Are You Being Too Conservative with Your CMA?

By Paul Feldman

By David Tassone

As financial planners, we must scrutinize every data point our clients provide. Are they maxing out their 401(k)? Will their estate plan be properly executed? Do they have the proper insurance?

How do we project investment returns in the future given their risk appetite? The last question is arguably one of the most important questions an advisor must consider, and one that can easily get overlooked.

With most financial planning software, including E*Money and MoneyGuidePro, advisors are given three options when it comes to their capital market assumptions (CMA): input your own, use historical data, or use projected assumptions. Through just the push of a button, the advisor can dramatically impact a client’s financial plan —either positively or negatively.

Predictions, Assumptions, And History

A popular maxim in psychology is that the best predictor of future behavior is past behavior — and the same could be said about the markets. The most dangerous phrase in investing is, “It’s different this time,” because we are fooled into thinking new regulations or technology have changed the landscape entirely. Time and time again, we are reminded that this mindset can be a trap.

When building out capital market assumptions, companies like JP Morgan and BlackRock create their own long-term CMAs that are readily available to the public and commonly used by financial planning software. Looking at historical data from the last 20 years it is common for forward-looking CMAs to be more conservative than they used to be, yet also more volatile than projected.

This begs the question: why? In an environment where we are seeing historically low interest rates with a downward trend combined with a Federal Reserve that has repeatedly shown its resilience to back the financial markets, why are we projecting weaker long-term growth in the future?

A variety of factors may be at play. Geopolitical risks, the use of big data, and the rise of technology can all point towards us living in a different world now than in 2002, but should that lead to more conservative projections?

There is a risk in being overly optimistic with your assumptions. CMAs typically take a variety of different returns and standard deviations and allow the advisor to run a Monte Carlo Simulation to project a client’s probability of success. If an advisor is too aggressive, the client may be crippled with unrealistic expectations of the future and an actual plan that falls short of the projected plan.

If an advisor is too conservative, the client may experience unnecessary stress that their plan will fail or demand aggressive savings plans that don’t allow the client to live their desired lifestyle. Choosing the proper assumptions is essential in building out a proper financial plan.

Which Is Best?

In the end, advisors all need to recognize that a financial plan changes over time, and the assumptions surrounding the plan also change. A financial plan, just like life, is a permanent rough draft. We must constantly adjust to the new circumstances that surrounds both our clients and the larger macroeconomy. Constant communication with our clients and adapting a plan to their lives is the best way to maintain realistic expectations in their pursuit of financial independence.

The unfortunate reality is that there is no single best practice or solution for your clients. Instead, advisors are empowered to choose. As such, conviction when building out your client’s financial plan, and sound rationale for why you’ve chosen a certain CMA, are just as important as choosing whether your CMA is based on your firm’s own assumptions, historical or projected.

David is the Vice President at Kaye Capital Management where he works to bring peace of mind to his clients to make their hard financial decisions easy.

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