The Problem With Using Reasonable Assumptions

John De Goey There is a strong consensus from a wide number of reputable companies, analysts, professional organizations and the like that are suggesting future returns will be substantially lower than they have been. Furthermore, it is a generally accepted industry best practice to lower those already low expected returns by the cost associated with their implementation due to investment products and financial advice.

In the past, I’ve written about how many financial planners do not use sufficiently reasonable assumptions when making their retirement planning forecasts. That’s only the obvious tip of the iceberg. There’s a more dangerous and often unspoken presumptive value proposition that is being implicitly promoted when using unreasonably high assumption projections that requires serious consideration because the impact could be massive.

As consultant, Mike McCracken once said when giving testimony at a parliamentary committee hearing looking into the Goods and Services Tax in the early 1990s: “garbage in; garbage out”. My translation of those four words is: any projection is only as good as the reasonableness of the factor inputs. We’ve reached a point where almost everyone is using assumptions that are straight out of a fairy tale.

Most people I encounter don’t have formal written planning projections for their retirement in place — that’s obviously the first problem; they ought to. However, those who do have projections in place often use return assumptions that are in the high single-digit and sometimes even low double-digit range. That’s the second problem — and it’s ridiculous. Virtually all reputable industry players expect future returns to be considerably lower than they have been to date. To make an already bad situation much, much worse, many people fail to take into account other important considerations when doing their planning. Three additional material considerations include the rate of inflation, the cost of investment products and the cost of financial advice. Taken together, these considerations would almost certainly cause actual returns to be lower still.

While the actual numbers vary moderately between assumption providers, there is a broad consensus that the expected return for income products ought to be somewhere between 0% and 2% above inflation. Similarly, there is a broad consensus that the expected return for equity investments ought to be between 2% and 6% above inflation. While people differ on their assumed inflation rate, virtually all reputable thought leaders expect inflation to run between 2% and 3% for the near future. Real returns are constant, so lower inflation means lower nominal returns.

Taking all these things into consideration, we are left with expected returns on a balanced portfolio of perhaps 3% above inflation, and that’s before product costs and advisory costs. Assuming inflation remains modest (2%) we’re talking about a total nominal return of less than 5% annualized for the rest of our lives. The Financial Planning Standards Council (FPSC) and Institut québécois de planification financière (IQPF) are the standard setters for qualified financial planning services in Canada. They recommend that product and advisory costs be incorporated into planning projections as a “best practice” and that the assumed rate of return used should be lowered by the same amount. If the cost of advice and products is a combined 2%, that leaves (reasonable) investors with a white-knuckled return expectation of about 1% above inflation (!).

There are very few people who have projections that are even remotely reasonable when all reputable considerations are applied. In fact, I would wager that most people who are retiring a generation or more from now will realize a total annualized rate of return that is likely to be at least 2% lower than what is being illustrated in the majority of financial plans being approved by virtually all compliance departments across the country today. There is a crisis looming. It seems no one wants to hear the evidence that expected returns will be low and that costs need to be applied against those returns to lower client expectations even further.

Here’s the real problem: people often give their business whoever tells them they should expect higher returns in the future — as if assuming higher returns actually produces higher returns and as if people who use higher assumptions are actually more desirable as a result of their more favourable (read: less reasonable) assumptions. It is patently inappropriate to think that the advisor who promises the highest expected return should get someone’s business. In fact, it’s backwards, because that outcome is both perverse and unfair.

Choosing an advisor based on higher return expectations amounts to the person who likely ends up using the biggest misrepresentation of evidence getting more business as a direct result of their misrepresentation. It amounts to the marketplace rewarding the “bad guys”. As it stands, truth, evidence and reasonableness are frequently and unwittingly being punished by shallow consumers who (to be fair) usually don’t know any better. Bigger advisor promises seldom equate to better client experiences.

To be clear, no one has a crystal ball. As such, no one really knows what the actual realized return might be for a balanced portfolio looking ahead 10, 20 or even 30 or more years. Here’s a thought exercise: If you’re a prospective investor who will be interviewing a few prospective advisors in order to have them provide advice for your retirement plan, ask the question that everyone else seems eager to ask. Specifically, ask: “what sort of return should I reasonably expect?” Then, ask the candidate a series of credibility-testing following follow-up questions:

What is that expected return based on?
Is that a real return or a nominal rate of return?
Please explain the difference

(Nominal = Real + Inflation)

What inflation rate did you assume?
What are the costs associated with this portfolio (for both products and advice)?
Have those costs been factored into the return expectations that you just shared?
If not, why not?... and what are the expectations once the costs are incorporated?

The answers to the questions above should enlighten you as to the level of professionalism of the advisor you are speaking with. It is entirely possible (and in my opinion highly probable) that the person who suggests the lowest rate of return will, in fact, ultimately prove to be the best, most reputable and most reliable advisor of the batch. Call it “the ultimate reverse indicator”.

John De Goey is a Portfolio Manager with Industrial Alliance Securities Inc. and the author of The Professional Financial Advisor IV. Industrial Alliance Inc.is a member of the Canadian Investor Protection Fund. The opinions expressed herein are those of Mr. De Goey alone and may not be aligned with the opinions and values of Industrial Alliance Securities Inc. or any of its affiliated companies.