This article documents the general modeling assumptions I use and some related definitions. Think of it as default settings. Sometimes there are good reasons to deviate from these defaults (e.g. to stress test a projection) but unless otherwise stated I will use the assumptions and definitions documented here.
Inflation Rate, Rate of Return and Borrowing Rate
There are several key percentage rates that underpin any personal financial modeling.
- Inflation Rate – Anytime we are talking about money in the future, we have to take into account inflation. Inflation reduces the purchasing power of our money over time because it causes goods and services to cost more. This also means when talking about dollar values in the future, we have to be careful to distinguish between nominal and real values. Inflation also effectively “takes away” from other rates so we can extend the idea of nominal and real values to rates as well.
- Nominal – a dollar value or rate that is not adjusted for inflation
- Real – a dollar value or rate that is adjusted for inflation
- Rate of Return – Any investment asset has a rate of return. This rate represents the change of value in the asset over time. Normally we want this rate of return to be positive, but it can just as easily be negative or zero if the investment isn’t doing well. Rate of returns are expected to be different across assets classes (e.g. bonds, domestic stocks, foreign stocks, housing, etc.)
- Borrowing Rate – This is simply the interest rate you pay to borrow money. That actual interest rate on a liability is typically well known but might be fixed or variable. When modeling we sometimes need to pick a default rate to use that is representative of the expected rate over the loan’s lifetime.
In general, I will use the FP Canada Projection Assumption Guidelines (PAG) for these rates.
FP Canada has experts that do this stuff. Why re-invent the wheel? And FP Canada is the gold standard for financial planning certification in Canada. If you’re working with an advice-only financial planner they are likely using these same assumptions.
Actuarial Stuff
How do insurance companies figure out rates for life insurance and annuities? How do pensions figure out if they are properly funded? That’s what actuarial science is for.
For everyday personal finance modeling, the main assumption we need from this world is how long will you live?
Another fun phrase in the personal finance world is that your planner could make the perfect financial plan if they only knew when you would die. Because we don’t know that, we have to make some assumptions based on actuarial tables.
The FP Canada PAG comes to our rescue again. It has Probability of Survival Table that gives us an expected age of death cross-referenced by your current age and probability. It’s a lot of data, but to keep it simple I generally assume living until 98 years of age. That feels pretty conservative and lands smack in the middle of the expected age for the 25th percentile and good enough for most of the projections we’re doing.
Income
If you’re doing personal finance analysis for yourself, you can of course use your own income in any modeling or projections.
However, for the purposes of examples on this site we can’t use that. Nor should we use my income. Fortunately if we want to make some assumptions about income levels in Canada, then Statistics Canada has us covered. In general any assumptions around income levels will be based on the data available from Statistics Canada.
We may also need to make assumptions about how someone’s income will grow over time. Fortunately, the FP Canada PAG also has a recommend assumption for this wage growth rate.
Taxes and other Government Numbers
When it comes to tax rates, the general assumption is that the tax system stays the same and the current tax brackets are indexed to inflation. Sure the tax system may go through some drastic changes, but your guess is as good as mine as to what those changes may be. So for modeling purposes we assume no such drastic changes.
For retirement projection purposes, it is very important to have as accurate an estimate of things like CPP and OAS that we can get. Both have payments that are indexed to inflation, and we’ve got our inflation rate assumptions provided by FP Canada (see above). CPP is a little trickier in that the Yearly Maximum Pensionable Earnings (YMPE) increases at the rate of annual wage growth, as measured by the Canadian government. We’ve already established a wage growth rate borrowed from the PAG (see above under Income), so we use that for YMPE growth projections.