Guest Spot: Optimising probability in retirement planning

optimising-probability-in-retirement-planning
  • Author : Just
  • Date : 12 Jan 2021

Delivering a reliable income stream from a diversified portfolio over an unknown period of time has, rightly, been described by William Sharpe as “the nastiest, hardest problem in finance” and he should know. He created the “Sharpe Ratio” which looks to identify the performance of an investment against a risk-free asset, after adjusting it for risk as measured by standard deviation… rocket science in other words!

And it’s a type of lower level rocket science, statistical analysis, that is at the heart of how advisers can try and deal with this nasty problem and give their clients greater confidence that their retirement plans will ultimately succeed. This is the basis for the Probability-driven advice approach, pioneered back in the 1990’s by one time engineer and US financial planner Bill Bengen. To properly understand Bill’s groundbreaking research, we need to be clear on what question he was trying to answer on behalf of his clients and for which types of clients. As far as the question, it was something along these lines…

“If I want to hold on to my accumulated portfolio and use it to sustain my lifestyle during retirement, how much can I withdraw without running out of money before I die?”

So in other words, Bill Bengen was looking to establish the cost of self-annuitisation for clients who would rather put their trust in the investment markets than pay a lump sum of capital to an insurance company in return for a guaranteed income for life.

This approach is referred to as Probability-driven, because at its heart you are trying to identify a probability or likelihood of a plan working, based on the stochastic modelling of an investment portfolio against a number of variables; the greater the probability of success the more likely it is that the plan will work and the less likely it is to fail, bearing in mind that a failed retirement plan is pretty likely to end up in some form of complaint. So you want to avoid failures!

All good so far?…

There are however, two aspects to this approach of self-insuring your longevity throughout your retirement that have a cost when it comes to accessing a good level of income in the earlier years of retirement, when you are probably most likely to want to enjoy it:

  1.  The retirement time horizon that needs to be modelled has to be sufficiently lengthy to ensure the funds outlive the client and avoid plan failure. This can lead to having to model retirement periods of 30 years plus
  2.  You have to plan for a poor investment experience to ensure a high likelihood of success. This will normally mean you’re working on the worse 5%-10% of potential outcomes, although even at this level it would suggest you’re happy as an adviser for 5% – 10% of your clients retirement plans to fail, with all the reputational impacts this would have down the line.

So it can be argued that the Probability-driven advice approach could deliver sub-optimal outcomes when it comes to the sustainability of a given level of income, especially when a retiree is looking to take a higher amount in the earlier stages of their retirement.

There are however, a couple of things you could consider doing if the above sounds unpalatable. You could avoid all this malarkey around statistical analysis altogether and just ‘hope for the best’… turning probability into possibility, but I hope you’ll agree that’s not a wise planning strategy. Alternatively, you could consider how the inclusion of guaranteed income for life provided by Secure Lifetime Income into a client’s retirement portfolio can increase the starting level of sustainable income due to the valuable addition of mortality credits, compared to holding a similar amount of fixed income within that portfolio. Just take a look at Secure Lifetime Income available within the Novia platform SIPP, to find out more.

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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