Contributed by Nathan Gehring
I’ve been writing on this blog for a couple months about some of the similarities and differences between conventional financial planning and cross-border planning (I’ve linked to the first pieces at the end.) I want to continue this exploration by discussing a particular assumption that cross-border planners have to make which rarely, if ever, comes into play for the conventional financial planner: assumptions about currency exchange rates.
The entire concept of financial planning is based on assumptions. Virtually every projection a financial planner, whether conventional or cross-border, prepares and almost every bit of analysis delivered and recommendation made is based on a variety of assumptions. These assumptions cover a litany of areas: rate of inflation, expected returns on investments, employment and other income expectations, future tax rates, life expectancy, and on and on. The assumptions we make can be relevant for a short period of weeks and months to very long periods: years and decades.
There are a variety of ways financial planners go about establishing reasonable assumptions. Often historical averages are used for items such as inflation rates and investment returns. Some planners choose to make assumptions based on personal research and opinion and future expectations. Assumptions specific to a client, such as future employment income or retirement date, are often directed by the client’s expectations.
The goal for assumptions used in a plan is not to perfectly represent the future –they won’t–, but to be directionally meaningful. The assumptions should be reasonable and prudent and good enough to allow us to help clients make well-reasoned and informed decisions. (Of course, we’d love to have perfect assumptions; it’s just not possible to do so.)
Exchange Rate Assumptions
In cross-border planning, we often have to deal with an important assumption conventional planners don’t generally consider: currency exchange rate assumptions. Cross-border clients often have assets which are held in the currency of their home country, but will have to be converted to the currency of the country they wish to retire in or move to. As cross-border planners, we have to make an assumption about what the currency exchange rate will be when the assets are moved to the new country.
Sometimes this assumption will only be needed for a short period in the planning work for a client, if that client plans to move all assets over the border at one specified period of time. Other times, the assumption needs to be meaningful for years or even the lifetime of a client if they will move assets slowly or if they continue to receive an income stream in the original country’s currency.
A Kinda Nasty Assumption
The currency exchange assumption is a bit of a nasty one. The assumption plays in a plan in conflicting ways. For example, selecting an assumption where the original currency is weaker can lead to both “conservative” and “non-conservative” results. If the original currency has weakened, the client’s assets once across the border will be projected to be lower. This results in fewer assets available for cash flow and retirement funding…a conservative position to take. However, a lower asset base also can be viewed as non-conservative as it leads to a potential understatement of income tax, a reduction in potential estate tax exposure and potentially inaccurate projections of exit/entrance related issues for a client. Turn the assumption around, making the new currency weaker, and the entire conservative/non-conservative issue is flipped on its head.
The assumption is further complicated because exchange rates can be very volatile. They are influenced greatly by governmental actions, economic conditions of both countries involved and, sometimes, heavily influenced by currency speculators.
Making The Assumption
Despite these complexities, cross-border planners must make currency exchange rate assumptions in one manner or another to help clients make decisions. Historical averages could be used to reach an assumption. The assumption could be based on the planner’s (or client’s) expectations about what the exchange rate will look like in the foreseeable future.
As KeatsConnelly, our exchange rate assumption is designed to do one thing, be directionally accurate to help our clients make good decisions. We do not try to predict the direction of exchange rates in the short, medium or long-term. Ultimately, the assumption will prove wrong at some point, but it needs to be prudently arrived at and good enough so that decisions made won’t be dramatically impacted.
Fortunately, financial planning is a living process. We don’t put together recommendations and ask our clients to follow these recommendations blindly into the future. Projections and recommendations are continuously updated as the real world dictates they need to be. If our exchange rate assumption turns out to be meaningful different than reality, analyses would be updated to reflect this change and to make any necessary course corrections.
Previous Cross-Border Planning Posts: