but how does it impact your life, your future and your ability to sleep well at night? Without a doubt, earning a return of 8 percent, instead of 6 percent, will produce more wealth. But is the additional risk worth the possibility that, in a down market, your assets might not cover your needs or meet your goals?

At Glenmede, we believe that achieving a  high rate of return or beating a benchmark doesn’t tell you what you need to know. What matters most is meeting your personal financial benchmark — the level of wealth required to live a desired lifestyle and achieve your important goals, including those relating to legacy and philanthropy. This requires a different process — starting with a thorough understanding of your short- and long-term financial goals and then devising a wealth plan and investment strategy to achieve them in a quantifiable way.

Traditional approaches to benchmarking

Historically, a common approach to establishing a financial benchmark started with determining a target rate of return, based on the “efficient frontier,” a risk and reward model developed by economist and future Nobel Laureate Harry Markowitz in 1952.

In simple terms, the efficient frontier represents the maximum expected portfolio return for a given level of risk. Using this model, we can create a series of diversified portfolios — ranging from low- to high-risk — each with a targeted rate of expected return and risk. But these targets along the efficient frontier are, at best,  an intermediate step. They still don’t answer critical questions such as: Will you have enough to meet all of your spending needs without the possibility of your assets running out?

Another approach to benchmarking is measuring performance against a market index, a good starting point for understanding whether active management is adding value, compared with index funds. But active management is generally a small part of investment performance, given that asset allocation tends to be the primary driver of portfolio returns in big market moves. If the market is down 25 percent and your portfolio is down only 21 percent, active management likely added value by reducing your losses. However, you are still incurring substantial financial loss with implications for how much you can spend in the future.

To understand how well your investments are doing, a different benchmark should be considered — one based on your personal financial goals.

Creating a personal financial benchmark — based on your goals

Constructing a personal financial benchmark requires knowing your financial goals — how you plan to use your wealth. Goals can be as diverse and varied as any group of families or individuals. Generally, though, they come in three categories:

• Lifestyle — having enough money to sustain your spending
• Legacy — passing assets to your family and loved ones
• Philanthropy — funding your charitable passions

For many, setting financial goals can be the hardest part of goals-based planning. But it needn’t be overwhelming. Trusted advisors can talk you through the options and share the ideas and experiences of others in similar situations.

Another comforting fact: A goals-based process doesn’t mean settling on a single well-defined and final set of objectives. You can make your best guess and, using flexible technology, test and compare any number of different scenarios.

Measuring the probability of success

In a goals-based approach to investment and wealth planning, the benchmark becomes the estimated probability of success in achieving your goals. This benchmark requires a different and more integrated approach to wealth advisory. Unlike traditional approaches that treat wealth planning, trust advisory and investment management as separate disciplines, requiring separate discussions with different experts, goals-based planning views them holistically.

This integrated approach and goals-based methodology enable more personalized planning to develop the combination of investment and wealth planning needed to achieve the highest probability of success.

The actual process typically involves using sophisticated computer technology to simulate thousands of potential market scenarios, spanning the range from earning below-normal, normal and above-normal returns. These simulations can incorporate your specific goals and combine them with your financial data, including spending needs, retirement and deferred compensation plans, charitable accounts, trust mandates, accounts for children and other financial details. The resulting wealth projections make it possible to estimate the likelihood that your investments will earn enough to meet various personal goals —  your probability of success.

Generally, we recommend that investors adopt a set of investing and wealth planning strategies that provide an 85 percent or greater probability of meeting their goals. If you’re uncertain about your goals — for example, you may or may not decide to buy a second house — we recommend creating alternate plans to determine whether you can still achieve an 85 percent probability  of success.

A measurable margin of safety

Another useful benchmark, the fixed-income reserve, estimates the number of years your cash and fixed-income assets would last if they had to cover your personal spending needs. In the event of an extended equity bear market, defined as a 20 percent market drop, the reserve would allow you to spend cash and fixed-income assets without having to sell equity assets at depressed values.

Ideally, the reserve should last through a bear market of 15 months, the average length of nine bear markets since 1956. A more cautious approach might be to build a sufficient reserve to withstand a sustained market downturn, like the Great Depression, from which equity markets didn’t recover for 25 years in nominal terms, or about five years when adjusted for inflation, dividends and a broader market comparison.

Some might argue that this measure is unnecessary if you are already arriving at an acceptable probability of success. But others may find this to be a particularly comforting and tangible form of benchmarking.

Monitoring your financial benchmark over time

Glenmede encourages all of our clients to engage in a Goals-Based Wealth Review and to annually reestimate their probability of success and fixed-income reserve. Income sources beyond your investment portfolio and market fluctuations will, of course, influence the simulations.

More importantly, your goals may change over time. For example, your desire to purchase art or travel might increase. You might sell your house and move to another state, changing your after-tax income. A new charitable pursuit may excite your imagination and passion, necessitating a substantial capital commitment. An adult child who needed extended financial support may be getting on his feet. Or, your tolerance for risk may have decreased. These are just some of the possibilities that argue for revisiting your plan regularly.

Goals-based investment and wealth planning is not unlike embarking on a long voyage. At each stage along the way, you set your direction by establishing your current goals and benchmarking your probability of success and fixed-income reserve. Your port of destination may indeed change, and no journey is without ups and downs. In any event, when you select an investment and wealth planning strategy that best meets your goals,  you can achieve peace of mind.

Case Study: Making Informed Decisions By Setting Personal Benchmarks

One couple, planning to retire within the year, was ready to explore new financial goals for the next phase of their lives. They had spent decades accumulating wealth to raise their children and plan for a comfortable retirement. Approaching the finish line, however, they didn’t know how much of their assets would be available for creating a family legacy and pursuing philanthropy. They needed help in envisioning their retirement and how big they could dream.

The first step in Glenmede’s goals-based wealth planning process is determining a personal financial benchmark. What was their probability of success in achieving goals, based on their current wealth and plans to spend $350,000 a year in retirement? Financial simulations showed they had a 99 percent probability of success, while more than tripling their wealth from $14.5 million  to $47.6 million by the time the younger spouse reached age 95.

Exploring new goals and spending scenarios

Based on the couple’s projected increase in wealth during retirement, the analysis showed they could afford to expand their horizons and adopt new goals:

• Lifestyle: Buy a second home for $750,000
• Legacy: Provide gifts to their two children totaling $3 million
• Philanthropy: Donate $1 million to their alma mater

Even with the increase in spending, simulations showed the couple would have an 87 percent probability of success and increase their wealth to $21 million by the time the younger spouse reached age 95. Their relatively conservative investment portfolio — split equally between equity and fixed income — included a large fixed-income reserve projected to last 19 years, far longer than a typical bear market. In fact, the size of the reserve was a clear indication the couple could afford to take more risk if they wanted to further enhance their goals for retirement.

Changing investment strategy

Our Glenmede relationship management team helped the couple explore additional scenarios that increased their equity exposure, resulting in higher projected asset accumulations and a smaller fixed-income reserve. The couple ultimately chose a strategy with a 70 percent equity exposure, projected to increase their wealth to $31 million by the time the younger spouse reached age 95, with a reserve that would last nearly eight years and an 85 percent probability of success.

By taking additional investment risk, the couple created new possibilities to expand their goals, whether a larger legacy for their children or other philanthropic gifts.

^{This example is provided for illustrative purposes only and is not intended to be individualized investment advice. Projected estimates of assets, fixed-income reserve and probability of success reflect Monte Carlo simulations, based on hypothetical scenarios. Investment involves risk. Despite projected probabilities of success, there can be no assurance that projections will be accurate or that objectives will be achieved. Past performance may not be indicative of future results.}

^{Source: Glenmede}