With apologies to Charles Dickens, our views of what the future might hold may need some re-calibration. Like his novel Great Expectations, the world today is full of challenging circumstances. The modern financial planning world is dealing with a situation that may ultimately border on becoming an existential crisis.
Much like the novel, the modern retirement planning universe has a colourful cast of characters – only ours includes central bankers, well-intended certification bodies, industry regulators and ubiquitous pundits. Financial advisors need to navigate these stakeholder groups when offering advisory services to their clients. Dickens’ themes in the novel include wealth and poverty, love and rejection, and the eventual triumph of good over evil. Those themes sound like a contemporary to me. The morality play (or is that mortality play?) of our times stems from keeping our expectations in check.
The challenge for some CFP registrants who want to be both ethical and compliant revolves around the purposeful use of the Projection Assumption Guidelines which are released every April as a joint project undertaken by both FP Canada and the Institut quebecois de planification financiere. Basically, these organizations are the ones who tell financial planners just how great their clients’ expectations about future returns ought to be. While they have been correctly lowering expectations for years now, the pace is unreasonably slow, which results in current expectations remaining unreasonably high.
To begin, returns simply aren’t what they used to be. Research done by Callan Associates for the Wall Street Journal shows that over the past generation, investors have had to take on substantially more risk to generate similar returns. Stated differently, if people wanted to achieve a return of (say) 7.5% annualized, they could have done so using only government bonds a generation ago and likely would not be able to do as well even if they were in an all equity portfolio today.
That’s only half the problem. They would also need to endure substantially more volatility in their attempt to wring out higher returns. Even then everyone needs to recognize that return expectations are set for asset classes and that the cost of both financial advice and investment products needs to be incorporated in the projections. The 2021 assumptions are included here. Only one asset class – emerging market equities – has a higher expected return than what would have been available using plain vanilla bonds a generation ago. To top it all off, we’re living longer, so those lower returns will need to generate inflation-protected annual incomes for far longer than they used to.
In an illustrative application shown in the guidelines themselves, a 50/50 portfolio (half stocks; half bonds) might be expected to return 4.48% before fees and expenses. If one were to factor in an advisory fee of 1% and product costs of 0.25%, the net return after fees would be only 3.23%. In addition, if inflation was to run at 2% (the approximate level for the past 30 years), that would result in a real return net of fees of 1.23%. Don’t shoot the messenger.
Basically, what we’re looking at here is a real return that is about equal to the cost borne by the investor. Stated differently, the financial planning and advice industry might well be eating up half your return while you take all the risk.
Even that may be optimistic. Some people (including yours truly) have been pounding their fists on the table that the assumed returns are STILL too high. The projected annual gross return for fixed income is set at 2.7%, for instance. If you know of a place where I can get a 2.7% guaranteed return, please write back to inform me because, for the life of me, I can’t find anything.
The guidelines are established and updated using a variety of publicly available and presumptively credible sources. The challenge, it seems, is that these sources are not particularly logical or consistent in their thinking. That might strike you as an overly harsh assessment but hear me out. In 2020, the expected long-term return for Canadian equities was 6.1%. This year, it is set modestly higher at 6.2%. Similarly, foreign market equity return expectations (including those from the U.S.) were set at 6.4% in 2020 and 6.6% in 2021. Again, modestly higher. The guidelines would have us believe that it is reasonable to expect returns to be modestly higher in the future – even though returns in the between the two most recent guidelines were massively positive. How positive? The total return for the TSX for the year ended on May 5 was over 30% and the total return for the S&P 500 over that timeframe was almost 48%.
Think about it for a moment. Let’s say a world class athlete wants to run a 4-minute mile and a mile is four laps around the track. In his first lap, he clocks in at a solid 56 seconds. What does that mean he should expect for the last three laps? Well, if he were to run those three laps at an average speed of 61 seconds per lap, he’d finish in exactly 3:59, thereby achieving his goal. See the problem? How, exactly are we Canadians to believe that 6.1% was a reasonable assumption last year and that 6.2% is reasonable for this year when the market returned 30% in between and that 30% outcome does not count in the 6.2% assumption? Logically, future return expectations should be lowered the year after a massively positive return experience.
Again, I say to you, this problem is existential. The financial advice business has zero interest in confronting its own demons. The assumptions that planners are now being asked to use are deemed to be “reasonable” and “professional” by the organizations that produce them, but are, in fact, just barely low enough to not be embarrassing. More honest numbers would be lower – perhaps even significantly so. Cognitive dissonance abounds. Be careful.