Why a robust estimate of future returns is important for investment planning

WHEN I started my career in the financial services sector in the late 90s, comprehensive financial planning was not widely practised. Most of the time, it was really just product sales.

I first learnt how to write a basic comprehensive financial plan from some books I found in Hon Sui Sen library at the National University of Singapore in 1999. In planning for clients, I needed to work out how much clients need for a certain financial goal and how much they need to invest in order to reach that goal.

To do that, I would need to assume certain rates of return on investment (ROI) for planning. There wasn’t a lot of guidance back then on how to do so; different advisers used different methods. Some would take the projected returns of an investment-linked policy (ILP). In the 1990s, the higher end of the projection was 9 per cent a year.

Others might use the historical returns of financial markets. Some others might use the actual annualised returns of the funds they were recommending as the planning ROI to determine how much clients should invest. But using these methods to derive the return numbers for planning presented a lot of problems.

• The returns that were used for developed market and emerging market equities were not differentiated even though they are different. In a globally diversified portfolio, there is usually an allocation to these two markets.
• Past returns from markets or the unit trusts may not be repeated in the future.
• There is cost in using unit trusts, ILPs or even ETFs. Returns will be lower net of management fees. This was not considered in determining the planning returns.
• Whether using direct stocks, bonds, unit trusts or ETFs, there will be platform/custodian costs as well as an ongoing advisory fee. These too were not considered in arriving at the planning return numbers.
• Advisers in the same advisory firm may use different return assumptions for planning, so there is no consistency within the same firm. 

When I started Providend in the early 2000s, we decided to be more robust in deriving the planning returns used for constructing our clients’ wealth plan. We first used historical data to estimate the expected returns and risks of developed and emerging markets equities. From these results, we built different portfolios with different allocations to equities and bonds, with different expected returns and volatility.

We then subtracted away all the costs of investing such as the fund’s total expense ratio, the custodian fee as well as the ongoing advisory fee that our clients paid us to arrive at the planning return numbers. These numbers are also used by the investment team to monitor if our portfolios are delivering sufficient returns for our clients.

However, the challenge of using historical data is that they might not be the best representation of future returns. Thus, we decided to use the Ibbotson-Chen model to derive a forward-looking expected return for equities.

The Ibbotson-Chen model was invented by Dr Roger G Ibbotson and Dr Peng Chen, and published in the Financial Analyst Journal in 2003. For their work, they won the prestigious Graham and Dodd Awards of Excellence.

Although there are different ways to estimate forward-looking expected returns of equities, the Ibbotson-Chen model is a robust model as it is not based on subjective forecasts of market participants. Rather, it is a data-focused approach that breaks down the components that contribute to the market returns of equities and uses them to estimate their forward-looking expected returns.

These components are inflation, current dividend yield of equities and earnings growth. The differentiator of the Ibbotson-Chen model is that it excludes price-to-earnings ratio (P/E) change because P/E is unpredictable and not based on economic outcomes. Also, there are investors’ expectations of future stock prices that are built into P/E, which cannot be quantified.

Our investment team worked with Dr Peng Chen to use the Ibbotson-Chen model to estimate a range of expected returns for equities. To be conservative, we used the return at the 50th percentile as the returns for our different portfolios of varying asset allocation. Similarly, we then subtracted all the relevant costs to arrive at the planning numbers.

We worked out two sets of planning returns. One set is for long-term planning and another is for short-term planning for the portfolios with a higher weightage in bonds to account for the current higher bond yields.

We are so serious about properly determining the planning returns because they allow our advisory team to determine which portfolio is suitable for clients and the amount they should invest. Inaccurate planning returns can lead to over- or under-investing. While planning returns are not our portfolios’ target returns, they are useful to enable our investment team to know if portfolios are delivering the required returns.

In a recent public webinar that we did, some attendees asked an interesting question: “What does Providend do after clients invest? If clients are supposed to just buy and hold, then wouldn’t monitoring the portfolio not require too much work?”

This couldn’t be more wrong. Wealth planning and investing work hand-in-hand, and are not one-time events. This is because personal circumstances will change; the future world will be different from today; and markets have their ebb and flow. Besides regular reviews of clients’ circumstances, we monitor the portfolios regularly and search constantly for other suitable instruments that may give clients a better investment experience.

We also re-estimate the planning returns on a yearly basis. While staying invested in the right portfolio will give you positive returns in the long run, positive returns do not mean sufficient returns to meet your needs. Being more diligent in the planning and investing process will help you reach your life goals in a more reliable manner.

The writer is CEO of Providend, South-east Asia’s first fee-only comprehensive wealth advisory firm.