Andrew Pyle
April 29, 2022
Re-examining financial planning assumptions
As our clients know, it is important to have a financial plan but equally as important is the need to regularly update it; which is why we have always followed a disciplined three-year update process. Sadly, the majority of Canadians still don’t plan, let alone return to a plan on a scheduled basis. We follow this update routine because things change in a person’s or family’s life. Things also change in the economy and markets and what we have been through in the past two years has been change on steroids. This has many wondering whether all of the underlying assumptions in their plan need to be altered as well.
Assumptions are critical in any financial plan and no plan should be considered to be an accurate to-the-penny look into the future. However, if the assumptions made are reasonable and conservative, then the plan should be a close approximation of what the future could look like. If done properly, the plan should be a useful guide, allowing one to construct budgets that are consistent with their needs and expectations. Yet, because an assumption is simply that – a guess – the gap between that assumption and reality will grow over time and this is why they have to be re-examined on a regular basis.
There are several assumptions contained in a plan – some more important than others. Life expectancy, date of retirement, expected CPP and OAS payments are ones that I consider to be important, but not necessarily in the camp of those that will change a lot. The emergence of health issues may affect the former and it is possible that some Canadians have changed their retirement date in response to the pandemic. Indeed, this has contributed to the shortage of labour plaguing many industries, but I will save that topic for a later blog. The more critical assumptions, when it comes to what drives a plan, will be things like investment return, spending patterns, and inflation.
When we think of what constitutes a reasonable long-term average investment return, it may sometimes feel like throwing a dart at the board and for some components of that return, this could be a fair analogy, But what I have told clients over the years is that for any portfolio that is not 100% equity, the answer is going to come from two assumptions – what can I earn on equities and what I can earn from fixed income or bonds? Now, after the last few months, one might say both markets are shots in the dark, but the reality is that bond market returns will be have less variance than stocks and will be driven more by what we can see.
Buying a 10-year government bond back in July 2011, with a 2.75% coupon and holding to maturity this coming June will still have generated a 2.75% average annual return, despite the sizable price swings since it was issued. The certainty of that return diminishes as we buy bonds with more risk, like corporate debt, but you get the idea. The more a person has in fixed income the greater the degree of confidence they should have in the long-term investment return assumptions made in the plan, even if those returns will likely be lower than what we would assume for portfolios with higher equity exposure. The problem is that the higher degree of equity exposure, the higher will be the estimated volatility of returns over time. The preferred approach is to adjust the returns for volatility (or risk) in each market and then take what the particular balance of the portfolio would reasonably generate as a combined return.
I would still argue that even with the rebound in equities since the pandemic and weakness in bonds since 2020, an appropriate average annual return assumption would still be in the 3-5% area for a balanced portfolio. There will be 3-year periods where that might be low, which is just fine, and then there will be periods where these assumptions aren’t met. And there will be situations where the individual themselves have shifted into a different portfolio strategy, which requires a different long-term assumption. Another reason why the plan should be updated regularly.
What of the spending side of things? This is one area, where there probably have been some significant changes if we prepared an update today versus April 2019. First of all, households made major adjustments in spending behaviour during the pandemic. Some spent less (like on restaurants and travel), while others spent more to provide for their “staycationing”. Some may be spending less on commuting because they have found employment that allows for working from home. Then again, other households may have moved from rental accommodation to purchasing a home and now find more of their budgets going to service mortgages and property taxes.
Higher inflation has also played a role in changing the nominal level of spending being done by a household, although that same inflation has also helped to boost nominal wages. This is a tricky one from a planning perspective since it might prompt some to want to change their long-term inflation assumptions. Prior to the pandemic we would normally use a 3% inflation projection and I remember individuals saying that this was high, given that we mainly lived in a 1-3% world. Those same people now tell me this assumption is too low because current inflation is almost 7%! What I would say is that, even though inflation has spiked, the central banks of the world are still targeting inflation around 2% and are in the middle of ramping up interest rates to get it.
Some prices of goods and services, which have seen a sharp jump, may not go back to where they were and that is why we have to be careful when figuring out updated annual spending patterns, but some will revert back. That would include things like energy and food prices and, yes, even used car prices. Households may also be doing some substituting within the household budget because of higher prices, such that their overall spending is kept more or less the same. In short, I would suggest that a 3% inflation rate assumption is still reasonable in any plans being updated today.
Having said there are some important aspects of the plan where costs will have likely been permanently shifted. Post-secondary education is probably on a higher sustained trajectory now than before the pandemic, even though the adoption of virtual learning would suggest that costs should actually be lower. Health care costs are also likely to be higher into the future than originally estimated. Again, the counterargument is that some incomes have also been permanently lifted due to labour shortages and history tells us that wages tend to be very sticky even when shortages disappear. The bigger risk here, in my opinion, is labour substitution. Companies will eventually look for more efficient ways to produce and this could lead to less hiring and less job stability. Depending on the industry the individual works in, this might require some careful planning into the future.
Bottom line, there have been so much upheaval in economies and markets over the past couple of years that many Canadians will be forgiven for thinking that their financial plans are completely out of whack with reality. I would argue that if they have been following a three-year update approach, they are probably not as far off course as they think. Their portfolios may or may not be where they projected three years ago, but their real estate assets are likely worth way more. In other words, their overall net worth is probably higher today than estimated. They do need to re-examine their employment situation and retirement timeline, in addition to long-term spending plans; however, they are still probably close to where their original long-term trajectory was.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew
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These are the personal opinions of Andrew Pyle and may not necessarily reflect those of CIBC World Markets Inc.