As a reality check on what investment returns to plan for over a multi-year horizon, the newly published guidelines for Canadian financial planners are recommended reading for advisors and investors alike.
This year's Projection Assumption Guidelines are effective as of April 30.
Developed and updated annually by the Financial Planning Standards Council (FPSC) and Institut québécois de planification financière (IQPF), the guidelines are designed for financial planners who are dealing with time horizons of 10 years or longer. The guidelines project the returns of five core asset classes, as well as the rate of inflation and an assumed cost of borrowing. (See table below.)
As the authors point out, the guidelines don't differentiate between U.S. equities and those of the developed markets of Europe and the Asia-Pacific region. Nor are there any guidelines for small-cap equities, style-specific equities, global bonds nor any one of the large number of non-core asset classes available to investors.
The guidelines also avoid making any projections about real estate, since local market conditions will vary, and any such projections would need to differentiate between residential, commercial and industrial properties. In making assumptions about real-estate growth, the authors recommend using inflation-based assumptions that are suitable for local market conditions.
Among the sources that the financial planners relied on to create this year's guidelines are the Canada Pension Plan Actuarial Report, Quebec Pension Plan Actuarial Valuation, the DEX 91-day T-bill Index, the DEX Universe Bond Index, the S&P/TSX Composite, the S&P 500 Index and the MSCI EAFE (Europe, Australasia, Far East) Index.
|The CIFP-IQPF assumed-return guidelines|
|Rates and returns||%|
|Foreign developed-market equities||6.7|
|Source: Financial Planning Standards Council (FPSC) and Institut québécois de planification financière (IQPF)|
In reviewing the planners' report, here are eight key take-aways for investors:
Inflation will remain low. The assumption of 2% is consistent with the long-standing trend in Canada. Since 1992, the Consumer Price Index maintained by Statistics Canada has never exceeded 2.9% in a single year, and in only three years -- 2000, 2003 and 2001 -- has it been higher than 2.5%. Assume that inflation will erode the purchasing power of your dollars, but that it will do so slowly.
Short-term investments will barely keep above inflation. The assumption for the most conservative types of holdings, such as short-term bonds and GICs, is 2.9%. That's less than a full percentage point above the assumed inflation rate. And if you are holding these assets in a non-registered account, you'll have an even skimpier after-tax return, if any.
Longer-term fixed-income assets will earn more, but not much more. The projected fixed-income rate of return, which also applies to preferred shares, is 3.9%. Though that's a full percentage point higher than the assumption for short-term holdings, investors in longer-dated fixed-income securities are exposed to greater duration risk. This is the risk that the value of their fixed-income holdings will fall if market interest rates rise. Alternatively, investors who seek to increase their yields without assuming higher duration risk can choose to invest in riskier credits. Choices include holding bond funds that invest primarily or exclusively in corporate credits, as opposed to top-rated government issuers, or investing in high-yield bonds whose credit quality is below investment grade.
For higher returns, invest in equities, starting at home. The assumption for returns of Canadian equities is 6.4%. Though this is considerably lower than the long-term historical return of about 9% dating back to 1977, it's still 2.5 percentage points higher than the projected return for fixed-income investments. Assume that you will be rewarded for taking the risk of investing in stocks. And if you hold your Canadian stocks or Canadian equity funds outside a registered account, the dividend income will be taxed at a lower rate than fully taxable interest.
There's more than one reason to hold foreign equities. The assumed long-term return for developed markets, including the U.S., is 6.7%. That's slightly higher than for Canadian equities. So potentially higher returns are one reason to invest abroad. The other main attraction is a sure thing: diversification beyond Canada's stock market that is heavily weighted in the financial services and resources sectors.
Emerging markets are a mainstream asset class. The planners' assumed return for these markets, which include China, India, Brazil and many other developing countries, is 7.4%. As the FPSC-IQPF guidelines note, the risk premium over fixed-income investments is 3.5%, "reflecting the additional risk inherent with investments in emerging countries." The report adds, however, that the world economy has become increasingly financially integrated. "When one country experiences a financial crisis, it quickly propagates among others." This suggests that the differences in risk between investing in developed markets and emerging ones have narrowed.
Be wary of borrowing to invest. The assumed cost of borrowing is 4.9%. That's lower than the assumed returns for investing in equities, which suggests that aggressive investors can profit from leveraged investments. However, the authors of the guidelines caution that while current short-term lending rates are low by historical standards, they are subject to change. "It is prudent professional practice to consider the potential for borrowing rates to increase for purposes of assessing the relative benefits and risks associated with leveraging." Consider yourself warned.
Assess the risk of outliving your savings. Other useful information provided in the report includes a mortality table created by the Canadian Institute of Actuaries, which shows the probability of survival for ages of men and women ranging from 20 to 100.
For example, a 60-year-old man has a 50% probability of surviving until 89, and a 25% probability of living to 94. For a 60-year-old woman, the life expectancy for each of these two probabilities is two years higher. The authors of the guidelines recommend that financial planners assume a life expectancy for clients such that the probability of outliving their capital is no more than 25%.