moneyFYI
Financial Freedom Is Merely Organized Common Sense
Using Models
People like to use models to gain insight into how a complex set of variables behave. The idea is to create something representative of potential reality and see what happens when one variable changes while the others do not. The variables usually include a given portfolio, siloes like tax-free savings accounts and RRSPs, spending, tax rates, investment rates, inflation, the ability to split income, and a margin for error. (Unforeseen expenditures) The outcome will be a projection of future income and portfolio value.
The purpose is to find surprises.
For example, a change in tax rates will have a bigger effect if spending is nearly equal to after-tax income income. Inflation might too, but it depends on the investment mix and spending pattern. Not all expenses are equally affected by inflation.
For a couple, you can test what happens if one or the other dies.
Usually, the costs to settle the estate can be calculated too.
The danger
Models do not predict the future. Models are for insight alone.
The reason is clear. No model of anything includes all the variables now, nor those that will appear in future. They do not always include how variables might interact with each other. Change one, another must change too. They cannot include people’s decisions regarding responses to emergencies or the precise timing of decisions like an illness, downsizing a home, selling a cottage, or gifts to children.
The programmer assesses how to weigh the variables in terms of their volatility and impact. Those choices are at best, informed guesses.
A person’s attitudes change over time, so a model can be reasonably predictive in the short run and utterly worthless in the long run. Think about how you assess investment risk as an example of a change that makes the future very different from what the original perception might show.
Averages disguise the effect of time-sensitive events. For example, if the stock market falls 30% the year you retire, even if you average the market rate of return over 30 years, you may run out of money. Always test for near-term problems that can create a catastrophe in the long run.
The upside
- Using a model as insight for the short-run future and a danger analyzer for the long run
- Permits you to make portfolio construction more defensive.
- Establishes a value for income splitting
- Assesses whether current surpluses are indicative of the future or just a timing difference
- Assess surplus assets and allow reasoned transfers to heirs earlier than the estate distribution
- Minimize income taxes
If you can anticipate the future, you have a much better chance of having it work out to suit you.
I build strategic, fact-based estate and income plans. The plans identify alternate and effective ways to achieve spending and estate distribution goals.
Be in touch at 705-927-4770 or by email at don.shaughnessy@gmail.com.
moneyFYI 