Ignore the Limits of Financial Plans at Your Peril

November 6, 2015

by Michelle Perry Higgins


Many investors tend to take financial plans literally. They will look at the net-worth number 20 years in the future and think of it like a guarantee. But financial plans have limitations—and not realizing what they are, and adjusting accordingly, can be costly.

One limitation is the straight line extrapolation of plan assumptions after the first plan year. For example, an inflation rate is specified and then applied to expenses every year going forward. Or, a rate of return is specified for a particular investment account and then carried forward over the life of the investment. This may make the plan appear to be more robust than what is likely to occur in the future.

Another limitation is the inherent difficulty of making accurate assumptions about plan variables such as rates of return or inflation. We cannot predict the future, so we often work with historical averages derived over long periods of time. The assumption within the assumption is that the future will be familiar to the past.

But what if it isn’t, especially over the shorter period of time that constitutes the client’s time horizon? If an adviser doesn’t use historical averages, what should he or she use? Should an adviser use past averages as a starting point and then modify the data by some forward-looking estimate based on a best guess of future conditions?

For example, the increase in Social Security benefit payments for 2016 is 0%. So, looking forward, is 2% a good estimate given the current low level of inflation, or should an adviser assume that inflation will revert to a higher level in the future? Ultimately, it comes down to judgment and the client being comfortable understanding the assumptions.

There are a few ways around some of the limitations. Some planning software allows for changing inflation or return rates over the life of the plan so higher inflation can be assumed for later years or different rates of return can be input before and after retirement.  Also, many financial-planning software packages include Monte Carlo simulations that utilize thousands of scenarios in an attempt to predict the probabilities of various planning outcomes.

The effectiveness of the financial plan also may be limited if important information is not conveyed. An investor may fail to share information for a variety of reasons, such as a desire to keep some things private or a lack of diligence or engagement with the financial-planning process.

The financial plan, however detailed and accurate initially, is just one path out of an infinite number of potential paths. It is a financial planner’s responsibility to explain clearly and without apology the limitations that affect the plan’s predictive power while also imparting reasons why the financial plan is so beneficial.