A recent article in Investment Executive points to a troubling break with reality. A new survey from Toronto-based Natixis Global Asset Management Canada has found that clients typically expect an annual rate of return in the inflation plus 9.3% range. That is an example of an unreasonable expectation. Over long time periods, inflation plus 5% is on the edge of heroic.
The second finding is these same people would like to achieve these results using a passive, low-fee fund.
My instinct is to say, “No problem. Second door on the left, just past the flying pigs.” but that may not be helpful.
There are two problems here.
- Many clients do not understand markets
- People may take the numbers from the survey and assume they have meaning.
As an advisor, what should you do?
It appears there are two choices.
- Use facts and logic to show that while such returns are occasionally available in the real world, to assume they would exist for a long time is unsupported by any past performance. Logic and facts will sway about 1% of the people. Too bad.
- They know someone else who says their estimate is possible. Let them go to the other and keep in touch. Eventually they will begin to see how facts and reason make a better basis for a financial plan than do hopes, hype and other delusions. It is the real world after all.
We can look at the survey and tease out some reasoning for why, for these unfortunates, the yield makes sense. That is only possible using facts and reasoning.
According to the Bank of Canada inflation has averaged about 1.4% over the past four years. If someone saves $6,000 per year, plus inflation, in a tax free savings account and earns 9.3% plus 1.4% inflation, after 35 years they will have about $2.3 million. Very nice.
Now let’s suppose that the $6,000 our young couple saved is some share of income. Call it 5% of income. We know from experience that cost of living after debt and savings and taxes and the like, runs about 40% to 45% of total income. (less for higher rate tax payers) We can therefore say that these people are saving about an eighth of their consumption and we suppose they expect the resulting accumulation to replace that spending in retirement.
We can look at projected year 36 saving and it comes to $9,429.65 which implies that cost of living to be replaced must be about $75,000. At inflation plus 9.3%, the $2.3 million accumulated will continue to grow after spending. 25 years after retirement, it will be about $18 million. Clearly these people are over-saving.
What assumption would make the yield reasonable?
If we rework the figures saving 1.75% of income, and leave cost of living unchanged, we find the fund comes to $810,000 and can supply the cost of living to for 23 years after retirement.
We could infer the sampling is finding people who save very little. Like young people.
The example that works for these people says save $175 a month on income of $10,000. A token. Likely that is hard for them because they have other wants and needs and commitments, but $175 works so inflation plus 9.3% must be right. Mistake one. Confirmation bias.
We know these people have never taken financial literacy 101. If they had, they would know:
- The economy does not return more than it earns, so no index will return these numbers for a long time. (58 years in this scenario) Maybe a few carefully selected businesses could, but that requires management not an index fund.
- Future capital is a function of yield, time and savings. Needing a high yield shouts that your savings are too low or your time too short.
- The future is unpredictable. Year over year yield is highly variable. What is the plan when your index fund loses 20% as it did in 2002. You may need someone to talk you down. That has a price.
- The fabric of your cost of living changes over time. Paying down debt now frees investment money later. What is true today is not true for all of time.
- The biggest impediment to wealth is not rate of return, it is emotional responses from the investor.
Expecting a high yield because you need a high yield, is not the same as looking for investment opportunities. Requiring an unreasonable rate of return implies other serious defects in the way you have structured your finances. Look there first.
Never pay attention to any advisor that starts by supporting unreasonable beliefs. They will be of no value to you. Remember the flying pigs.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772