• Wed. Apr 24th, 2024

Why advisors are using higher inflation assumptions in financial planning projections

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If spending is different from CPI, clients could experience more or less inflation, says an advisor.Jose Luis Gutierrez/iStockPhoto / Getty Images

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Some advisors are beefing up their inflation assumptions when conducting financial plans for clients because rising costs.

In April, FP Canada changed its official assumption guideline to 2.1 per cent for inflation projections – a small increase from 2 per cent last year. While the projection assumptions are updated each year, no ad hoc adjustments are made to individual assumptions outside of the annual review cycle, says Derek Dedman, chair of the projection assumption guidelines committee at FP.

“In this current time of elevated inflation, it’s understandable to feel this would warrant using a much higher assumption for financial planning projections,” Mr. Dedman says. “However, these assumptions are intended for longer-term time periods [of 10-plus years].”

He says rapidly rising inflation is unlikely to continue over a longer time frame. He adds that increasing just the inflation projections also ignores the corresponding movements that would likely occur with interest rates, fixed income and equities.

“It wasn’t more than a couple of years ago that many questioned the validity of the fixed-income assumption given the unusually low-yield environment of the time,” Mr. Dedman says. “If adjustments were made purely based on that current environment, the assumptions would be quite far off now that the environment has changed.”

In certain circumstances, he says financial planners are justified in using projections outside the FP guidelines.

“One example may be for short timeframes,” he says. “However, if they do deviate from these guidelines, they should document the rates they used and the rationale behind why they’re using them.”

Projecting inflation above the guideline

Jason Evans, a fee-only certified financial planner (CFP) at Evans Retirement Planning in Winnipeg, has opted to project inflation higher than the FP guidelines, at 2.5 per cent. He understands FP Canada’s assumption rationale over the long term but also wants to acknowledge his clients’ uneasiness in these unsettling times.

“If we’re currently in the period of higher inflation, that’s going to have a longer-term impact on retirees’ ability to spend from their investments,” he says. “Early retirement is going to have a bigger effect on a longer number of years than if the inflation came later. It’s the sequence of the inflation that matters.”

Mr. Evans adds that clients are concerned about how much income to expect in retirement, and the answer to that varies depending on the client’s situation.

“Someone who has a workplace pension with an annual cost-of-living adjustment will be more shielded from inflation even if it’s a little bit higher than what we expect,” he explains. “But for someone using solely investments for their income, there could be some more volatility.”

It really depends on that level of inflation-protected income, he adds, and that’s something he goes over with clients.

For clients who want even higher inflation assumptions, Mr. Evans will run scenarios at 3 per cent and beyond to help quantify things. But he also emphasizes that plans aren’t going to go exactly as forecasted; it’s more a fluid document that changes constantly.

“That’s why it’s important to update on a regular basis,” he says.

Keeping assumptions ‘in line with reality’

He will often spend time discussing ideal retirement budgets versus essential budgets. Put another way, what are their basic needs in retirement and if they needed to do so, how could they reduce their spending?

“You might get some spending shocks in retirement – inflation and poor market returns,” he says. “So, we plan in advance by considering where we could cut expenses before we actually need to do so.”

Mr. Evans also talks to clients about how their personal experience with inflationary prices could be different than the posted consumer price index (CPI).

“That’s an aspect that people don’t think about too much,” he says. “If spending is different from CPI, they could experience inflation that’s either higher or lower.”

Janet Gray, CFP at Money Coaches Canada Inc. in Ottawa, is sticking with the FP Canada guidelines and explains how assumptions work to clients. Still, some clients definitely ask for more illustrations depicting the next few years as their expenses have increased but investments have not kept pace. When doing so, she emphasizes illustrations are still a snapshot from today.

“You need to revisit these assumptions as you go forward to keep them in line with reality,” she says.

“If I can sense there’s a real sense of stress and anxiety around it, then I might build in a couple of years at a higher inflation rate and maybe a lower rate of return on their investment that sometimes mitigates it as well.”

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