Garbage In; Garbage Out

Garbage In; Garbage Out

                                               James Tissot, CFP®

 

As the CFP Board contemplates the inclusion of a completed financial plan as a prerequisite for CFP® Certification, the discussion has begun as to whether the plan should be completed using spreadsheets, financial planning software or both. All three choices have their merits and advocates. This article thankfully does not explore the virtues of the different options. Instead, it focuses on some common errors made when inputting data into planning software. Some planners (especially those relatively new to the profession) can make crucial errors by relying too heavily on the default settings of their software: as the old saying goes; “Garbage in - garbage out.”

Probably one of the areas most prone to error by accepting the default settings are the income tax assumptions. Most software packages to a good job at the federal level as long as we stay within the classic tax brackets, provided your software is updates at least annually to reflect new tax law. We start to run into problems though when we get into state and local tax rates. Many companies have a decent take on the state level, but some don’t and very few will include local rates. This is when the planner has to do some leg work on her/his own.

We especially have run into when a couple is unmarried; whether it be same sex or unmarried heterosexual couples, which are increasingly more common in a planner’s practice. In order to do this, one must find out what percentage each individual is contributing. Then you find out each individual’s tax bracket and use a weighted average. It is even more complicated when it is a married same-sex couple. The federal government does not recognize the marriage and they can not file MFJ. However to arrive at the proper rate, a “dummy” federal return is prepared MFJ. These figures then flow onto the state return which is filed MFJ. We then revert to the weighted average for the actual federal rate. 

You may also want to think about the long term capital gains rate. It hasn’t always been 15% and there is no guarantee that it will remain so. If you use a conservative approach, you may want to consider a rate of 20%. You also have to make an estimate of what percentage of assets will be taxed at the long term capita; gains rate and what percentage will be at the marginal rate.

Inflation can be an ugly thing and even uglier if not properly taken into consideration in a plan. Some software comes with preset defaults and others leave it blank. In whichever case, don’t just use the current inflation. Even though inflation has been moderate in the past few years and is barely visible right now; things can change quickly. Just look at the Dow. It is best to go back at least 20 years and get an average inflation rate. I personally, go back 30.

It is also important that you check what numbers you are adjusting for inflation. It is fine if you use it against Social Security payments (if you are including them at all) but are you using it against pension payments and annuities. Some payments remain flat during retirement. You can throw your projections way off by such assumptions.

How have your clients’ portfolio returns been lately? It is one thing to reduce the balances in their 401(k) s, but what do your historical returns look like. This recent downturn has actually affected the historical returns for many asset classes. You should make sure yours are current and adjust accordingly. In addition, you may want to check that the asset classifications you are using. Is that large cap growth stock still growth or has it gone over to the value side? Many mutual funds change managers and with those changes come different approaches and fund focus.

Are you a fee based or fee only planner? Most software programs take mutual fund fees (hopefully; you better check) into consideration, but what about your fee? Do you charge 1%? Are you reducing your client’s projected returns by 1% to reflect your fees? In high flying times, 1% may not seem like much. But, we’re not in high flying times and a 1% error can dramatically skew your results. Depending on the number of years of pre-retirement savings, number of years in retirement, retirement income and projected returns; 1% can mean the difference of anywhere between 3 and 10 years before retirement resources are exhausted. A difference that easily can be the difference between success and failure of a plan.

Financial planning software can be a valuable tool for a planner. But without thorough understanding of the numbers that you are being entered and how the software interprets them, they are more a hazard to a client than an aid to the planner.