The Financial Planning Standards Council (FPSC) recently issued new guidelines for Certified Financial Planners (us!), in the development of financial plans. 

Many assumptions go into building a financial plan. Rate of return on investments is only one of them, but it’s a critical one. 

Spoiler alert – the new FPSC guidelines are sobering:

  • For conservative investors, the FPSC wants planners to use 3.25% as the annual rate of return for the long term. By long term, they mean ten or more years 
  • For balanced investors, planners are to use 3.92% 
  • For aggressive investors, 4.75%. 

Do these numbers sound very low to you? They probably do. You’ve lived through times that had much better rates of return. It’s hard not to expect and count on the more generous returns you’re accustomed to. 

But these lower rates are very familiar to us at Caring for Clients, and in our wheelhouse. We typically use 4% when working with a balanced investor in building our plans and we have for a while. 

Why should you err on the conservative side in rate of return assumptions? 

If you overstate returns in your planning, and don’t experience what you planned for? You’re going to look at yourself 10-15 years from now and realize that you haven’t saved enough. 

If you are heading into, or already in retirement, you’re likely to be spending too much. Not to mention, you’ve used up 10-15 years that you can’t get back, when you could have been saving more. 

So planning conservatively is critical! 

Now, planning for 4% doesn’t mean you are going to get 4%. You could earn more (or less). However, it’s easier to adjust to lower-than-expected returns than expected than higher. The key is to plan conservatively and review your progress in 2-3 years. If you are well ahead of plan, then you simply re-project, recalibrate and carry on. 

There is a wonderful real-life example of the pain and cost of overestimating return assumptions, from the insurance industry. It was based on a product called the Vanishing Premium Policy.

'London Life' headline

The magical vanishing premium 

Here’s how it worked:

  • You bought an insurance policy and the premiums levied were higher than the cost of insurance
  • The extra dollars would be invested on a tax-sheltered basis
  • Providing you earned the projected rate of return on the money inside the policy, you would be able to stop paying premiums after a number of years
  • Hence the name!

Unfortunately, the rate of return assumptions used to sell the clients this concept were far too high. Just when the premiums were expected to vanish, policy holders realized they needed to continue to pay. And they couldn’t stop paying their premiums, or the policy would lapse. 

In summary

Anyone can make financial plans look prettier by using a high rate of return assumption. It will make their client feel good in the moment, but it’s not going to help in the long run. 

So make sure your planner and/or you are using conservative return assumptions in your projections and planning. Use sensitivity analysis to find out where you will be if your assumptions turn out to be a bit high. Use realistic projections, not just past return patterns. 

You’ll be glad you did.

This information is of a general nature and should not be considered professional advice. Its accuracy or completeness is not guaranteed and Queensbury Strategies Inc. assumes no responsibility or liability.