If the financial advice industry is ever to be considered a profession, changes are needed in the method of arriving at assumptions for planning purposes. The lack of discipline and process in assessing future risk and return are key challenges.
Below are some examples that illustrate the problem – and the industry’s latest response.
As actual returns go up, the investment advice industry has tended to raise return expectations. Last year, I reviewed a presentation for a pension plan committee that was prepared and presented by a large consulting firm. I was struck by how the consultant’s expected return estimate had crept up over the past 30 years.
Double-digit bond yields and cheap stocks were the order of the day in 1983. At that time, the consultant’s return estimate was just 2% more than inflation (which was running at a good clip at the time). By 1993, real-return bonds (RRB) yielded more than 4% above inflation and stocks were cheap; the estimated future real returns had risen to 3% per year. In 2003, RRB yields fell to slightly less than 3%, while stocks were more expensive than they were a decade earlier. Yet, the consultant bumped up expected returns to 4% above inflation.
In 2013, RRB yielded less than 50 basis points, while stocks were much pricier; but the consultant’s estimated total portfolio return was unchanged. As valuations rise, future returns should drop – and vice versa. But the consulting firm saw fit to advise a large pension plan to do the reverse – an indication that the consultancy’s projections were disconnected from the fundamentals.
Similarly, risk-rating changes for many mutual funds have followed the same pattern. As asset prices have risen strongly, a long list of funds have been given reduced risk ratings – to be reflected in regulatory documents. For example, a dividend fund that holds 80%-85% in stocks saw its rating lowered from “medium” to “low.” That fund lost 29% of its value during the 2000-09 bear market – a good showing, but not what can be considered low-risk.
Moreover, when stock prices rise, future return potential drops and valuation risk increases. Fund sponsors could justify leaving the risk rating unchanged. But after six years of nearly uninterrupted gains, I can’t think of one good reason why risk would lessen.
Enter the financial planning oversight bodies for Quebec and the rest of Canada. They recently released a joint document laying out a standardized set of assumptions to be used for medium- and long-term planning. Although these include a good dose of subjectivity, the output is sound and backed by a repeatable process.
These standards may not be perfect, but they are a huge improvement. Using them will – for many advisors – improve the quality of financial plans and, by extension, upgrade advisors’ practices. Advisors without a sound process for projecting returns are doing clients, and themselves, a disservice.
Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.
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