Background/ Basics
The Projection Assumption Guidelines are published annually jointly by the Institute of Financial Planning (the Institute, and FP Canada Standards Council™. By using standardized assumptions based in method can help in protecting both the planner and the client. Financial Planners can reply on these assumptions and their sources as they are established using a variety of reliable and publicly available sources, including the actuarial reports for the Quebec Pension Plan (QPP) and Canada Pension Plan (CPP), 50 years of historical data for inflation and benchmark fixed income and equity indices, and the Shiller earnings to price average for relevant equity market indices. Given the multiple sources it draws upon to establish the guidelines, it mitigates the risk of bias. The PAG is published annually and financial planners should be using the most current version. Financial Planners may work for a firm that provides the assumptions that are to be applied to their plans and need to follow the policies and procedures within their firm.
Financial Planning is combination of art and science. CFP/QAFP Professionals need to apply both of these as they develop projections into the future where the actual outcomes are uncertain. These Guidelines are intended as a guide and are appropriate for making realistic long-term (10+ years) financial projections. These assumptions include investment returns, inflation, life expectance and many more. The projections also need to err on the side of conservative to minimize the risk that the client does not achieve their objective if their investments do not grow as projected, they live longer than expected, or if inflation erodes their purchasing power at a rate higher than expected. Assumptions should not be forced or adjusted simply for the purpose of securing a client’s goal.
While there may be circumstances in which assumptions may need to be adjusted from what may be deemed reasonable, it is important that the adjustments are changed based on rationale and documented accordingly. For example, if your client has a reduced life expectancy based on a terminal illness, it is reasonable to reduce the life expectancy assumption accordingly, and then document within the plan that this assumption was adjusted based on this reason.
Life Expectancy
When applying an assumption for life expectancy in a financial plan, longevity risk, the risk that one may outlive their capital, is the risk to mange in an effort to ensure the client does not run out of money. The PAG uses the Canadian Pensioners Mortality Tables which is the table used to project the life expectancy of pensioners in Canada in both public and private sector pension plans. Studies show that those who receive pensions have a longer life expectancy that those who don’t, and therefore this figure is likely to be more conservative than standard mortality tables of general population, assisting in managing longevity risk.
The table provided in the PAG includes the probability of survival given a certain age, with the 25% probability being the recommended figure to apply. The table also reflects the fact that women live longer than men.
Other factors may impact a clients life expectancy that should be considered when applying an appropriate age such as health, family history, smoker status, and other lifestyle factors. It is recommended that the financial planner look at different scenarios and apply +/- 5 years to assess different outcomes.
Rates of Return
Rate of return assumptions are applied to a financial plan to establish the rate at which investment will grow. It is not capturing historical performance, but instead a linear rate of return that is reasonably aligned with the client’s risk profile applying a weighted average of the returns by asset class according to their target allocation. The rates have been established for short-term investments (91-day T-bills), fixed income, Canadian equities, U.S. equities, International developed-market equities and Emerging market equities. Foreign equities consist of Europe, Australia, Far East and emerging market equities.
In a non-registered investment account, projections must take account of income taxes. For significant sums, it might be appropriate to divide the return into two categories: dividends and capital gains. Historically, 25% to 50% of overall equity returns have been made up of dividends. It therefore seems reasonable to assume that 33% of the overall equity return will be made up of dividends and that the rest will be capital gains.
The rate of return assumptions are gross of fees and therefore a fee assumption must be applied. Fees are charged in a variety of ways such as embedded fees in managed products or fee-based accounts and need to be captured by applying a reasonable assumption that will be subtracted to arrive at the net return. The suggested range for fees is 0.5% to 2.5%.
Financial Planners need to be transparent about the fees they are paying and how they impact the overall investment returns, and in turn reducing the rate at which their funds will grow. Where appropriate, financial planners may deviate within plus or minus 0.5% from the rate of return assumptions and continue to comply with the Guidelines. Rationale should be documented and communicated with the client.
Inflation
The assumption for inflation is a very important input into a financial plan as it reflects how inflation impacts purchasing power and adjusts figures to reflect their future value. A dollar today is not a dollar in the future, and this must be reflected when projecting figures. The inflation assumption is determined by a combination of different sources including actuarial reports for CPP and QPP, industry survey, and Bank of Canada target inflation rate.
Short term inflation, as we saw in 2022, is not necessarily a reason to increase the inflation assumption within a plan. The target inflation rate for the Bank of Canada is 2%, and therefore when inflation is beyond this target, monetary policy measures will be implemented to move inflation back down to its target. Therefore, the assumption is that if inflation is higher than target, it should not be long term, and therefore the impact on long term projections should be minimal.
The inflation assumption for wage increases is deemed to be 1% higher than the overall inflation rate to reflect productivity gains, merit and advancement and is reflected in the year’s maximum pensionable earnings (YMPE) assumption.
Best Practices
Financial Planners need to ensure assumptions are documented, with sound rationale, and clearly communicated to clients together with a written explanation. They may also wish to show alternatives that deviate from the stated assumption as a “what-if” scenario. For example, you may use the stated rate of return assumption in the plan, but then also include an alternative scenario which shows the outcome should the rate of return assumption not be achieved. This may also be done through sensitivity analyses to illustrate and assess the impact of changes in assumptions on clients’ financial position. Any deviation in excess of 0.5% in either direction of the guidelines should be reasonable, supportable and documented with a written explanation.
Financial Planners can rely on the Projection Assumption Guidelines to provide assumptions that avoid potential biases and ensure their plans are based on sound methods and evidence. By using these guidelines, financial planners can promote trust and confidence in their projections with clients.
This article was written by Julie Seberras, who chairs the Standards Panel for FP Canada. The panel oversees important work including the FP Canada Standards Council Projection Assumption Guidelines Committee, tasked with maintaining and updating the Projection Assumption Guidelines.
