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Twenty years ago, had you offered a real return of 3% after fees and inflation, clients would have walked out the door.

Today, that’s the norm.

“When I started 30 years ago, with the interest rates you had bonds that were 10% to 12%,” says Janice Ricken, director of wealth management at Winnipeg’s Ricken Tanchak Wealth Management Group, under Richardson GMP. “I didn’t do managed money then. I’d buy some mutual funds and a few stocks and buy long-term strip coupons.”

Now, when Ricken does clients’ financial plans to age 90, she uses a 5% return projection after fees, with 2% inflation, making for a 3% real return (the target she uses is her own, not RGMP’s).

Ricken is one of many advisors being cautious in an environment characterized by radical uncertainty, stubborn global growth and challenging returns. Managing client expectations is key.

“You can see it in their face when you talk about returns,” says Paul Vorstadt, a portfolio manager at National Bank Financial in Peterborough, Ont. “But when you walk them through it, most people understand.”

It’s not the 1990s, when people were projecting 10% to 15% returns, he adds. Those days of healthy corporate earnings, higher inflation and growth are “slowing down to say the least, if not coming to an end,” Vorstadt says.

Estimate conservatively

Being realistic means estimating returns conservatively, even if market activity suggests otherwise. Last year, for example, unexpectedly finished with most financial plans ahead of schedule. As Ricken reviewed clients’ portfolios, she found double-digit returns, but warned them it was unusual.

“This is your one-year return: it’s 13%,” she’d tell a client. “But this is not normal. Your financial plan is at 5%. We’re in the bonus round now.”

Ricken, who’s been with RGMP for nearly a decade, says most of her clients are in or nearing retirement and have at least 30% fixed income. Her practice’s minimum portfolio size is $500,000, and most clients have $1 million to $7 million.

While many advisors use 6%, Ricken says, her approach helps ensure a client won’t come up short. “I’ve never had a client run out of money, and that’s how I sleep at night.”

Vorstadt says he uses conservative return targets of 6% to 7%, before inflation and fees are taken off, for someone five to 10 years away from retirement.

“I hope I’m wrong,” Vorstadt tells clients. “If I’m wrong, you’re going to benefit. But I’d rather be wrong my way than on the other side, because the other side’s going to hurt you.”

Surprise, surprise

New clients tend to be the most surprised when discussing today’s return projections.

“That’s more where the bubble is being burst,” Vorstadt says. Adds Tony Mahabir, chief executive of Canfin Financial Group in Toronto: “They could be out to lunch. They could still live in the past and say, ‘Well, I want my GICs to pay me 12%.’”

For new clients, Vorstadt pulls up visuals and tables on a TV screen, showing the plan, scenarios and the impact of inflation, and adjusting it as needed for risk and income. “All of it’s done right there with the client—with their interpretations—so it’s their plan versus us telling them,” he says.

Mahabir likes to show Morningstar Andex charts that depict historical performances for asset classes. They help demonstrate the importance of diversification by asset class, industry and geography.

“The right horse isn’t one asset class in itself,” he tells the client. “If you were all in Canada, this is what your return would have been.”

Inflation

Inflation, when it’s high, can eat returns. When it’s low, however, it helps offset lower returns.

Mahabir argues real returns are only slightly lower than they were during periods of high inflation. “In the years where you were using a 10% return projection, less a 2% management fee, and then subtracting inflation of 5%, that gap was almost the same,” he says. “It’s the real return that matters.”

While inflation is currently about 2%, Vorstadt uses a cautious 3% projection for price increases. That’s based on National Bank’s projections, as well as private forecasts. Subtracting about 3% for inflation and about 1% for taxes, he says, yields a real return of about 3% for the average person in retirement, or 4% for someone five to 10 years away.

While using 3% for inflation may be high, he says, “You ask somebody about their gas bill, their electric bill or going to the grocery store, they’re going to say it’s [rising by] much higher than that.”

Calculations

Mahabir calculates return expectations by blending current and historical returns for different asset classes. He uses guidance provided by the Financial Planning Standards Council to validate projections for clients (see “Historical projections”).

While foreign and emerging market investing is generally reserved for aggressive growth clients, Mahabir uses the MSCI EAFE index to help provide assumptions for foreign developed markets, and the MSCI EM Index for emerging markets. The FPSC also provides assumption guidelines for foreign developed markets and EMs, which in 2016 were 6.8% and 7.7%, respectively.

“We don’t expect our clients to be math geniuses, but they need to understand the process,” he says. “They need to see there are a lot of assumptions made when we’re projecting out over the long haul, and that my planner is using an intelligent, credentialed approach, as opposed to just winging it.”


historical projections
The return target can only be calculated after determining the client’s risk profile and how much he needs to achieve his goals.

If the return needed isn’t realistic, the client may need to adjust the plan or their expectations. Mahabir advises clients not to be too rigid. Include some levers they can pull for additional flexibility—perhaps alternative retirement dates or an adjustment to monthly savings. He suggests clients also keep qualitative levers in play where necessary, which may include downsizing their home or perhaps spending less time in Florida.

Then, stress test the plan for lower-return scenarios. “What happens if we don’t get 6%, and we get 4%?” Vorstadt says. “What happens if the order of returns is negative at the beginning? If you’re going to talk about return, you have to talk about it in terms of what the client gets to keep.”

If he does see early negative returns, they may mean the client’s projections for a sustainable, long-term withdrawal rate are no longer reasonable. Vorstadt may take the client back through the process and change retirement scenarios.

Responses could include building up emergency cash, giving the client alternative cash flow after a significant market drop, or expanding guaranteed investments and guaranteed income. The idea, Vorstadt says, is to have “less of your retirement income tied to the markets.”

Annual reviews

Projecting returns is not a one-time deal. It’s part of a regular conversation about future income, with portfolio or plan adjustments being necessary.

That being said, Ricken tries to get clients to focus not on the return but on their financial needs. “One of the things I try to explain to them is, ‘Think of the income we give you, the retirement income from your portfolio, like a pension. When the markets go down, your pension doesn’t go down. Nor will your income from us,’” she says.

For clients, Ricken uses the NaviPlan tool to produce about a five-page report, with tables and a summary. The report explains the client’s long-term plan, how much they can withdraw each year and the most tax-efficient ways to do so.

Annually, she shows clients the sum of their portfolio. A perk of conservative estimates? The client is usually ahead of schedule. If so, she tells them they’re in a good position and can even withdraw a little extra if needed.

And what if the portfolio is down? Ricken will analyze it to find out why: Was it the markets? Was it a fund manager? Did the value funds underperform? Some tweaking can be made but, ultimately, “we just have to stay the course, because we know that value and growth offset each other,” Ricken says.

What to do with those bonds?

The traditional allocation to fixed income is presenting risks, as inflation is expected to rise after years of record-low rates. The gains could drop bond prices, lowering returns for retirees.

Talbot Babineau, chief executive of asset management firm IBV Capital in Toronto, says institutional investors have been addressing this issue, but the average individual portfolio continues to have significant bond exposure.

Rising inflation presents risks for the typical 40% fixed income holding—which magnify as the client approaches retirement and the bond allocation increases.

“That to us is extremely concerning,” Babineau says. “We see fixed income as far riskier than most are led to believe.”

Using U.S. rates as an example, Babineau estimates that if the average 10-year bond yield increased by 100 basis points (one percentage point), the bond value would fall by about 8.3%.

“The probability of a permanent loss of capital is pretty high if they continue to liquidate their portfolio for retirement in a rising rate environment,” Babineau says. “With current bond yields, after you remove taxes, fees and account for normalized inflation, you’re likely to earn a negative real return.”

Babineau says alternatives and private equity funds are good options for those looking to reduce exposure to bonds. But some firms restrict how much advisors can expose clients to those spaces, he adds.

“Strategies that benefit from flexible capital, which are most often found in alternative investments […] can be drawn from either the fixed income or equity component of one’s portfolio,” Babineau says.

Returns aside, clients want to know whether they’re going to have enough. Ricken has one client with a multimillion dollar portfolio who, when they meet for lunch, doesn’t want a portfolio review. He wants only a single number—the one reflecting his monthly retirement income.

Fees

Discussing returns often means talking about fees. Ricken says she explains her fees (usually 1% to 1.25%) in detail. Perhaps an annual fee equals $20,000; if so, Ricken would tell the client half of it goes to RGMP, and then a big portion to her staff, office expenses and taxes. From the $20,000, Ricken explains, she might take home $2,500. The client is usually happy once they understand the value.

If a client asks Mahabir about fees, he’ll break them down. If the client is still concerned, he will hand her a checklist of five jobs he does for clients (e.g., an annual rebalancing; a quarterly review) and ask her which she would prefer to do herself.

“Every element you take off my table, I’ll reduce your fee by 20%,” he’ll tell the client, so that a 1% fee would become 0.8% if she takes one task, then 0.6% with another task, and so on. The exercise helps demonstrate the value of the service and, most of the time, clients decline the do-it-yourself approach.

And, if clients object to the fees, he says, he offers an hourly rate. And, he’ll usually undercharge on the hours: “A client could sit with me for six hours but feel good knowing I’m only charging them for four,” Mahabir says. “People like a good deal.”

Simon Doyle is Senior Editor of Advisor Group. Email him at simon.doyle@tc.tc.

Originally published in Advisor's Edge

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