Making the correct assumptions

NST Online » Focus
2008/06/14

Business: Making the correct assumptions
By : Yap Ming Hui

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IN wealth management, you could go to three different wealth management advisers and get three completely different financial plans depending on the assumptions used in the calculations.

It boils down to the assumptions used by the wealth management advisers.

Some of the key assumptions that will result in the wide variations are: - The expected rate of return (ROI) - Rate of inflation - Marginal tax rate of the person - How long will the person live - The income the person needs to support his lifestyle in retirement


I will now highlight how different assumptions used can affect the amount required for a retirement nest egg.


Wong is 45 years old and earns RM100,000 per annum. He would like to retire at 55 and estimates that he is going to need 60 per cent of his current income (RM60,000, taking into consideration inflation value).


He would like to use two per cent as the rate of inflation and eight per cent as the rate of return.


Based on the above factors, he would need RM991,076 for his retirement by the age of 55. With this amount in place, Wong can afford to spend RM60,000 per year and finish spending his capital at the age of 80.


However, by varying the assumptions used, we can get different results.



Rate of inflation


If Wong used four per cent as the rate of inflation, then the retirement nest egg required would be RM1,465,771 instead of RM991,076.


With a difference of two per cent in rate of inflation, we have a difference of RM474,695 in the amount required for the retirement fund.


The rate of inflation experienced by any individual or family is basically dependent on two main components.


First is the basic inflation factor experienced by the general population. This rate of inflation can be projected by using the rate of consumer price index.


However, each individual and family also experiences an inflation that we term as life style inflation. Life style inflation basically refers to the inflation on those items consumed other than the common household items, for example the car, house to stay in and holiday package.


Since the different inflation rate will influence the end result of any wealth management, it is important to use a rate of inflation which is as accurate as possible.


In an era of high inflation, we need to review the assumed rate of inflation. Without adjusting the rate of inflation, you may under prepare your various financial goals.


Income needed to support retirement living


If Wong decides that 80 per cent rather than 60 per cent of his current income would be sufficient for him to enjoy a comfortable life style then he would need a retirement fund of RM1,321,435 instead of RM991,076.


With a difference of 20 per cent in the income needed for your retirement, we have a RM330,359 difference in retirement fund.


Undeniably, the figure will become more accurate as you get closer to retirement. There is a rule of thumb that suggests a person will need about 60 to 80 per cent of his pre-retirement income. To have a more accurate projection, you must continue to update the calculation as you get closer to retirement age.


How long will you live


Wong chose 80 years as his life expectancy for his retirement plan calculation. If he chooses to use 95 years, the retirement nest egg will change to RM1,166,515 from RM991,076.


It is obvious that the assumptions made on your life expectancy have a relatively smaller impact compared to the other assumptions. If you live longer than you have assumed, then you risk outliving your money.


Rate of return


When we use an eight per cent rate of return, Wong would need RM991,076 by the age of 55. If he were to assume that he could achieve 12 per cent rate of return, he would need RM730,280. With a four per cent difference in the estimated rate of return, we have a difference of RM260,796 in the retirement fund needed.


While you may want a higher rate of return, no one can guarantee what the financial market will earn eventually.


So what rate of return should be used in your financial plan? It should be the rate linked to the economic outlook, your personal asset portfolio mix, the inflation rate and the long-term historical rate of return for your investment asset, less management charges.


In order to have a more accurate financial plan, we must be cautious in deciding various assumptions used in wealth management calculation. Since the impact of using the wrong assumptions could be a financial disaster, you may want to confirm your assumptions with an independent wealth management professional.


In fact, a prudent practice would be to do more than one financial projections in each scenario so that you can see the impact of the different outcomes on your ability to achieve your financial goals.


One financial projection is certainly not enough, not when preparing a business plan, and not when doing a personal financial plan.


Yap Ming Hui is the managing director of Whitman Independent Advisors Sdn Bhd, the first multi-client family office in Malaysia.

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