What assumptions are you using for investment growth?

By Philip Reynolds

Assumptions for investment growth can have a significant impact on a financial plan over a long period of time. The difference between a 6% and an 8% growth rate on £100,000 over a period of 30 years is £491,315.

This can fundamentally change the outcome of a Financial Plan.

It is nothing new to learn that due to compounding, financial plans and assumptions are very sensitive to investment growth assumptions. However, what can we do to ensure that we are using reasonable growth assumptions?

As a starting point, it makes sense to be more cautious than optimistic when projecting the value of assets into the future. It is much better for a financial planner to allow a margin of safety in growth assumptions than to stretch a client’s finances, because ultimately, if the assumption falls short, the client and the planner will need to adjust the plan, which will impact their goals.

We also need to consider some of the external factors that will impact investment growth when considering our assumptions.

Firstly, the charges associated with investing. If we do not take into account the cost of investing, such as adviser initial and ongoing charges, platform charges, DFM charges and portfolio charges, then there is a risk that we are overstating the returns clients can expect to experience. As simple as it sounds, it’s important to remember that the returns clients earn on the underlying portfolio performance are not the returns that they see.

Secondly, inflation. In the introduction, I showed the impact of reducing of a client’s £100,000 investment from a growth rate of 8% to 6%. This 2% difference could represent the impact of inflation on the long-term growth rate. But how accurate is a 2% growth rate?

2% is the Bank of England’s target for inflation. However- recent years have seen double digit inflation. Whilst some planners are factoring in a slightly higher inflation rate into their plans, an interesting question would be whether this is recency bias or a cautious assumption that we may endure higher inflation for the foreseeable future. However, in my view, this should be balanced with the client’s investment time horizon, as recent inflation data over the past two years cannot be applied to a 30-year investment horizon, and therefore, a longer average needs to be taken into account.

Another factor that needs to be considered is market events. As we know, investment returns are not linear. Investment markets move in a cycle of bull and bear markets, with significant market events occurring infrequently. The impact of these events can have an impact on a client’s financial plan. Sophisticated cashflow software can allow advisers to include market events in a client’s plan to stress test their portfolio. Often this can be done as a separate forecast to see how bulletproof their Financial Plan is. This is even more important following pension freedoms, as fewer retirees are purchasing annuities, and more are remaining invested for multi-decades.

In summary, there are several factors that can impact the growth rate assumption a financial planner can use for the purposes of working with clients and planning their financial futures. Clearly, most of these factors are external, uncontrollable and can only be measured in retrospect. Much more importantly is the Financial Planner’s role in constantly reviewing and updating a client’s Financial Plan, obtaining accurate data and keeping clients in their seat.

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