Guest Spot: Exploding retirement income myths #4

explode 4
  • Author : Just
  • Date : 30 Jun 2021

For adviser use only.

Myth #4: ‘My straight line cashflow plans prove my clients are better off with drawdown’

Imagine it’s around 500 BC and your best mate happens to be Pythagoras. Beside himself with excitement, he explains to you that by looking at the sky at night, he’s discovered that the earth is… well, it’s not flat!

Over the coming weeks Pythagoras takes you through all the clever mathematical stuff to prove his hypothesis and talks of his need to share this remarkable discovery, but you’re worried that the average Greek citizen isn’t ready for this level of statistical science so your advice to him is…. “look Pyth, I know you’re right… and you know you’re right, but just keep telling people the world is flat… trust me, it’ll be easier in the end and it won’t do anybody any harm.”

Back in the present day, many commentators say it’s commonplace for some financial professionals, whose role is to understand the volatility and overall unpredictability of capital markets, to show retiring clients colourful graphs of their retirement. These can be based on the financial equivalent of the flat earth myth, which is that their investment portfolio will grow by the same amount year in, year out, even when they as financial professionals know that isn’t how things work in practice.

The normal explanation cited by observers for this preference for fiction in the planning process rather than fact, is that the average person struggles to understand the output from the more sophisticated ‘real world’ stochastic forecasting compared with the simplistic but artificial world of deterministic modelling. That may be a fair statement, but the question then becomes, could this practice of suggesting the creation of retirement income is simpler and more predictable than it really is, lead to poor decision making and potential customer detriment?

The majority of the factors that will determine the success or otherwise of a retirees hopes and expectations for their later years can be seen as ‘known unknowns’ at the start of their journey… we know things like how long they live for, what happens to investment markets, inflation and their health will all be important factors, but we don’t know the outcome of any of them in advance. It is the variability of all of these factors that makes the retirement income conundrum stochastic in nature. It also supports why many professional commentators are voicing concerns over the continuing use of the overly simplistic straight-line, deterministic cashflow modelling.

The next obvious question at this point is just how different can the picture of a clients’ retirement journey look when using these two different modelling approaches?

Let’s consider the graph below. For consistency with previous articles we’ve authored, we’re using the same hypothetical fit and healthy 65 year old client, who we’ve already established could get an income rate of 4.78% pa from Secure Lifetime Income within the Novia SIPP. What we want to do is compare this with taking the same level of income via drawdown, using a 60/40 mature equity/investment grade bond portfolio with a total cost of 1.75% pa including advice fees.

For the simple deterministic model we’ve assumed a gross annual portfolio return of 5% and to try and reflect a little of the real world uncertainty, we’ve added a -20% market correction in year five of our 35 year plan.

This chart shows the steadily reducing portfolio value as a result of drawing £5,000 pa from an initial portfolio of just over £100k. It suggests that at age 100 there will still be approximately £10k remaining in the portfolio, therefore giving the impression to a typical lay person that this retirement plan will work.

However, when you model the same income requirements from the same portfolio stochastically, by creating 1,000 random simulations, the plan would only succeed in 44% of outcomes, meaning there is a greater than 50/50 chance that the portfolio will actually be depleted before the end of the plan or the retiree will need to reduce their income at times to avoid this.

So, one approach suggests the plan works and in the other, that it’s statistically more likely to fail than succeed! The former may be easier to understand, but is simplistic.  The latter more accurately reflects the nature of the challenge but requires a bit more explanation. The former is more likely to lead to a poorly informed decision where the latter may lead to discussions around how the likelihood of success could be increased by considering things like the blending of solutions.

To finish, many advisers will cite the fact that deterministic calculations underpin the current KFI regime, so they must be OK. KFIs arguably serve a very different purpose in the advice process than a cashflow forecast. KFIs help advisers compare and select the appropriate provider based on all data being known and certain (product costs and charges etc) whereas cashflow modelling should help to inform the appropriateness or otherwise of the solution itself, in other words, the advice and as we’ve seen, the retirement income conundrum is stochastic in nature.

The FCA’s addressing suitability II will surely see an end to flat earth techniques. If you’d like to find out more about Secure Lifetime Income within the Novia SIPP please get in touch with your usual Novia contact.


The statements and opinions expressed in the Guest Spot are those of the author and do not necessarily reflect those of Novia Financial plc or any of its employees. The company does not take any responsibility for the views of the author. Any links, web pages and documentation within the Guest Spot are provided by pages maintained by independent third parties and Novia accepts no responsibility for the availability, content or use of the information contained within them.

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