Reasonable assumptions in financial planning

Part of a financial planner's job is to help clients get a handle on how much money they will require to maintain a certain quality of life in retirement. And because there is no accepted standard regarding the kinds of returns on can expect from various investment types, many planners use different assumptions in doing their own financial independence calculations.

But what exactly is a reasonable assumption? Most fair-minded people believe that past history is as good a guide as any in making projections about the future. We know this is true in the planning world because of the number of planners who use various rating resources such as Morningstar to filter their product recommendations. These filters rate products based on past performance.

Let's use Canadian data as an example. According to data compiled by Morningstar, one can see that for the period from January 1940 to December 2007, the average annualized return for various asset classes is as follows:

    * Treasury Bills: 5.2%
    * Canadian Bonds: 6.5%
    * Canadian Stocks: 10.6%
    * U.S. Large Cap Stocks: 11.3%
    * U.S. Small Cap Stocks: 15.1%

If those are the numbers your advisor and you use in doing your planning, they may be defensible enough. However, this is the point where many advisors then start to use some discretion. They do this especially where active management is concerned. Specifically, I know of many who inflate the numbers by some amount (let's say 1%) on the pretense that active management will allow their clients to "beat" the relevant benchmark(s). This is almost certainly incorrect.

Just as far more than 50% of all people with a driver's licence believe they are above average drivers, a majority of advisors thinks most active managers can "beat the average" -- i.e. the benchmark -- as evidenced by the fact that far more money is being invested into active products and strategies than in passive ones. This also suggests that these advisors believe they can reliably identify the good managers, even if the average ones are, in fact, below average.

Simple logic demonstrates that the average return for any mutual fund is likely to be the return of the benchmark minus the fund's management-expense ratio. Therefore, if the expected return for the Canadian stock market is 10.6% and the Canadian equity fund you invested in has an MER of 2.4%, your expected return is 8.2%. That's a far cry from 10.6% and it makes the assumption of 11.6% look absolutely outrageous. In other words, it is likely far more responsible to deflate projections -- especially when using high-cost products to build portfolios.

When you calculate projections and change only the variable of expected return, a difference of 2% or more over the course of many years is gargantuan. Let's look at the example of a $200,000 portfolio over a 20-year time horizon and compare the outcomes for growth at 8.2%, 10.6% and 11.6%.

At 8.2%, the portfolio grows to $967,331. A princely amount to be sure. At 10.6% (the result one gets assuming both the products and advice are cost-free and therefore have no impact on return), the portfolio grows to $1,500,143, which is over half a million dollars more than the expectation where costs are included in the assumptions. For those people who are really curious and want to see what can be generated using some truly outrageous assumptions, the 11.6% return assumption generates a portfolio value of $1,796,031.

Remember the simple rule of thumb called the Rule of 72. It suggests that the approximate time required to double your money is the rate of return divided into the number 72. In other words, an 8% rate of return should result in a portfolio doubling its value approximately every nine years. It's not exact, but it works as a reasonable "back of the napkin" kind of self-assessment for those people who don't have a financial calculator at the ready.

The need for meaningful, professional disclosure is clearly evident when it comes to incorporating investment costs -- whether it is fund fees, commissions or asset-based advisory fees -- into planning assumptions. Advisors who suggest they can "outperform" their peers by simply using unsustainable assumptions in their planning are doing their clients a disservice.

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Reasonable assumptions in financial planning