Thursday, July 7, 2022

Portfolio Projection Assumptions Use and Abuse

FP Canada Standards Council puts out a set of portfolio projection assumption guidelines for financial advisors to use when projecting the future of their clients’ portfolios.  The 2022 version of these guidelines appear to be reasonable, but that doesn’t mean they will be used properly.

The guidelines contain many figures, but let’s focus on a 60/40 portfolio that is 5% cash, 35% fixed income, 20% Canadian stocks, 30% foreign developed-market stocks, and 10% emerging-market stocks.  For this portfolio, the guidelines call for a 5.1% annual return with 2.1% inflation.  This works out to a 2.9% real return (after subtracting inflation).

We’ve had a spike in inflation recently, but these projections are intended for a longer-term view.  The projected 2.9% real return seems sensible enough.  Presumably, if inflation stays high, then companies will get higher prices, higher profits, their stock prices will rise, and the 2.9% real return estimate will remain reasonable.  Anything can happen, but a sensible range of possibilities is centered on about 3%.

However, the projections document has an important caveat: “Note that the administrative and investment management fees paid by clients both for products and advice must be subtracted to obtain the net return.”  For a typical advised client, total fees for products and advice can be around 2%, leaving only a real return of 0.9% for the client.

This creates a dilemma for the advisor: to use 2.9% and conveniently forget to subtract fees, or use the embarrassingly low 0.9% that will surely make clients unhappy.  It’s easy enough to justify using the larger figure; just pretend that great mutual fund selection will make up for the fees, even though all the evidence proves that this rarely happens.

But it gets worse.  The guidelines offer some flexibility: “financial planners may deviate within plus or minus 0.5% from the rate of return assumptions and continue to be in compliance with the Guidelines.”  So, unscrupulous advisors can lower inflation by 0.5% and raise all return assumptions by 0.5% to get a 3.9% expected return assumption (if they conveniently forget about fees) and still claim to be following the guidelines.

The typical problem with sophisticated portfolio projection software and spreadsheets is the return assumption baked into them.  No matter how impressive the output looks, it’s only as good as the underlying assumptions.


  1. assumptions are the keys to any forecast.

    1. True. And they're usually hidden from both clients and those advisors who don't understand the tools they use.