A financial plan, as with every other planning and analysis document, requires the use of assumptions. In contrast to facts, assumptions are uncertain and can change over time. Real life events can significantly change planning assumptions; which in-turn can have a large impact on the implementation of a financial plan and your way of life.
Choosing the wrong assumptions can lead to a financial plan that is unattainable, thus not meeting your goals and expectations. There are a variety of methods that can be used to determine the best assumption to use in your financial plan, however I suggest using historical data or commonly accepted rules of thumb.
Inflation Rate Assumptions
Overtime the cost of goods sold within an economy will change due to the forces of supply and demand. More often than not prices rise, at least in a healthy economy. The rise of prices overtime is the effect of inflation.
Inflation will eventually affect both your income and expenses. Historically many economists, financial planners and analysts assumed an annual inflation rate of 3% for use in a simple model. This assumption was based on historical data and government economic policies.
Complex financial plans include a few different inflation assumptions to cover the changes of prices in different sectors in the economy. In example, healthcare and education costs usually rise faster than the general economy at an average of 5% annually.
Investment Rates of Return
In a financial plan, the accomplishment of your future goals and objectives is highly contingent on the growth of your portfolio. To estimate the growth of your investments overtime you will need to estimate a rate of return.
Rates of return vary significantly among investment vehicles. This is due to the varying levels of risk associated with each type of investment. Investments with higher risk demand a higher reward and the inverse is true with investments with lower risks.
The assumed rates of returns for various stock investments should be derived from historical prices. It was once assumed that the entire stock market would return approximately 10% a year, however recently this figure has been lowered. In my analyses I like to use an average annual rate of return of 6-8%.
More often than not, projected bond rates can be calculated using historical prices, however you can also choose to use current rates in your financial plan. When looking for a quick assumption for bond yields, you can choose to incorporate 2-6% into your financial plan.
Please keep in mind that the assumptions mentioned here are extremely rough and are meant to be used as a rule of thumb. Assumptions differ from facts, as they can change rapidly. Every financial situation is different, thus the assumptions in your plan should be tailored to your specific situation.