Financial planners need to use assumptions about the future to paint a realistic picture for their clients. Since we don’t have a crystal ball, most rely on the projection and assumption guidelines put forward annually by FP Canada.
These assumptions include estimates about inflation, investment returns, life expectancy, wage growth, borrowing costs, etc. Note that these assumptions are meant to approximate an average over 10+ years. Forecasting any economic variable over a short period of time is pretty much impossible, but while the short-term may be volatile (hello 2020s), long-term trends are a bit easier to predict.
Take inflation. Sure, in the past two years we have experienced higher than normal inflation. It might be tempting, then, to increase the inflation expectations in your plan to match the present (or near past) environment. But that would be a mistake for two reasons:
- Nearly every central bank in the world is working to get inflation back down to a steady and predictable 2%. Canada is also an aging, developed, slower growth economy that lends itself to lower interest rates and lower inflation over time. Furthermore, in looking at two-year rolling averages over the past 60 years, the inflation rate was at 3% or lower nearly 75% of the time.
- Inflation affects other variables. Increasing the inflation rate in your retirement plan also means that your CPP and OAS benefits will increase at the same rate. Same for those with defined benefit pension plans that offer inflation protection. Higher inflation would also lead to sustained higher interest rates, which increase the rate of return for assets like cash, bonds, and equities. In summary, we can’t change one assumption in isolation.
FP Canada assumes that inflation will average 2.1% annually over the long-term, and I don’t have any reason to disagree.
This article explores other retirement assumptions used for financial planning projections and explains the rationale behind them. I’ll also share some common objections or misperceptions that I hear from clients about some of these variables.
FP Canada suggests using a projection period for clients where the probability of outliving their capital is no more than 25%. If we assume the average life expectancy is about 81 years for Canadian men and 85 years for Canadian women, then by definition half of men and women will live longer than the average.
Then there’s your probability of survival if you’ve already reached a certain age. For example, a 60-year old male has a 25% chance of living to age 94 and a 50% chance of living to age 89.
That’s why I run my planning projections to age 95 as a default (unless there are specific health or genetic reasons to move that age up or down). I want to stress-test your plan to make sure that you have enough resources to last a long and healthy retirement.
And, no, it’s not sensible to change your otherwise normal life expectancy to 75 in order to retire earlier and spend more money. Taking up smoking (or sky diving) is not a sound financial plan.
I don’t ascribe to the Dave Ramsey approach to investment returns – thinking you can earn market returns of 12% per year indefinitely. FP Canada offers a more realistic estimate of between 6.2% to 7.4% per year before fees.
If we assume a globally diversified portfolio made up of 30% Canadian stocks, 62.5% US and International stocks, and 7.5% emerging markets stocks, we get a projected rate of return of about 6.5% before fees for an all-equity portfolio best represented by Vanguard’s VEQT.
FP Canada projects that aggregate bonds will return 3.2% annually (again, before fees). If we apply that to the classic balanced portfolio of 60% stocks and 40% bonds (best represented by Vanguard’s VBAL) we get a projected rate of return of 5% before fees.
This closely aligns with the investment return assumptions I use for planning purposes. I assume 6.1% net of fee return for equities, 3.1% net of fee return for bonds, and a 4.9% net of fee return for a 60/40 balanced portfolio.
For cash, I assume 1.6% – or inflation minus 0.5%. The idea is you keep your savings in a high interest savings account to capture the best rate of return on cash that you can. It’s not in a chequing account or big bank savings account earning nothing, and it’s not stuffed under your mattress.
By the way, it should go without saying that these returns represent a long-term average rate of return. Investment returns can be incredibly volatile from one year to the next. But you don’t abandon a perfectly sensible and diversified portfolio after one bad year. Similarly, you don’t get excited and prepare your resignation letter early after one good year in the markets.
Clients still in their working years are often puzzled when it comes to forecasting their expected wage growth. They typically don’t want to assume that their income will increase at all, let alone by the rate of inflation.
They’re even more puzzled when I tell them that the typical wage growth is inflation plus 1% (or 3.1% per year). That’s right, in normal times your wages will outpace inflation. That’s a fact.
I get it. I went through five years of wage freeze hell in the public sector. But when you account for cost of living adjustments and potential promotions or increases from job switching throughout your career, it’s not out of line to think that your wages can grow by 3.1% per year on average over the long term.
Still, try explaining to someone making $100,000 today that they’ll be making $215,000 in 25 years and they’ll stare at you in disbelief.
Spending in Retirement
Many people have no idea what they’ll spend in retirement. A helpful starting point is to determine what you’re spending in your final working years. Most of my clients want to maintain their existing standard of living, if not enhance it with some extra money for travel and hobbies.
We also may have heard that retirement spending keeps pace with inflation during the “go-go” phase of retirement, then reduces during the “slow-go” phase (inflation minus 1%), and and then levels off during the “no-go” phase (no more inflation adjustments).
While this sounds intuitive, I’m not a fan of this approach to retirement spending because I don’t want to arbitrarily impose spending cuts for my clients at age 75 and 85 (for example). I can also easily see spending on travel and hobbies being replaced by in-home nursing care and mobility aids as you age.
For this reason, I keep spending increasing with inflation to age 95 when possible.
I also encourage clients to think about one-time expenses that will likely occur throughout their retirement. The big four items include new vehicles, home renovations and repairs, financial gifts to kids, and bucket list travel and experiences. We weave these expenses into the plan as needed.
Housing in Retirement
A big question for homeowners is what to do with their paid-off home in retirement.
Sometimes, it’s painfully clear that the client will need to access their home equity by downsizing, selling and renting, or using a reverse mortgage.
More often, the client has enough resources to maintain their lifestyle without selling the home and so we assume they remain in their home (or home of equivalent value) for their lifetime. There’s no use trying to predict their health situation at 85 or 90 and the need to move into a retirement facility. The home is there and equity can be tapped if needed.
Still, if the goal is to maximize spending or “die with zero” then clients should consider the eventual sale of their home to add the proceeds to their savings and investments for consumption.
There are a lot of unknown variables that go into a financial plan. We need to use reasonable assumptions to help understand how you’ll use your financial resources over time to achieve your goals.
Assumptions should be conservative, but realistic. You won’t do yourself any favours expecting 12% returns on your investments. On the flip side, there’s no need to be pessimistic about the future and expect persistently higher than normal inflation, Great Depression-like returns, or low to no wage growth.
Finally, know that these are assumptions about what the world is going to look like in the future, but the world is surprising and unpredictable (hello 2020s). Check in on your plan and projections from time-to-time to make sure you’re still on track and course correct as needed.