Creating an Optimal Financial Plan
“Does the default logic in Snap create an optimal plan for my client?” This is an excellent question and one of the most common questions we get asked. This article provides a detailed discussion of the topic. We’ll introduce you to the terminology of efficient and optimal plans while discussing the differences between each type of plan and how you can use Snap Projections to create both types.
In this article:
- Differences between an efficient and an optimal plan
- Assumptions and calculations that Snap uses to create an efficient projection
- Deciding which type of plan is right for your needs
- Creating an optimal plan
- Step 1 - Define and prioritize your client's goals
- Step 2 - Identify strategies most likely to achieve the desired goals
- Step 3 - Determine when to revisit the plan
- Challenges of creating an optimal financial plan
- Key takeaways
Differences between an efficient and an optimal plan
An efficient financial plan takes advantage of common best practices, material financial information, and accurate calculations to provide a client with enough information to make informed decisions.
For example, you may show a client that if they contribute $10K per year to their RRSP, then retire at the age of 65 with a spending goal of $50K (in today's dollars) they'll have $1MM in their final estate at the age of 98 (provided they receive an annual average gross return of 4%). This information may be enough for a client to decide to change careers, knowing that they'll be able to meet that savings goal of $10K per year to their RRSP and that in their new career, they're comfortable they can work to the age of 65 or longer if required.
While the client may live to age 102 instead of 98, or earn a return of 3% instead of 4%, provided that the final outcome is within the client's comfort, additional analysis and optimization won't change the decision being made from the financial plan, which is whether to change careers or not.
An optimal financial plan takes into consideration the client's unique circumstances (e.g., preferences, behaviour), detailed financial information, and probabilities to give recommendations that provide the highest likelihood of the client achieving their goals.
For example, in the client scenario above, it may be the case that rather than saving $10K per year to the RRSP, the client should save $5.5K per year to the RRSP and the rest to their TFSA. With additional financial information, it may be the case that this would bring the client's taxable income out of their current marginal tax rate to the next lowest bracket. If the client's taxable income increases in the future, they can use the TFSA money to contribute to the RRSP and receive a higher tax refund than they would have originally. However, if the client's behaviour/history would suggest they're more likely to spend the TFSA money because it's accessible for withdrawal without penalty, then maybe the RRSP is best after all. An optimal financial plan takes into consideration additional information to try and provide more detailed and higher-value recommendations.
If the only reason the client is looking for a financial plan is to determine whether they can change careers, then an optimal financial plan may not be required. The pros and cons of different contribution strategies may wash out to the point that it's not worth the additional effort and complexity. The more material the difference between decisions the more likely an optimal plan would be worthwhile.
The great news is that Snap can help you create either plan. The software is set up to allow you to quickly create efficient plans that will answer your client's important questions and Snap is flexible and customizable so that you can adjust any plan to optimize for your client's unique goals and circumstances.
Assumptions and calculations that Snap uses to create an efficient projection
Snap Projections is designed to create efficient financial projections easily, quickly, and transparently so that you and your clients have the information needed to make important decisions.
Some of the calculations and assumptions Snap uses to create an efficient financial plan include:
- Withdrawals are automated using a tax-deferral strategy that has been shown through research to help minimize the chance that a client will outlive their money in the majority of client cases. The tax-deferral strategy prioritizes using non-registered and then TFSA withdrawals in addition to registered account minimums in order to reduce future taxes payable on investment returns and defer the taxes payable on registered withdrawals.
- Pension income splitting is turned on by default to help demonstrate the tax efficiencies available through this strategy.
- Common and material tax credits are applied to plans by default. These include the personal amount, age amount, spousal amount, employment amount, and pension amount.
- OAS clawback and marginal tax rates are calculated and displayed to help with discussions.
Snap applies transparent and simple base assumptions to allow you to easily modify the plan for any optimizations that you'd like to apply.
Deciding which type of plan is right for your needs
In most cases, the efficient financial plan created using Snap’s default assumptions is all that's required. However, for some decisions and client situations, you may wish to proceed further and take advantage of Snap's flexibility in order to build an optimal financial plan. To know whether this next step of optimization will be worthwhile you can first ask yourself why you and the client are creating the plan and then you can review whether the efficient financial plan addresses that need.
Common reasons to create a financial plan include:
- To answer one of the 6 most common client questions.
- How long will my money last?
- How much can I spend so I won't run out of money?
- When should I take my government benefits (e.g., OAS, CPP/QPP)?
- Which of my assets should I spend first?
- I'm currently saving $X, is this going to be enough?
- How much can I pass on to my children if I pass away?
- To answer a different client question.
- Can we afford to buy a home?
- Can I afford to change careers?
- How should we use the inheritance we just received?
- To determine a client's investment allocation.
- To provide general peace of mind.
Once you know the purpose of the financial plan, you can decide which assumptions are going to be the most material to answering the client’s questions or providing them with the desired information. Then you can ensure those assumptions are reflected in the plan.
Creating an optimal plan
Once you've reviewed the efficient projection created by Snap automatically, along with your client's goals, you may decide that developing an optimal financial plan is worth the additional analysis.
There are several reasons that Snap doesn't create an optimal plan on its own. There are many qualitative aspects of the client's situation that Snap doesn't capture today (e.g., preferences, family circumstances, health). The number of potential client circumstances makes it difficult to automate calculations and program logic that will be correct 100% of the time. It's often better to apply efficient and simple assumptions and logic and allow professionals to review the plan with the client's circumstances in mind to determine any optimizations that are required in the plan.
To illustrate this, we can use an optimization that many advisors recommend clients do, contributing to a TFSA in retirement from a non-registered account. While this is beneficial in many circumstances and Snap could automate this in the software, there can be unique cases where the client shouldn't take this action. If the client has a large unrealized gain on the non-registered investment account and they have a high taxable income in a year (e.g., due to selling an investment property and purchasing a cottage), then you may not want to realize the capital gain from selling the non-registered investment to contribute to the TFSA in that year. Instead, you could liquidate the non-registered investment the following year and contribute to the TFSA for two years' worth of contribution room at once. Another example would be if the non-registered account is invested in fixed income for retirement spending purposes and the TFSA is invested in a balanced portfolio for longer-term growth. If you contribute non-registered money that you need in the foreseeable future to the TFSA and then the market declines, then the tax savings may be offset by the difference in risk profile between the accounts.
While it's difficult to automate the creation of an optimal plan, Snap is here to help you create them by following three steps:
- Define and prioritize your client's goals.
- Identify strategies most likely to achieve the desired goals.
- Determine when to revisit the plan.
Step 1 - Define and prioritize your client's goals
The first step when creating an optimal plan is to determine what value you're optimizing for. In order to decide which plan is preferred you need a metric or set of metrics to compare the plans across. For example, are you optimizing the:
- Highest expected after-tax spending ability?
- Highest expected after-tax estate value?
- Lowest chance the client runs out of money before passing away?
- Highest chance of meeting the client's short-term liquidity needs?
The best metric(s) to use will depend on your client's goals. For instance, they may have the following prioritized goals:
- Have $50K per year for their non-discretionary (e.g., housing, food) expenses.
- Have an annual travel budget of $20K for the first decade of retirement.
- Leave an estate of $500K for their children.
- Have an annual discretionary budget of $15K.
- Leave $250K for philanthropic purposes.
With these prioritized goals, we can adjust the efficient plan into an optimized financial plan that helps them maximize the likelihood of achieving their goals.
Step 2 - Identify strategies most likely to achieve the desired goals
You can adjust the efficient financial plan to compare different strategies to see which approach is most likely to help the client achieve their goals. You can start with the client's current plan to see whether that is likely to achieve their goals. Then you could compare alternative strategies to see whether you can recommend different actions going forward.
For instance, if the above client had $1MM in liquid investments, the following strategies might be identified as providing the highest likelihood of achieving the prioritized goals:
- Defer CPP until age 70 to increase the inflation-adjusted income for life. This would help them achieve their primary goal of ensuring $50K of annual non-discretionary spending.
- Purchase an annuity that will cover the non-discretionary expenses if either spouse passes away early and the CPP and OAS benefits end.
- Purchase a joint-last-to-die life insurance policy to provide the children with $500K when the last of the couple passes away.
- Invest money needed in the foreseeable future into fixed-income investments.
- Invest excess money (for discretionary expenses in future decades and for the aspirational philanthropic estate goal) into a blend of equity and fixed-income investments.
- Withdraw registered money up to the available non-refundable credit amounts (e.g., personal amount, age amount) and then use non-registered money to meet annual spending needs and contribute to the TFSA, until the non-registered money is depleted.
With these strategies identified, you can update the plan to best reflect them. You can:
- Defer the CPP Start Age to 70 under Scenario Setup -> Gov't Benefits.
- Add the annuity as a Defined Benefit Pension Plan under Scenario Setup -> Income.
- Add the life insurance policy under Scenario Setup -> Insurance -> Insurance Policies.
- Set up different Capital Assets with the desired balance, asset allocation, and return assumptions. Then on the Planning Page, you can override the Contribution/Withdrawal column to use specific money in your desired years.
- Snap will default to use registered money when available for withdrawal in a year tax-free. Then it will use non-registered money, then the TFSA, and then registered money again if no other assets are available. You have the ability to change this withdrawal order logic (CFM Order) in any given year or period in the plan.
You can then compare your new scenario with alternate strategies to determine the optimal path forward for your client.
For more financial planning considerations please refer to our Plan Review Checklist.
Step 3 - Determine when to revisit the plan
Financial plans can help answer questions and provide direction for clients to begin taking action today. In the example above, the client may need to purchase an annuity and life insurance policy. They may also need to adjust their investments to align with the optimized plan. Over time, the plan will need to be updated with new information and reflect any changes in the client's goals. The following may trigger a need to update the plan:
- Changes to your client's financial circumstances.
- Asset growth above or below the projected returns in the plan.
- Unexpected cash flows (inheritance, medical emergency).
- Changes to your client's priorities.
To ensure these are being caught, you can ask your client to notify you of any material changes over time, and also go through questions in your quarterly or annual client meetings to see when you need to update the financial plan.
Challenges of creating an optimal financial plan
Creating an optimal financial plan is quite challenging. You will often arrive at a point where additional analysis is unlikely to result in a better outcome for the client because it can be difficult for your client to identify and rank all of their priorities and there are many assumptions required.
The difficulty of gathering your client's goals and their relative priorities:
If the clients above had taken CPP at 65, not purchased the annuity and life insurance, and simply invested all of their money into fixed-income and equity investments, they may have been able to achieve all of their goals. Or, they could guarantee the two most important goals and reduce their likelihood of achieving the other goals. It can be difficult to gauge the relative priority and flexibility that clients have when it comes to their goals. This can then make it challenging to choose the best plan to recommend.
The difficulty of handling unknown variables:
There are many assumptions required in a financial plan. In some cases, a change of 0.1% to the client's investment returns can have a larger impact on their financial plan than the optimizations of withdrawing from the RRSP first or the corporation. Some of the assumptions that go into each financial plan include:
- Financial market conditions (e.g., inflation, rates of return).
- Health and life expectancy.
- Changes to tax rules (e.g., credits, brackets, registered accounts) and government benefits (e.g., OAS, GIS).
Snap was designed to give you the best of both worlds:
- the ability to create a valuable, efficient plan in a short period of time to quickly answer your client’s top questions using well-defined default assumptions that make sense for most client situations.
- the ability to further optimize that plan in order to meet specific goals that your client may have by taking advantage of Snap’s flexibility and customizability.
You don’t need to optimize all aspects of the plan, you can choose to optimize just the most material components for your client. Balance the time spent on optimization with the benefits those customizations will provide.
Snap has steadily provided increased automation with past product releases and we are focused on continuing to add automated tools to help you more easily and quickly adjust your efficient base plans into more optimal scenarios.