Guidelines for Financial Planning Assumptions

Q2 | July 2019

Topic: Wealth Planning

Nicole (Weiss) Louthe 

July 8, 2019

Image used with permission: iStock/ktasimarr


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Guidelines for Financial Planning Assumptions

Q2 | July 2019

Financial planning involves creating a variety of projections to model the future as accurately as possible. These projections include, but are not limited to, cash flow, net worth, estate worth, retirement planning, retirement income, insurance needs, etc. The quality of any financial forecast depends on the quality of the inputs used. So, it is imperative to use assumptions that are realistic and objective.

Recently, the financial planning regulatory body of Canada, FP Canada Standards Council (FP Canada), published its financial assumptions guidelines for 2019. The guidelines recommend long-term (10+ years) rate of return assumptions for a variety of asset classes ranging from cash to emerging market equities. To eliminate potential bias by relying on a single source, the guidelines use data from numerous third parties. Historical experience drives much of the forecast. But in order to be realistic and objective, FP Canada takes into consideration special factors that reflect the changing nature of capital markets.

This table summarizes FP Canada’s guidelines and compares them against our own assumptions for financial planning:

Note: the rate of return assumptions are nominal and before investment management fees.

As indicated in the table, Nexus’s current financial planning assumptions for inflation and equities are largely in line with FP Canada’s guideline, whereas our assumptions for short-term money market and fixed income asset classes noticeably differ.

In our view, FP Canada’s short-term return assumption is generous. However, the difference is financially immaterial for most of our clients as the allocation to short-term instruments is typically small. What deserves more explanation is the significant differential (1.9%) between the fixed income return assumptions.

There are three reasons for the difference. First, Nexus is more conservative about fixed income returns over the long-term, given that interest rates are now at 50-year lows. Should interest rates creep up over time, this will exert downward pressure on bond prices, such that bond returns will suffer as a result. Second, bonds perform the important role of ensuring liquidity in our clients’ portfolios. This is why we hold bonds that are higher in quality, resulting in slightly lower yields – we intentionally prefer lower credit risk. Third, in line with our expectation of higher interest rates to come, the average maturity of our bond portfolio is shorter than the benchmark, placing our holdings on the lower-yielding part of the yield curve. Another way of looking at this is that FP Canada’s guideline may, in part, simply rely more on historical fixed income returns than our prospective view. In summary, when interest rates are this low in both nominal and real terms, we believe the role of bonds is mostly to add stability to the portfolio.

There is no way to predict when times will be good and when they will be challenging, so we prefer to be conservative when planning for the future. At Nexus, the investment team reviews our financial planning assumptions periodically. Recently, in light of slower potential global economic growth, we trimmed our assumed rate of return on equities from 7% to 6.5%. This reduction is minor and should not affect clients’ existing financial plans. Other inputs, such as saving and spending rates, the length of your working life, and asset mix each have a far bigger impact on the robustness of long-term financial projections than minor adjustments to rate of return assumptions.

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