The use of over-simplistic deterministic projections renders most cashflow models fundamentally flawed and dangerous, Bruce Moss warns
Cashflow modelling tools that use deterministic or over-simplistic stochastic projections are fundamentally flawed because they are unable to consider ongoing variables that will affect the plan over time.
Now more than ever, with increased market volatility and other economic uncertainties, the limitations of deterministic and some stochastic models need to be fully understood to avoid potential catastrophic harm to retirees' future plans and lifestyle.
Deterministic tools overestimate sustainable income because they are unable to take into account market volatility, which causes ‘pound cost ravaging' and sequencing risk, both of which have a significant negative effect on sustainable income.
Any retirement planning tool that is unable to model the effect of market downturns in the early years of income withdrawal is simply unsuitable. At risk of stating the obvious, if the technology you use systematically understates risk and overstates outcomes, then it's not an adequate planning tool.
Managing drawdown effectively and choosing suitable investment strategies requires the ability to model investment risk and return realistically.
The problem is that nearly all strategies and solutions are currently designed using an assumed fixed rate of investment return throughout retirement. This is obviously unrealistic and ignores the important effect that the sequence of returns and volatility has on drawdown outcomes.
The problem applies not only with deterministic modelers but also with a commonly used type of stochastic model - mean, variance, co-variance (MVC) models. Essentially, MVC models provide time-independent forecasts, which means that they ignore the sequencing risk.
What is needed is a model which forecasts a wide range of realistic potential future investment scenarios, which develop year by year and allow for the possibility of high volatility and a sequence of bad returns in the early years both of which are major threats to the success of a drawdown plan. Allowing for these real world effects when modelling drawdown outcomes is essential and only economic scenario generator (ESG) models, which reproduce real life characteristics of assets, do this.
Although an ESG model is built by looking at historical data to determine the characteristics of different investment classes and their correlations, using historic performance does not provide enough independent scenarios, is highly dependent on the periods selected, and, as the FCA keeps reminding us, past performance is not a reliable indicator of future results.
But using an economic scenario generator with thousands of forward-looking forecasts from the current economic situation is a uniquely powerful way of understanding the risks associated with drawdown and providing sensible and realistic forecasts of sustainable income.
Consumers and advisers need access to reliable modelling tools so that they can develop reliable plans. Not allowing for sequencing risk and realistic levels of investment volatility will systematically result in over-estimating the retirement income that can be supported by a drawdown plan. Put in the simplest possible terms: if it's not stochastic ESG, it's not fit for purpose.
Bruce Moss is founder of EValue
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