Financial Planning Assumptions
Dale Walters, CPA, CFP
There is a wealth of information being published on sophisticated planning techniques, but there is very little information on the fundamental attributes of a good financial plan. No one will deny that a financial plan (or any plan for that matter) is only as good as the assumptions upon which it is built. Why then is there so little thought put into this extremely important subject? This article is an overview of a few basic planning assumptions and suggestions on how to arrive at reasonable, well thought out assumptions.
The dilemma surrounding assumptions is that they are by their nature uncertain, yet vitally important to the projected outcome. It is those projected outcomes upon which advisors base their recommended course of action. Therefore, poor assumptions equal poor recommendations.
I believe advisors should use a process by which they endeavor to construct an accurate (that is, reliable, consistent and non-arbitrary) representation of the world – otherwise known as the “scientific method.” By using a consistent method, planners reduce the risk of providing bad advice to clients, as well as provide them with a strong theoretical and legal footing.
The core inflation rate assumption should be the cornerstone for many of the other assumptions. Core inflation is the basic cost of living assumption. Because different inflation assumptions may be desired for expenses such as medical and education, it is important that these assumptions have a logical relationship to the core inflation assumption. In my opinion, the most important reason to start with the core inflation assumption is that it is readily available, subject to minimal manipulation, and a high degree of correlation exits between other inflation rates.
The best predictor of future inflation is the difference between the yield to maturity on Treasury Inflation-Protected Securities (TIPS) and the yield to maturity (YTM) on Treasury bonds of the same maturity. For example, on September 21, 2004 the 30-yr. Treasury had a YTM of 4.84% and the 30-yr. TIPS had a YTM of 2.13%, for a difference of 2.71%. Therefore the best guess of the market as to future inflation over the next 30 years is 2.71%. The fact it is easy and doesn’t require justification makes this method very appealing; it is simply the best guess of the market. If an advisor were to use history as an indicator of the future, the advisor would most likely use 3.9%, the average from 1950 to 2003. There is a huge difference between 2.7% and 3.9%.
For the period 1958 to 2001, the annual rate of tuition increase averaged 6.98%, or approximately 1.62 times the overall rate inflation for the same period, which was 4.3%. Therefore, if the expected long-term inflation rate were 2.7%, then the expected rate of inflation for education would be 4.375%. Many advisors attempt to predict the future by looking at the history and using a 6 or 7% rate of inflation for education. Others take a shorter glimpse of history based on the last few years and expect education costs to increase 10 to 12% per year. This same error in reasoning holds for many other assumptions, with medical expenses and investment returns being the most notorious.
We are all aware that the information we see or hear last is the information we are most likely to remember. More importantly, all of the assumptions within a plan should be congruent. It is inherently illogical to say that on one hand long-term inflation will be half of its 44-year average, but yet education expenses will be double their 44-year average… unless there is a separate assumption stating that the rules of economics that existed in the past will not hold in the future.
A big issue today is: What should we assume for the return on for real estate? The average increase in single-family homes from 1950 to 2003 was five percent, or 1.25 times the average inflation rate for the same period. Using a long-term inflation rate of 2.7%, the expected rate of return on real estate would be 3.375% if the correlation between inflation and return remained constant going forward. I am not saying you can’t assume real estate will appreciate 10% per year over the long-term. I’m simply saying if you do so, you need to have an explanation as to how things are different today.
The last assumption I want to discuss is future investment returns. The average return of the S&P 500 from 1925 to 2003 is 10.4%. I have seen many advisors use 10% as the assumed rate of return even though no properly diversified portfolio would be invested entirely in the S&P 500, and despite warnings that past returns are not a predictor of future returns. If the past is not indicative, then how do we arrive at a reasonable rate of return? Most “experts” use a building block approach. They start with the dividend rate (1.8%), add the earnings growth rate (5.4%), and add or subtract the speculative return, i.e. the change in Price/Earnings (P/E) ratio. The consensus of the experts from the Blue Chip Forecaster for the 10-year period 2003-2012 was 7.2%.
I was only able to discuss a few areas in a very cursory way, but as I close, please remember that the advisor should: 1) list every assumption made in the plan; 2) have a logical and defensible position for every assumption; and 3) every assumption should be logical and consistent with one another. Advisors need to take the time to think about and document each and every assumption; the clients deserve it and courts demand it.
Dale Walters, CPA, CFP, is CEO of Keats, Connelly & Associates. He can be reached at (602) 955-5007.
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