So What Goes in a Full Financial Plan Part 3 of 3

So – now the wrap up of this series.

Financial Planning is intensely personal and clients need to have complete faith and trust in their advisor to make the process work properly, effectively and efficiently. The relationship is the key to success.

It is for this reason, that top planners spend the first meeting just working on laying the foundation for a relationship to grow and blossom – listening is the key of course – the good Lord gave us two ears and one mouth – and good planners and advisors use them in that ratio! This is what as known as a “non-interview”.

I first learned about this concept about three decades ago by reading a book by a fellow named J. Douglas Edwards – “Questions are your answer” – copies are still available in used book stores and on-line – I highly recommend that everyone involved in the financial/estate/retirement planning process, read it – and read it several times. In fact, it is excellent reading for anyone in a sales, marketing and/or management role.

I want to touch on the reporting now – I can hear advisors and planners already saying that if they covered everything I listed in my two previous posts, the final report is going to be 100 pages in length! Well, that depends, doesn’t it ——– on the client.

Some clients are detail-oriented, number crunchers, navel inspectors, etc. – and for those people, a planner can create dozens of reports and many dozens of pages – looks impressive I admit – but of what value to the client?

I learned from studing about and listening to people like Jim Rogers, John Savage, Jack and Gary Kinder, Norman Levine, Charlie Flowers, Don Pooley, Hal Zlotnik, Rick Forchuk, Dick Kuriger, Jim Otar and many others – that simple is best.

In my experience, I have found that the planners who use the longest reports are often trying to impress clients with quantity as opposed to quality. Certainly the attitiudes of the client drive the entire process – including the reporting and some clients do want more details than others – but this is a fine line to follow.

I have found that there needs to be enough detail to illustrate to the client that their goals can be achieved given a certain set of circumstances, what changes they need to make and actions they need to take and I allow the client to determine how that is done. As an example, before I present a plan, it is my normal practice to ask them a few questions first, including: How much time to you want to spend at our next meeting reviewing the plans? Do you want to go over the entire plan in detail, or do you want just a high-level summary and then decide on what sequence to follow before getting deeply involved in the entire report? As part of my interview process, I ask clients very early on to indicate their priorities in dealing with their goals – and regardless of my personal preference or prejudice, I follow the sequence or timing as verbalised by the client – this is critical IMHO.

My preference is to give a high-level overview at the first reporting meeting – typically no more than 3 or 4 pages – I don’t want to frighten them or have them start to think they can’t change anything – spoon feeding in other words. Then the rest is covered over the next two or even three meetings so they aren’t overwhelmed and I use LOTS of pictures and graphs and as few tables of numbers as possible. If they ask for some specific details, of course I can produce them, but I don’t try to bury them.

Last, but not least, as a professional financial planner, it is great to have a plan but unless it is implemented and there is regular follow-up (at a minimum of once every two years) to make adjustments as necessary – the whole thing collapses into a pile of snot with only some wasted money and good intentions left lying on the ground!

Anyway, that wraps up this series – hope you find some of the comments of value or at least thought-provoking – agreement is neither necessary, required or expected! Cheers Ian

So What Goes in a Full Financial Plan – Part 2 of 3

So here we go on part 2 of this 3-part series

Post-employment/work Income PlanningAll sources of potential revenue.

1) Employment pensions:
a) Type – Defined Benefit Plans, Money Purchase Pension Plan (Defined Contribution) Deferred Profit Sharing Plans, Employee Profit Sharing Plans, Employee Share Purchase Plans, Group RSP, etc. – past and present – valuations, statements, benefit formulas – early or late – contribution rates, maximums, etc.
b) Portability, commutability – formulas, etc.
c) Inflation protection – none, partial or fully indexed.
d) Pension choices available – spousal requirements, pension splitting options, etc.
e) Income buy-back availability.
f) Integration with OAS or CPP as applicable.

2) Personal retirement assets:
a) RRSPs, Spousal RSPs, Locked-In Retirement Accounts, Locked-in RSPs, Tax Free Savings Accounts, OPEN – depending on current purpose if in existence.
b) Valuations, statements, reasons for choices of investment holdings.
c) Plans for disposal of other investments/business interests/tax-shelters, etc. to supplement other retirement income assets.
d) CPP and OAS benefits statements – OAS maximization/claw-back minimization and planning.
3) Other Savings/Investments earmarked for other purposes/re-direction possibilities.
4) Review potential for partial employment or other post-retirement income supplements, potential inheritances, etc.

Education Planning – as appropriate For clients and family members as applicable.
1) RESPs, other in-trust holdings earmarked for education:
a) CESG and related possibilities including low-income education benefits for grandchildren/great-grandchildren.
b) Retiring student loans effectively.
c) Potential uses of Tax Free Savings Accounts for children.

Charitable/Philanthropic Intentions Family, living and/or posthumous recognition or benefits, donation planning.

Special needs – challenged or gifted Registered Disability Savings Plans, other government assistance plans, trusts, grants.

Wills, Codicils Inter-vivos/Discretionary Trusts, Alter-Ego/Joint Spousal Trusts, General and
Restricted POAs – including bank accounts, Limited POAs, Enduring POAs,
Representation Agreements (Living Wills), Multi-jurisdictional Wills/Multiple Wills for non-situs assets,
Planned inheritances, tax implications, contingent ownership issues etc.
choices for Executors/Co-Executors/Corporate/Contingent Executors, Guardianship
of the person and financial guardianship, conservatorships.

Marriage Marital regime, prior divorce, financial obligations from previous relationships that
survive death. Discuss domestic partnerships as appropriate.

Special tax-planning issues Restructuring cash flows, taxable inheritance planning. Review previous
personal, corporate, partnership, Limited Partnership financials, trust tax returns for missed items,
trends. Discuss Health and Welfare Trusts or Private Health Services Plans, as appropriate.

Risk tolerance assessment Separated by family member, goal specific – generic asset allocations, generic product
allocations.

Gift planning Family and others – refer back to Charitable/Philanthropic.

Intergenerational Wealth Transfer Tax effective and efficient transfer of wealth – next and/or subsequent generations.

Implementation roadmap Suggested target dates, sequences.

So What Goes in to a Full Financial Plan? Part 1 of 3

I start this series with a bit of trepidation – I have so far, in more than 20 years of doing financial planning, been able to find some sort of universal agreement on what should be covered – but here is my attempt. I fully expect some disagreement – but that is good – it means people are thinking about it seriously! Also, readers should be aware that “financial planning” is NOT about selling products – it is exclusively about helping clients create a roadmap for their lives – financial and otherwise. For brevity, I am covering these issues in point form – obviously the actual discussions drive the ultimate destination and no two clients(even spouses or partners) have exactly the same vision – which keeps life interesting! If anyone would like confirmation of what some of these abbreviations and notes mean to me – just ask!

LifestyleCurrent and future, hobbies, interests, health issues/family history, soft-facts via
non-interview. Potential for changed occupation(s), children? Where do they
see themselves in 5, 10, 15, 20 years??

Cash Flow Actual versus planned, leakage (un-accounted for loss of revenue)/budget/cash flow
Planning.
Income tax assessment/recommendations. Income splitting (CPP and other options).
Debt analysis and review – consolidation, refinance, Line(s) of Credit, Total Debt Service Ratios,
eliminate debt through use of other assets to improve cash flow, TDSR, etc.

Assets and Liabilities Including property assessments, mortgage/loan statements and schedules, details of
co-signing, credit card statements, revolving LOCs, bank accounts, GICs, TFSAs,
RESPs, all Registered Products, notes/mortgages receivable, loans to family
members, ACBs, assessments, valuations, cash flows, etc., stock options,
student loans

Risk Management Risk assessment – lives, property, automobiles and business.
Assessment of risk protection alternatives.

1) For individuals – all family members:
a) As appropriate, discussions about life insurance, disability insurance, critical illness insurance and long-term care insurance.
b) Discuss beneficiary appoints (contingent), previous spouses, blended families.
c) Review of group insurance benefits available – including life, AD & D, STD, LTD,
Medical, Dental, Vision Care, Out-of-country, HSAs, etc.
d) Current and available accident benefits, credit life insurance, disability insurance and critical illness insurance.
e) Potential for expanded benefits through ICBC re automobile injury/death.

2) For business/investment real estate/tax shelters/etc. – all involved family members:
a) Over-head Expense Coverage, Disability Buy-Sell, CII Buy-sell.
b) Grouped Executive Enhanced Benefits Plans.
c) LOC coverage as appropriate.
d) Discussion of Buy-Sell situation, liabilities, potential problems for survivor and deceased family.

3) Contingent Liabilities – all involved family members:
a) Who signed what and are the debts protected and recoverable – including review of alternatives.
b) Can contingency be removed.

4) Residence – owned, rented – reviews as appropriate:
a) Coverage for buildings, contents, scheduled items, deductibles, floaters, exclusions (earthquake), limits.
b) Voluntary medical payments, own damage, personal liability, off premises items, properties.
c) No frills, Basic, Broad Form or Comprehensive coverage.
d) Is building or contents over-insured?
e) If strata – match coverage with Strata Insurance Certificate to ensure no gaps.
f) Loss-payees.
g) Improvements updated on policy – strata and detached residences.
h) Fair Market Value versus Replacement Value updated on policy
i) Scheduled items – basket-clause application for jewelry, collectables, etc.
j) Check coverage for ATVs, boats, etc. extended re damage, theft, destruction and liability.

5) Automobiles – Government and Private insurance as appropriate:
a) Are deductibles appropriate given age of vehicles, use, driver?
b) Waiver of depreciation appropriate
c) BC residents – RoadStar eligibility/benefits.
d) Loss of use
e) Underinsured Motorist limits
f) Uninsured Motorist limits
g) Supplemental Death and Income Benefits
h) Third-party liability
i) After-market upgrades or improvements
j) Change of use
k) Experience of drivers
l) Check coverage re ATV’s, boats, etc. extended as floaters or endorsements
m) For boats – Recreational Boater operator cards, etc.
n) Coverage for personal items such computers, cell-phones, iPads, etc. if vehicle stolen or destroyed.

6) Business/Rental Properties/investments/tax-shelters:
a) Coverage limits for structures, loss payees, flood, fire.
b) Third-Party liability, voluntary medical, own damage.
c) Loss of revenue – business continuation – business financial statements.
d) Recent valuations of all assets used in the business.
e) Business cash flow.
f) Tenant damage as appropriate.
g) Revolving Lines of Credit and terms/agreements/co-signing.
h) Business agreements – shareholder, partnership, operating, financing, royalty, revenue sharing, etc. as appropriate.

Taxation and financial planning – Part 2 of 2

So let’s pick up where we left off last week.

Whether people recognise it or not, wealthy people do pay more total taxes than lower income earners – they like more toys, more vacations, more luxuries – guess what – there are taxes included in all of those items too – but then, to admit that would go against the current 1% versus the 99% protests! The simple fact is, there is no “tax freedom” day – everything we spend goes for taxes or raw materials – everything in between is taxes or becomes taxes in one form or another – but let’s not get depressed about it! How does this impact on financial and insurance/estate planning?

Projecting future tax rates that might apply to retirement income or tax credits that might exist for personal health care is a losing proposition. The same applies to the future impact of estate succession/capital gains or even inheritance taxes (which will come back in the future in one form or another – guaranteed!)

Most software programs in use today around the world for the financial services industry, add compelling statements such as “full income tax T-1 calculation done for each year of your plan” (pardon the Canadian influence – but I are one – and proud of it!!). What rubbish. The only thing that COULD accurately be said is the tax calculations are reasonably accurate for the PREVIOUS tax year – everything else is at best an estimate and at worst, a SWAG.

Canadians want more services paid for by “governments” so the governments have to get more $$ from the tax payers to pay for those services. Remember, there is only ONE taxpayer – that is each person. Businesses don’t actually pay any tax – never have and never will – they are simply conduits to get taxes from tax payers to the various levels of government. Some politicos say we are going to raise taxes on various businesses – how nonsensical! Does anyone seriously believe that the business is going to reduce profits to owners, partners and shareholders to pay the tax? Of course not – they just increase the cost of the item, good or service they sell to…….guess who……. tax payers!! But then, that isn’t nice to admit either! The same applies when businesses are charged royalties for accessing natural resources – the cost of those royalties are simply passed along to the consumer – who is also the tax payer – again! BOHICA!

In financial and insurance/estate planning, all we currently need to address are income taxes – and then only as a best estimate. It is my normal practice to include a large disclaimer relating to tax estimates and then I go further by increasing the projected costs by a further 10%. Why do I do that? I have never met a retiree in need of health care who complained about having too much money available to get the level and quality of care they want. I have never met a widow or widower or orphan or surviving business partner who ever complained about having too much tax-free cash available. And I know all governments are going to need more revenue in the future – and they can only get it from us!

BTW for those readers who may not be familiar with the words SWAG or BOHICA – they come from my past military experiences – SWAG – silly wild ass guess – BOHICA – bend over here it comes again! Cheers.

Is Your Car Taking You To Your Retirement Dreams?

When a mechanic is fixing your car, it’s probably a good idea for that mechanic to have as many tools he can. Your car is a complex system with many moving parts that, when working properly, takes you to your destination.

When you and your advisor are putting together your financial tools to reach your retirement destination, it’s also a good idea to have as many tools working for you to give you the best chance to reach your goal.

With conventional investments, the structure of the tools is fairly uniform… mutual funds.

In the Exempt Market, the structure of the tools varies, which in a lot of ways provides a complementary relationship for the overall tool kit. Here are a few tools to help the drive to your retirement destination be as smooth as possible…

Mortgage Investment Corporations (MICs) are investment structures that collect money from investors and then lends that money out in the form of mortgages. These investments are generally lower risk with the protection of the capital coming from the collateral. Unfortunately, these investments pay dividends that are taxed as interest income, so it will take the full brunt from Revenue Canada.

Flow Through Shares are special type of share that allows certain expenses to “flow through” to the end investor. Companies in the mining, oil and gas industries will use these structures to obtain capital to fund their operations. The strongest elements of these types of investments are their tax effectiveness. One of the best ways to minimize your tax bill is utilizing flow through shares.

Real Estate Income Trusts (REITs) are a way to participate in real estate, without having to collect late rent cheques or clean toilets. The good manager of the REIT will manage the asset while ensuring that it is in good order and revenue is coming in on a consistent basis.

Private Equity allows investors to be part of the ownership of an operating company through structures such as preferred shares or limited partnership units. Companies who are looking for growth capital, finance assets or to buy out competitors will often come to the Exempt Market to fund their initiatives.

These are just a few types of investment tools in the Exempt Market. Future articles will include more types and the benefits associated with them.

 

Marty Gunderson is a self proclaimed Exempt Market geek. He has served in a variety of leadership positions in the industry, from sales to issuer to dealer. He is the founder of www.BetterReturns.ca, a site that highlights a few quality exempt market offerings.  To contact Marty, please email marty (at) idealeader.ca

Taxation and Financial Planning – Part 1 of 2

A topic we all love to hate – but it needs to be examined a bit closer when it comes financial and insurance/estate planning – but no, I am not going to turn this into an course on Income Tax – but rather I am going to present some points for consideration in your planning processes.

I am always amused at various federal and provincial politicians that stand up and brag that “we have removed the burden of taxation from those Canadians with the lowest incomes”. Sounds wonderful and some politicos may actually believe it – but I assure you it is completely false. Other tax goodies such GST/HST tax credits for low income earners, Climate Action credits, planned low income tax credits, etc. are simply political smoke and mirrors. I will clarify something right here – I never have been, am not and never expect to be a member of any federal, provincial or civic/municipal political party or action committee – my comments are completely apolitical. I lump all political parties together when it comes to these games, and frankly I don’t trust any of them to be completely honest – but then I am a cynic or so I have been told!

OK, back to my point – sort of. Every person in Canada who purchases anything is paying taxes to all levels of government in Canada plus additional taxes to foreign governments if the item(s) purchased were made outside Canada or the raw materials came from outside Canada. And this applies to EVERYONE – from the person at the top of Canada’s Wealthiest list to the person who scrapes by begging for handouts or receives social assistance of one type or another. Charities pay taxes too – and this includes religious organisations that, for whatever reason, have been given charitable status – money is being moved around to all levels of government.

Many people “rejoice” when tax-freedom day arrives – somewhere around the middle of the year according to several organisations – I contend this is a complete fallacy – and I’ll tell you why!

Assume I make and sell a widget. When I calculate the price for which I am willing to sell it, I have to look at all the TAX inputs – buying the raw material to make it – I am paying taxes to the seller of the raw materials who is paying taxes on those raw materials to government in the form of royalties, licence fees plus taxes on purchasing the equipment that they used to get the raw materials. I have to calculate in the selling price the amount of money I paid to the manufacturers of the equipment that I use to make my widget and they have included in their price of the equipment all of the taxes they had to pay. I have to calculate the labour costs included in each widget I make and that includes payroll taxes such as CPP, EI, Health Care etc.

Then I have to include the property tax I pay for the building that houses the equipment in which I make the widget – and if I lease the building and land, then I pay a pro-rata share of the taxes my landlord pays. Next I have to package the widget and pay taxes on the materials used in the packaging, then I have to ship it somewhere and pay taxes on that including road and bridge tolls, provincial, federal and local taxes or surcharges, fuel taxes, port taxes, customs duties etc. Finally I get around to paying me – and I have to figure in my tax bill to figure what I need to have left to take of me and my family and pay all of these same types of taxes on everything we consume or use.

Whether people want to recognise it or not, wealthy people do pay more total taxes than lower income earners – they like more toys, more vacations, more luxuries – guess what – there are taxes included in all of those items too – but then, to admit that would go against the current 1% versus the 99% protests! The simple fact is, there is no “tax freedom” day – everything we spend goes for taxes or raw materials – everything in between is taxes or becomes taxes in one form or another – but let’s not get depressed about it! How does this impact on financial and insurance/estate planning?

Stay tuned for Part 2 next week!

Effects of Inflation on Financial, Estate and Retirement Planning and product illustrations

After reviewing different options for growth rate assumptions in previous blogs, let’s now examine inflation. From Statistics Canada’s website, the following inflation rates apply for the same 1992 to 2011 period.

1992 1.8 %
1993 1.4 %
1994 0.2 %
1995 1.5 %
1996 1.9 %
1997 0.7 %
1998 0.9 %
1999 2.4 %
2000 3.0 %
2001 0.7 %
2002 3.7 %
2003 2.1 %
2004 2.2 %
2005 2.2 %
2006 1.8 %
2007 2.6 %
2008 1.3 %
2009 1.5 %
2010 2.7 %
2011 2.7 %

Average 1.87 %

Median 1.85 %

CAGR 1.86 %

Inflation has ranged considerably since the 1950s – from mid-double digits (during the period of a strange PET creation called the Anti-inflation Board) to a minus during a recession. Even in this illustrative period it has gone from 0.2% for a low to a high of 3.7% – more than 18 times the lowest rate!! 3.7% is a plan killer – particularly over 20 or 30 years – and remember from a couple of blogs back, this is just the main CPI result – sub-indices for things such as Health Care and Recreation can be and very often are considerably higher – which results in an even larger impact post-retirement than just the basic CPI. But let’s continue the basic thread here.

If I take the Average, Median and CAGR results from one of the previous blogs and subtract these inflation figures, look at what happens.

Net Average 4.98 % $2,640.69 Overstated by 32.20 %

Net Median 8.00 % $4,660.96 Overstated by 133.34 %

Net CAGR 3.52 % $1,997.49

You can see that the Net Average drops from 6.84% to 4.98%; the Net median is reduced from 9.85% to 8.0% and CAGR drops to 3.52% from 5.38%. Putting these inflation-adjusted rates into the usual future-value formula, using the Net Average rate results in the initial $1,000.00 invested growing to $2,640.69, the Net Median gives $4,660.96 while using the Net CAGR provides a total of $1,997.49 after the 20-year period. I will further complicate this discussion by taking the CAGR from the blog adding money to the fund – 5.01% and subtract the 1.86% CAGR for inflation, and now I get a Net CAGR of only 3.15%!!

I am going to ignore the Median calculations in my future comments – and you can obviously see why – that leaves either the Net Average or the Net CAGR.

The CAGR is the actual calculated Compound Annual Growth Rate for the initial $1,000.00 investment over 20 years – it takes into account the actual up and down movements for each year to give the actual end result. The numerical Average does not consider the actual end result of the annual changes to the rates of return – rather just the annual rates themselves. Which, IMHO, is seriously flawed logic. As you can see from the table above, using the Net Average results in projected future values 32.20% HIGHER than actual history would indicate – can you justify an error rate this large to yourself or your clients??

I cannot.

I was told by a statistician many years ago that averages are nothing but the worst of the best and the best of the worst – reviewing these numbers proves that statement to me – and I hope to my readers as well.

Talking to various actuaries (a very interesting group of folks I might add) over many years, particularly pension actuaries, I have been told many times that the real rate of return on money over long periods of time (30 plus years), is typically in the 3.00% to 3.50% range – RROR being return over and above inflation but before taxes – and surprise, surprise, this is what is supported by the actual results over the previous 20 years using the S&P/TSX Total Return Index and applying the Stats Canada CPI and actual calculated Compound Annual Growth Rate!

Next time, I will discuss another favourite hobby-horse – income taxes! Cheers

Average returns versus CAGR for withdrawal plans

So here we are again, but this time we will look at the difference between Average rate and the calculated CAGR when there is a WITHDRAWAL plan in place. So again, same rate history and sequence as we have been using for the past several examples but now we start with $1,000.00 and withdraw $50.00 each year – as you can see the average is still 6.84% but the calculated CAGR required to get the same result after 20 years is now 6.14%. If you use the average rate of 6.84%, then the final result is HIGHER by $293.79 or 22%. In this specific case, the use of the average rate produces what APPEARS to be a better result for the client – but it isn’t in terms of the reality – the figures appear better, but the actual results prevail of course! If the sequence of returns is reversed, then the resulting capital is ONLY $577.92 – and the calculated CAGR is now way down to 3.73% – interesting to say the least!

Sequence of returns is absolutely critical for withdrawal programs as you can easily see. Using average rates is just unforgiveable and indefensible IMHO!

Year Rate————$1,000.00
1992. . . .7.8 %__________$1,024.10
1993. . . .-4.6 %__________$ 929.29
1994. . . .29.0 %__________$1,134.29
1995. . . .-2.5 %__________$1,057.18
1996. . . .11.9 %__________$1,127.03
1997. . . .25.7 %__________$1,353.83
1998. . . .13.0 %__________$1,473.33
1999. . . . -3.2 %__________$1,377.78
2000. . . .19.7 %__________$1,589.36
2001. . . . 6.2 %__________$1,634.80
2002. . . .-13.9 %__________$1,364.51
2003. . . .-14.0 %__________$1,130.48
2004. . . . 24.3 %__________$1,343.03
2005. . . . 12.5 %__________$1,454.66
2006. . . .21.9 %__________$1,712.28
2007. . . .14.5 %__________$1,903.31
2008. . . . 7.2 %__________$1,986.75
2009. . . -35.0 %__________$1,258.89
2010. . . .30.7 %__________$1,580.02
2011. . . -14.4 %__________$1,309.70

Average. . .6.84 % $1,603.49

CAGR. . . . 6.14 % $1,309.70

So all of this is interesting to look at and consider, but next I am going to throw inflation into the issue and finally, some comments on taxation! So this is nice and short – if anyone wants to see a printout of the other tables showing the reversed sequence and the CAGRs, just email me! Cheers

What happens to Average and CAGR when deposits are made every year?

So let’s go back and do the next problem in looking at averages and CAGR – as noted previously, I am going to ignore Median results as they are completely without any justifiable foundation. So here we have the same rates and sequence of returns with the only difference being the addition of $50.00 to the fund each year. As you would expect, the end result in terms of dollars is higher – no surprise.

However, check out the CAGR – IT HAS DROPPED from the 5.38% in the previous blog! Why – because there is an ever increasing amount of capital and the compounding effect of the ups and downs – particularly the downs, result in a lower overall calculated Compound Annual Rate of Growth – something that most people do not expect.

Year Rate . . . . . . .$1,000.00
1992 . . .7.8 % . . . . . .$1,131.90
1993 . . -4.6 % . . . . . .$1,127.53
1994 . . 29.0 % . . . . . .$1,519.02
1995 . . -2.5 % . . . . . .$1,529.79
1996 . .11.9 % . . . . . .$1,767.79
1997 . .25.7 % . . . . . .$2,284.96
1998 . .13.0 % . . . . . .$2,638.50
1999 . . -3.2 % . . . . . .$2,602.47
2000 . .19.7 % . . . . . .$3,175.01
2001 . . .6.2 % . . . . . .$3,424.96
2002 . .-13.9 % . . . . . .$2,991.94
2003 . .-14.0 % . . . . . .$2,616.07
2004 . . 24.3 % . . . . . .$3,313.92
2005 . . 12.5 % . . . . . .$3,784.41
2006 . . 21.9 % . . . . . .$4,674.15
2007 . . 14.5 % . . . . . .$5,409.15
2008 . . .7.2 % . . . . . .$5,852.21
2009 . .-35.0 % . . . . . .$3,836.44
2010 . . 30.7 % . . . . . .$5,079.57
2011 . .-14.4 % . . . . . .$4,390.91

Average . . .6.84 % . . . . . .$5,907.68

CAGR . . . . 5.01 % . . . . . .$4,390.91

As you can see the difference between the AVERAGE growth rate and the CAGR has now WIDENED to 1.83% – it may not seem like a lot, but in real dollar terms it is! If you re-run this table and substitute the Average Growth Rate of 6.84%, the resulting value after 20 years is $5,907.68 – a difference of $1,516.77 – or an increase of 33.5% over the actual value using the CAGR or the variable growth rates from the table. What a horrendous error rate!!

How can a potential error rate of this magnitude be justified in any financial plan – retirement, estate or any other component?? All I can suggest is that if you are going to use average rates, you will need plenty of E & O coverage within the next few years!

I am going to presume that readers are now satisfied with my statement that using historical average rates for forward-looking assumptions is a fools game – but remember, this discussion isn’t over as we have to examine the impact of inflation and then taxes – then to complicate matters I am going to compare the sequencing of returns during the both the accumulation phase and the withdrawal or decumulation phase of financial plans. More fun and games with numbers – I am going to stay with the same assumed growth rates in this table – but simply flip them end for end – and see what – if any difference this has on the end results!

Cheers

Average, Mean/Median and Compound Annual Growth Rate – what is the difference?

Greetings once again and welcome to the next discussion on these topics. I have created a small table (shown below) to illustrate the differences using a simple representative 20-year period that overlaps the market events of mid-2000 years. Charts and tables that project growth rates over long periods of time are always suspect, but we need to start somewhere. I have chosen 20 years as a period to which most people can relate. Most industry charts cover periods of 60 years and longer and show calculated results going back to day one – while interesting, I feel they are of very little value and clients find them confusing and relating to that duration is hard.

Average versus Median versus Compound Annual Growth Rate – initial investment of $1,000.00 January 1st, 1992.

1992 . . . . . . . 7.8 % $1,078.00
1993 . . . . . . .-4.6 % $1,028.41
1994 . . . . . . .29.0 % $1,326.65
1995 . . . . . . .-2.5 % $1,293.49
1996 . . . . . . .11.9 % $1,447.41
1997 . . . . . . .25.7 % $1,819.39
1998 . . . . . . .13.0 % $2,055.92
1999 . . . . . . .-3.2 % $1,990.13
2000 . . . . . . .19.7 % $2,382.18
2001 . . . . . . . .6.2 % $2,529.88
2002 . . . . . . -13.9 % $2,178.22
2003 . . . . . . -14.0 % $1,873.27
2004 . . . . . . .24.3 % $2,328.48
2005 . . . . . . .12.5 % $2,619.54
2006 . . . . . . .21.9 % $3,193.22
2007 . . . . . . .14.5 % $3,656.23
2008 . . . . . . . .7.2 % $3,919.48
2009 . . . . . . -35.0 % $2,547.66
2010 . . . . . . .30.7 % $3,329.79
2011 . . . . . . -14.4 % $2,850.30

Average . . . . .6.84 % $3,755.58

Median . . . . .9.85 % $6,546.38

CAGR . . . . . . 5.38 % $2,850.30

Total Growth Rate includes Interest, Dividend, Capital Gains and Capital Losses for a nominal portfolio based on 100% of the S&P/TSX. Rates are for illustration purposes only.

A simple average of the Annual Growth rates, results in a number of 6.84%, the median/mean is 9.85% while the actual Compound Annual Growth Rate equates to 5.38%. Please note the comments/disclaimer at the bottom of the table.

So now the question becomes, which rate do we use for financial, insurance and estate planning – assuming that the portfolio described matches the risk and KYC profile of the client.

The mean or median rate is obviously not valid as this simply means that half the returns were higher than 9.85% and half were lower – and the answer is really – so what! That leaves the average or the CAGR.

The table shows that if we use the average rate of 6.84% and compound that for the 20 years, you or your client will only have $3,755.58 – significantly MORE than the actual result of $2,850.30 using the CAGR of 5.38%. An argument can be made for using either one, but speaking personally, my comfort with higher rates has reduced over my career and I would always use the LOWER of the two numbers and would recommend this approach to both consumers and advisors. If you use the lower rate, you are unlikely to be disappointed while using the higher figure introduces a higher level of uncertainty into all calculations. I will point out – that I am not satisfied with using the 5.38% rate either as you will see in the next couple of blogs – too many uncertainties still arise – but 5.38% is at least something closer to reality that what I see being used in most financial planning scenarios, software and insurance illustrations.

This discussion is far from over – there are four other issues to discuss in future blogs: first – what about the effects of inflation on the results; second – what about the impact of income taxes; third – so far I have only looked at a single lump sum deposit – what happens with periodic deposits or withdrawals; fourth – what are the effects of reversing this illustrated sequence of results?

BTW, here is a link to a website that can do all of these financial calculations without requiring a financial calculator – I use it regularly! The S&P/TSX Total Returns I pulled from Jim Otar’s Retirement Calculator – I provide a link to his excellent website in an earlier blog. http://bing.search.sympatico.ca/?q=calculating%20rate%20of%20return&mkt=en-ca&setLang=en-CA