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Case Study: Assumptions are the bedrock of financial planning

The problem:

When meeting a client to discuss the construction of their financial plan, the client expressed a particular interest in the assumptions we use for financial planning and how these relate to their goals. What is our approach when it comes to deciding on the assumptions we use in financial plans?

The solution:

Assumptions are at the heart of financial planning, they provide the foundations for a robust plan. Because financial planning is an art rather than a science, it is important to make a number of assumptions about what might happen in the future. The more accurate these assumptions, the more likely it is the financial plan will remain on track over time.

Our approach towards assumptions in financial plans is to base them on reality, agree them with the client and review them on a regular basis, adjusting the assumptions as required. Assumptions need to relate to the goals of the client and also their own views of the future.

A good example of this is the assumptions we make around life expectancy. Our default position is to assume a life expectancy of age 100. We do this on the basis that the risk of the client running out of money is greater when we use a younger age.

Life expectancy is one assumption where clients tend to have strong views, often informed by family history or simply their own views about mortality.

Unless they are specific health conditions which suggest a very short life expectancy, using age 100 is the preferred approach to reduce the risk of the client running out of money during their lifetime. If a younger age is used, you should clearly explain the reasons for this and ask the client to confirm in writing their understanding of the risks.

Inflation is another important assumption, as it has a big impact on the rate of both income and expenditure over time. It also affects the real value of savings in the future. Understanding price inflation and the impact this has on wealth in the long term is a valuable part of the financial planning process.

Agreeing on a realistic inflation assumption is important because a small change in this assumption will make such a dramatic change to the financial plan in the future.

In the current economic environment, it can be very difficult to make accurate assumptions about inflation that will stand the test of time. Most would agree that we are not in ordinary economic times, so any inflation assumptions made today should be subjected to more frequent reviews than they would be usually.

Another important area of assumptions is the rate of return available from different investment assets. Setting return assumptions which are too aggressive can result in a disappointed client should the returns not be achieved. Being too cautious can make the financial plan unaffordable.

These investment return assumptions also need to stretch across a complete market cycle, so it should be explained to the client that the results seen after one or two years are less important than those experienced over five to seven years.

Convincing clients that they need to escape the short-term investment return mindset can be challenging when so much of the investment market is focused on short-term results, such as the daily movement in the value of the FTSE 100 index or one-year fund performance figures.

When we construct the initial financial plan for your client, it will, of course, contain our default assumptions and the reasoning behind each of these. The assumptions will be adjusted based on your discussions with the client. You should then discuss them further when you present the initial financial plan to ensure that both you and the client are happy with what is being used.

Shelley McCarthy is a senior paraplanner at Informed Choice


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