Financial planning assumptions

Financial planning assumptions, also known as projection assumption guidelines, are long term (10 years or more) estimates of future inflation, investment returns, and borrowing rates. Such assumptions are needed for projections, e.g. retirement plans, or education funding needs. The numbers can be seen as "central" values for use by financial planners, both professional and do-it-yourself (DIY). Realized inflation and investment returns may be more, or less, than these values, so a range of scenarios should be explored. Guidelines can also include longevity (probability of survival) tables to help decide on an appropriate planning (assumed death) age. Again, scenarios with different ages should be run. Some reports also provide expected standard deviations and expected correlations between asset classes.

This article first explains how to understand expected returns. It then introduces well known sources of financial planning assumptions used in Canada. Finally the article concludes with a brief discussion of how to deal with the uncertainty around those assumptions.

How to understand expected returns

It is important to realize that an expected return of say, 5.0%, used in a financial planning exercise, is not a prediction that the realized return over a certain period will be exactly 5.0% every year, or even that the annualized return will be exactly 5.0% over 10+ years. The expected return is a prediction about the center of the distribution, the most likely outcome. There is a considerable margin of error, "even over a 30-year horizon". For example, one prediction for global equity returns over the next 30 years is 4.6% real (after inflation), but taking one standard deviation into account, this means that "under the most likely scenarios, global equity will return between 2.8% and 6.2%".

Institute of Financial Planning and FP Canada guidelines

The Institute of Financial Planning (formerly: Institut Québécois de planification financière) and the FP Canada Standards Council jointly publish "Projection assumption guidelines" every year, for use by their members (financial planners).

How they are produced

The guidelines are arrived at by a committee that combines multiple sources of information, including forward-looking and backwards-looking information:

• actuarial reports for the Québec Pension Plan (QPP) and Canada Pension Plan (CPP), which provide estimates of inflation and expected returns (updated every 3 years)
• yearly industry surveys about expected returns and inflation
• the Bank of Canada inflation target of 2% (the mid point of the 1-3% range)
• for bonds and equities, market based expected returns (yield to maturity for bonds; Shiller earnings yields for equities)
• for equities, 50 years of historical data based on well known stock market indices (S&P/TSX index for Canadian equities, etc.)

The numbers are expressed as nominal (before inflation), pre-tax, pre-fees returns. Real returns can be arrived at by subtracting expected inflation from expected nominal returns. Investment fees and taxes should also be accounted for.

Geometric or arithmetic?

Another consideration is that these are geometric mean return assumptions, as opposed to arithmetic means. The geometric mean, a.k.a. compounded annual growth rate or annualized return, is the equivalent constant growth rate that would yield the same final dollar amount as a series of variable returns. Over the 30 years to 2020, the geometric mean (nominal) return of Canadian, US and EAFE equities has been about 1.1-1.2% lower than the arithmetic mean. Over the 10 years to 2020, the difference was about 0.5-0.7%, and indeed the IFP/FP Canada assumptions subtract 0.5% to their average estimates to "compensate for the variability of the long-term returns".

Is your planner using higher expected returns?

One reason why IFP/FP Canada publish their guidelines is to avoid planners (and hopefully, or other advisors) promising or implying unrealistic returns to attract clients:

There are many people out there who honestly think it is reasonable to expect a double-digit return over a multi-decade time horizon for a balanced portfolio. That expectation is utterly unreasonable.

John De Goey, Financial Post

Other sources for assumptions

Some wealth management firms and some asset managers also publish financial planning assumptions or at least capital market expectations. This includes:

• PWL Capital (30 year horizon)
• RBC Global Asset Management (10, 20, 30 years)
• TD asset management (7-10 years)
• Vanguard US (10 or 30 year horizon)

Example

Suppose that your portfolio consists of 40% Canadian bonds, 20% Canadian equities, 20% US equities, and 20% international developed (EAFE) equities. What is the expected annualized return over the next 10+ years, after inflation and investment fees of 0.2% (representing a simple index portfolio of four ETFs)?

Using the 2025 IFP/FP Canada projection assumptions, we get:

Asset class	Asset weight	Expected return	Projected annual portfolio return
Canadian bonds	40%	3.4%	0.40 * 3.4% = 1.36%
Canadian equities	20%	6.6%	0.20 * 6.6% = 1.32%
US equities	20%	6.6%	0.20 * 6.6% = 1.32%
EAFE equities	20%	6.9%	0.20 * 6.9% = 1.38%
Totals	100%	n.a.	5.4% (gross)
Minus: fees of 0.2%			5.2% (after fees)
Minus: inflation of 2.1%			3.1% (real, after fees)

In a non-registered account, taxes would also have to be considered. The pre-tax 3.1% real return number would be a neutral ("central") scenario for this portfolio over the next 10+ years. A "moderately bad" scenario would be, for example, higher inflation (say 3% instead of 2.1%) and lower returns (say 1% lower), yielding a real return of about 1%.

What if the assumptions are wrong?

As mentioned above, there is a considerable margin of error in expected returns. This is why multiple scenarios must be examined. And even with a perfect crystal ball in terms of future annualized returns and standard deviations, available retirement income can't be predicted with perfect accuracy because of the sequence of those returns: "the actual order in which returns occur can greatly affect spending sustainability".

Therefore, financial plans must be revisited regularly as new information becomes available. For example, making portfolio withdrawals that vary somewhat as a function of realized returns can help to minimize the risk of spending not enough or spending too much.

External links

• Financial Wisdom Forum topic: "Financial planning assumptions"