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Good Financial Planning relies on making reasonable assumptions about a variety of things. Getting these assumptions as ‘right’ as you are able can make the difference between a positive or negative result at the end of your Financial Plan.

If you are too optimistic with your assumptions, it is likely your Financial Planning will fall short of your targets. Make pessimistic assumptions and your Financial Planning could be unaffordable.

Because each assumption can have a big impact on the outcome of your Financial Planning, it is important to understand which assumptions to make and also how to make them.

Here are six Financial Planning assumptions you need to make and how you might make them.

1 – Your life expectancy

The likely date of your death will drive many elements of your Financial Plan. Understanding for how long you are likely to live helps you understand how much capital you will need to ensure you do not run out of money in your lifetime.

Life expectancy is the number of years you have left to live at a particular age. Average life expectancy varies between different countries, with the current world average estimated to be 67 years old.

Women typically live for longer than men. In the UK, the average life expectancy at birth is 76.5 years for men and 81.6 years for women.

The problem with looking at average life expectancy is that we tend not to be average. For this reason, whilst understanding your likely life expectancy is important for Financial Planning, a better number to use is 99 years old.

By picking an unlikely but possible age for your life expectancy you reduce the risk of running out of money too soon. This is a better outcome than living longer than planned and running out of cash in later life.

2 – Future price inflation

Goods and services typically become more expensive over time. We are all used to prices going up, although because these price rises tend to be quite gradual it can be easy to dismiss the relevance of price inflation for our Financial Planning.

The issue with price inflation is the compound nature of inflation over long terms. In the same way that compounding helps multiply returns from savings or investments, it also makes inflation incredibly damaging to your Financial Planning, unless you factor it in to your plans.

As a simple example, imagine you are 30 years old today and plan to retire in 35 years time at age 65. If you want an income in retirement equivalent to £25,000 in today’s money, inflation at 2.5% a year between now and age 65 means you need £59,330 of income to have the same purchasing power. That is the impact of inflation.

Of course inflation does not end when you retire. In fact, price inflation is typically higher for older people as a result of the types of goods and services they tend to consume.

We might be in a temporary period of negative price inflation (as measured by the Retail Prices Index – RPI) right now, but positive price inflation will emerge again. Start planning for it now by thinking about the real cost of living in the future.

3 – Interest rates

Understanding the rate of interest you can get on cash savings often forms a cornerstone of your Financial Planning. This is your ‘risk free’ return; the return you can get on your money without exposing capital to risk.

With the Bank Rate currently running at the historic low of 0.5%, it would be easy to dismiss cash savings as a sensible home for your money. It is important to always use cash as a starting point for your Financial Planning, and only consider taking investment risk if your financial objectives require a higher level of return (and you are prepared to tolerate the risk/volatility).

Interest rate assumptions also have a direct impact on the cost of servicing debts. Making reasonable assumptions about rates of interest in the future enable you to make important decisions about prioritising the repayment of debt over other financial objectives, such as investing for the future.

4 – Annuity rates at retirement

When you reach your selected retirement age, one way in which you can convert your pension fund into an income is to purchase an annuity. These financial instruments simply convert capital to income. They come in a variety of shapes, but can be a good starting point for understanding the income value of your accumulated pension fund.

Annuity rates vary depending on a number of factors including life expectancy, interest rates and gilt yields. They will also vary depending on the options you select, such as a benefit for your spouse or ‘indexation’ to reduce the impact of future price inflation.

A good plan to start when making assumptions about future annuity rates is the best rate you could obtain today, assuming you were at your selected retirement age. You should then keep this under regular review on at least an annual basis. It will change.

5 – Earnings inflation

Because the cost of living goes up (as measured by price inflation) we would usually expect earnings to go up over time as well. The preferred measure for this is the Average Earnings Index (AEI). This is published by the Office for National Statistics and is the key indicator of how fast earnings, or pay, are growing in Great Britain.

For the year to June 2009, AEI (including bonuses) rose by 2.5%, up from 2.3% in the year to May 2009. Over the long term we would usually expect to see AEI increase at a faster pace than the Consumer Price Index (CPI); the preferred measure of price inflation. For this reason you should link your price inflation and earnings inflation assumptions.

6 – Investment returns

Another important assumption for your Financial Planning is the return you are likely to get from your investments. This is another long-term assumption; unless you have a crystal ball you will not be able to accurately or consistently predict the investment return from a given market in a certain year.

We know that historically equities (company shares) have outperformed cash by a wide margin. Rather than selecting a single assumption for investments in general, you should make an assumption for each of the main investment asset classes – fixed interest securities, property and equities.

Based on these assumptions you can then work out an overall investment return assumption for the level of risk you are prepared to take with your money.

A final point

Because these assumptions can have such a big impact on your future financial well being, it is essential to keep them under regular review. Consider the assumptions you have made at the annual review of your Financial Plan to ensure they remain reasonable over the long-term based on current economic and investment market conditions.

If you keep your assumptions under regular review, and then adjust your Financial Plan accordingly when those assumptions change, you can keep your Financial Plan on track.

Martin Bamford is site editor of BrilliantWithMoney and a Chartered Financial Planner at Informed Choice.