Your Future Self Will Thank You

According to an article in Scientific American¹, psychologist Hal Ersner-Hershfield, then at Stanford University, studied a community from the San Francisco Bay area and discovered that, “those who identified most with their future selves planned their life with longer-term payoffs in mind: they saved more money and as a consequence had amassed more wealth than others”.

In financial planning, we incorporate variables, such as our life span, investment returns, inflation, income and expenses, to map out the future and to understand the needs of our future self. This allows us to plan our lives and consider aspects that we have more power over today, such as how long we work, how much we spend and how much risk we take.

At Nexus, we use a personalized Cash Flow Projection to help clients quantify their future needs and make sure they have enough resources to meet them. By comparing financial factors that affect your individual circumstances we can assess the risk of running out of money. Using financial modelling software we analyze these variables, and the interplay between them, to figure out “where the money goes” and help answer questions such as, “If my expenses increase with inflation over time, will I be able to enjoy this lifestyle in retirement”?

The first step in building a reliable cash flow projection is to make realistic assumptions about uncontrollable variables such as economic trends, market returns and life expectancies. Meteorologists are taught “weather is what you get; climate is what you expect”. The same logic applies to financial forecasting; no one really knows what tomorrow holds but it is easier to estimate long-term averages than short-term trends.

Investment Returns

The tendency of returns to even out over time is encapsulated in the powerful statistical concept of “regression to the mean”. The short-term, erratic and extreme market returns that are well above or below the long-term average don’t stay there forever. They normalize over time. Since a typical financial planning projection spans 35 to 50 years, we start by using the long-term average historical investment returns for stocks, bonds and cash. Then we fine-tune the returns based on our expectations of the future. Since the purpose of financial planning is to prepare for the worst, we make sure our investment return assumptions are aligned conservatively.

Inflation

For individuals living off their savings, inflation erodes their purchasing power and poses a major threat to their financial wellbeing. Fortunately for us, inflation targeting has been the cornerstone of Canadian monetary policy since 1991. The Bank of Canada’s focus has been to keep inflation low, stable and predictable-in the medium term at an annual rate of 2%. So far it has been effective in maintaining the target and we are comfortable using it to build our projection.

Life Span

How long are you going to live? The answer is actually good news, as described in an article written by Michael Finke, professor at University of Texas Tech². He cites data from the Society of Actuaries that in each decade since 1945, life expectancy of people who were 65 has extended by one year. This consistent increase in longevity is essentially linear and it is no longer appropriate to plan for a 30-year time horizon at retirement. We think it is prudent to assume life expectancy of at least 100 years for a couple in good health retiring in their 60s.

Once we establish assumptions about investment returns, inflation and life expectancy, the next step is to estimate the individual, but more predictable, variables like income, taxes and lifestyle expenses.

Income

In earlier stages of life, income is mostly generated from sources linked to employment. For someone in a matured career it’s reasonable to assume that earnings grow at a steady rate normally keeping pace with inflation. Still, for a better financial picture, one should look forward and make an allowance for factors such as the risk of losing a job, taking a sabbatical or structural change in one’s industry.

During retirement most income is derived from pensions, investment activities and personal savings accounts such as a Registered Retirement Savings Plans (RRSPs/RRIFs). While information on employer pension and government benefits is mostly accessible, determining the amount of investment income and withdrawals from personal saving accounts requires iteration, and can only be determined by factoring in the rate of savings and the assumed investment returns with the help of financial planning software.

As a nuance, once income is estimated at different stages in a person’s life, we can calculate the amount of taxes fairly precisely. This allows us to project income available after-tax each year for lifestyle needs and savings.

Lifestyle Needs

Individuals are pretty good at estimating future income but terrible at figuring out expenses. A study by the Journal of Consumer Research Inc.³ discovered that we are actually not bad at predicting our day-to-day expenses. What we struggle with is estimating our exceptional expenses. The study explains that most people end up underestimating unusual or infrequent expenses, with many of the largest expenses such as vacation, celebrations, home renovations being the most exceptional. Independently, each of these events put a dent in the budget. But over time these exceptional expenses add up and their aggregate effect can be detrimental to a financial plan.

So how do we short-circuit our natural wiring, to overcome our predispositions? We need to start with what we know – how much are we spending today. We need to track our ordinary and extraordinary expenses and include both in our lifestyle needs. Child-related expenses may end at retirement, but other expenses, such as for vacations or health, may increase and replace them. Therefore, our total lifestyle needs today, adjusted for inflation, is the best indication of our needs during retirement.

You to Future Self: “You’re welcome!”

The cash flow statement is like a financial time machine. It gives us the opportunity to bring the future into the present. It allows us to study the variables that affect our financial future, so, if needed, we can alter the course to protect our future self.

It’s impossible to predict all the factors that may have an impact on the cash flow projection.  While we can make reasonable assumptions about investment returns, inflation, life span, income, taxes, expenses, and use Monte Carlo models to assess the risk of a shortfall, our best shot at watching out for our future self is preparing ahead and taking control of the aspects of life that we have power over today.

So what should one do if the cash flow projection reveals a future shortfall? Adjust the levers that are in your control today: time your retirement based on your needs, alter your spending rate to save enough, devise a strategy to minimize your taxes and make sure you are taking the right amount of risk by choosing a suitable asset mix……one day, your future self will thank you!