(November 5, 2003) As boomers retire and live longer, while inheriting substantial amounts from their cautious Depression-era parents, financial planning stands poised as the 21st-century profession. But some of its basic tools remained rooted in the 1980s, says Dave Faulkner, an advisor who moved into financial software development before his firm was bought by CCH Canadian Ltd., where he now works.

Current financial software that planners rely on to project savings thresholds and rates of return for clients to achieve their retirement wishes is little different from pencil-and-paper replacements developed two decades ago, he told an audience this week at the fall education summit of the Independent Financial Brokers of Canada (IFB).

That creates a disjunction that ill-serves advisors. “Most of the software available to you as advisors does it much the same way we did it in 1980,” Faulkner says. “Twentieth century methods will not work for your clients in the 21st century.” The most important reason is its tax assumptions.

Though financial planning involves a panoply of components that must be integrated into a whole, from a client’s financial capacity to their expected retirement age and life expectancy through to their sources of income, what advisors seem to concentrate on is modelling investment returns and inflation rates. “We put a lot of effort into investment returns when we have no control over it,” Faulkner says. The same holds true for inflation. The one thing advisors actually have control over, when plotting a financial plan, is taxes.

All the same, “the one thing computers can do for us, we ignore,” Faulkner says. Instead, financial planning software generally includes a built-in assumption, that investment returns are taxed at 40%. That may not be true, depending on the income of the client, both now, and in retirement. And yet, tax seeps through every aspect of financial planning. “I don’t think there’s anything we do where tax doesn’t play a part,” Faulkner declares.

The basic problem is that financial planning software often assumes a marginal tax rate, or an average tax rate. Neither fully reflects the real-life circumstances of clients.

How problematic that can be, Faulkner explains, is illustrated by the fact that there are eight different marginal tax rates in Ontario, but only four federal marginal tax rates. The complicating factor, as experienced advisors know, is that no one pays the top marginal rate. Each bracket exacts a levy, and they average out to rates that are lower than the marginal rate tax crusaders often inveigh against.

The problem with using average tax rates is that investors can and do shift from bracket to bracket, especially given the fine granularity of the $60,000+ earners. There, tax rates turn on a dime (actually, on a few hundred dollars).

In addition, financial software often omits other tax costs, such as the OAS clawback and federal age credit. Beyond that, there are current taxes the software may miss, including compulsory unemployment and CPP contributions.

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    • All these factor into how much the client can potentially invest now, and how long their investments will last into retirement. Says Faulkner, “If you’re ignoring employment insurance and CPP, you’re overestimating liquidity,” or the total income a client has from which to make retirement contributions. Use the top marginal rate for projections, then the financial calculator underestimates the investment buildup, which is based on average, not marginal tax rates, and overestimates how much is taxed in retirement, again, thanks to marginal rates.

    At the same time, average tax rates can be hard to program, particularly when it comes to a couple with widely differing income sources. In retirement, one could fall into one tax bracket, while the other partner, even with investment income, may have no tax to pay at all.

    For the most accurate financial planning software, Faulkner recommends using the same tax calculations that are embedded in CCRA’s T1 General form, the basic tax form every taxable Canadian has to fill out once a year. “The best part of the T1 General is that you don’t have to make any assumptions,” Faulkner argues. “I think it’s the best method,” but few software programs incorporate it. A progressive tax schedule will work just as well, he says. However, that’s still a pencil-and-paper calculation redolent of the 1980s that financial planning software was supposed to resolve.

    If advisors aren’t using true tax figures, they are falling down on their own code of ethics, Faulkner argues, not only by not giving the best advice, but also by not using methods that meet the highest standards.

    He also warns against free software received from suppliers. While they might be appropriate to present an insurance or investment concept, advisors put themselves at risk when it comes to a planning engagement if they don’t disclose that, first, they’ve used software supplied by a manufacturer whose products they sell, with all its assumptions on taxes and rates of return, and second they’ve used software that fails to incorporate all the criteria considered relevant by the advisor’s own association, be it the IFB or the Financial Planning Standards Council.

    “The tools you use determine the advice your give,” says Faulkner. “Overestimating tax doesn’t make it better or right.”

    What do you think of financial planning software and how should it be improved? Share your thoughts and opinions about the various financial planning software available in the Talvest Town Hall on Advisor.ca.

    Filed by Scot Blythe, Advisor.ca, sblythe@advisor.ca

    (11/05/03)