The Portfolio Doctor

By David Cruise and Alison Griffiths
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Mail from readers is one of the bonuses we get for writing this column, though sometimes those letters aren't entirely positive.

On November 19th we examined the financial ramifications of a teaching stint in Bahrain for a 50-year-old couple, the Highburys. Shortly after the article appeared a gentleman wrote criticizing the financial projections used in the article.

He had two areas of concern. The article stated that if the couple were able to save $60,000 annually (their estimates), they would have approximately $850,000 at the end of 10 years. This figure assumed an average return of 7.5 per cent annually.

The gentleman, we'll call him the Mathematician, as he doesn't wish to be identified or quoted, says our projection is wrong. He maintained that they would have $850,000 dollars at the end of nine years and $912,000 at the end of ten years - a $62,000 difference.

The second area of dispute was the impact of withdrawing $55,000 annually to live on after returning to Canada. Our doctor of the week, Michael Hill of DeThomas Financial in Windsor, calculated their money would last "at least" 15 years.

The Mathematician asserted that with a 7.5 per cent return, the Highburys would actually have $1,000,000 left at the end of 15 years.

Oddly, though we're talking about numbers, the results of these calculations have as much to do with philosophy as with arithmetic and make for an interesting discussion about the impact of assumptions on numbers.

"First, let us remember that this is a simplistic calculation for illustrative purposes. The more information you have the better, more informed, projection you can make," says Hill.

The first figure ($850,000), is the future value of an annuity stream but with two different assumptions of the period of calculation. Because we didn't know when they would be paid, and neither did they, we chose the conservative assumption that they would be paid at the end of the period. The other calculation is based on the assumption that they would be paid the $60,000 before they actually started work."

As far as pure numbers are concerned, the Mathematician is perfectly correct, However other factors need to be taken into account for financial planning.

We believe in taking a conservative approach to calculations, and so does Michael Hill. As a result, we assumed the Highburys savings of $60,000 would be paid at the end of each year, rather than at the beginning. Neither choice is likely to be 100 per cent reflective of reality, but using the end of the year avoids an overly rosy projection. As a result, our projection was $62,000 lower than the Mathematician's.

Let's just say we assumed that the Highburys were saving their $60,000 in $5,000 a month chunks over the ten years. In that case, they would have $889,651 at the end of the period, $39,651 more than our initial projection.

Perhaps this would have been a more reasonable assumption. However, we know of some overseas situations where a portion is paid monthly with bonuses at the end of the year, or even at the end of the contract. Often the bonuses grow larger the longer a person stays in the job.

Many readers wrote to point out various other combinations and permutations in the way that teachers and other workers are paid for overseas contracts. It all reinforces our belief that the conservative assumption is best under the circumstances.

The second point raised by the Mathematician is similar to the first but a little more complicated.

As with the previous example, his number crunching is correct. "If everything goes right," Michael Hill agrees, "the Highburys certainly will have a million dollars left after 15 years. But in my experience nothing ever goes right for 15 years."

Life isn't linear and for the purposes of financial planning many possibilities must be factored into projections.

Michel Hill's assumptions and calculations were based on his many years of experience and generally accepted concepts in the business. They took into account inflation, the uneven return of the stock market, unexpected withdrawals and the standard financial planning practice of turning a year or two of retirement income into cash before withdrawals start.

"That ensures you have cash on hand and helps you avoid being forced to sell equities into a bad market," he notes. "However, it does reduce your return. If you set aside $55,000 of the $850,000 at the beginning of the first year, it will reduce the return of that portion of the portfolio to 3.5 per cent."

Every little financial planning nip and tuck cuts down on how long the money will last. After ten years in Bahrain, the Highburys would likely have significant expenditures to outfit themselves when they return -- cars, housing and insurance, for example. Those necessities of life could easily take $100,000 or more right off the top of their $850,000, which obviously has a dramatic impact on how long their money will last.

As well, Michael Hill has factored in the strong tendency of people to become more conservative investors as they age, particularly when they are actually into retirement years.

If mathematics were the only issue the $850,000 would certainly last much longer than 15 years but, taking life into account the cautious, even pessimistic, projection seems preferable.

The moral of the story is this. The next time some one gives you a financial projection, ask what assumptions went into the calculations. A change in assumptions can transform a projection, be it retirement, a prospective investment or savings from working in Bahrain, from a viable enterprise into a disaster waiting to happen.