Research often shows that investors are overly optimistic about future profit levels. This is especially true due to the strong showing of stocks as we have seen in the past year.
The total return of the S&P/TSX Composite Index over the past 12 months has been 34%. The S&P 500, in Canadian dollars, returned 24%. Over the past decade, the annual returns for these indexes have been 13% and 16% respectively—but financial planners aren’t looking at similar success going forward.
The FP Canada Standards Council and the Institute of Financial Planning update their Forecasting Guidelines every April. These guidelines apply to certified financial planners (CFPs) and Quebec Planificateur (Pl. Fin.). It is worth considering for Canadians who are thinking about their financial future.
Inflation
Inflation eased in Canada in 2022, with the year-over-year Consumer Price Index (CPI) running at 6.8%. For most of the past 30 years, it has been steady at 1% to 3%, which is the Bank of Canada’s target.
If you use long-term estimates, you cannot forget this increase in the cost of living. This affects costs, salaries, government pensions, and private pensions.
Canada’s inflation rate was 2.4% last year. The guidelines suggest an assumption of 2.1% for the long term. The salary increase should be inflation plus 1%, thus 3.1%.
Investment benefits
Long-term estimates also need to account for the possibility of market underperformance prior to retirement, which can have a significant impact on portfolio sustainability. Experts call this sequence reversal risk—that is, if stocks fall prematurely in your forecast. The following financial projections take this risk into account.
3.2% Fixed income (bonds)
6.3% Canadian Stocks (stocks)
6.4% US equities (stocks)
6.6% International advanced market shares (shares)
7.5% Emerging market shares (stocks)
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If you use Monte Carlo analysis—a mathematical simulation using variable market returns—you can add 0.5% to the equity (stock) estimate above. But investors should note that financial planners are assuming future stock returns in the 6.5% to 7.5% range, not the double-digit returns we’ve seen lately.
It’s also important to note that these returns are before investment fees, which can range from negligible for a typical investor to 2% or more for an investor in mutual funds. Most investors who work with advisors should reduce their return assumption by 1 to 1.5%.
These rates are called standard rates of return, so they do not take into account inflation. The actual rate of return that takes into account inflation may be reduced by 2.1% of the inflation adjustment. And they don’t take into account income taxes, which can vary widely.
Rising real estate prices
This is the first year that shelter costs have been included in the Guidelines. The proposal is to take inflation plus 1%, so 3.1% of house prices and rents.
Therefore, despite the strong appreciation of real estate prices until recently, it is wise to count on only 3.1% going forward. It is important to note that a rental property investor can expect to earn rental income above this rate of return.
Rents should be assumed to increase at the same rate of 3.1%.
Housing prices
The recommended lending rate is 4.4%. This is higher than the mortgage rates currently available on fixed and variable rate loans, suggesting rates are slightly lower than the long-term trend.
This may come as a surprise to younger borrowers who may be used to 2% to 3% mortgage rates, but now we’re back in the middle.
