Not so super calculators
Why financial advisers need to seriously consider new projection tools
The projections produced by superannuation calculators, and most existing financial planning software, do not allow for, or help clients understand, investment risk. Advice based on these calculators can be distorted and place financial advisers in a difficult position when investment returns are worse than projected. PFS believes simulation based tools can be used to illustrate investment risk with significant benefits for all stakeholders.
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When a person retires with a lump sum benefit they have the responsibility to manage their own savings. There are two issues that need to be regularly tackled. “How do I invest my retirement funds?” and “How much should I take out each year?” An informed decision on these matters must take into account:
Financial advisers are well placed to assist people with these decisions because understanding the legislative requirements is a core competency of any financial adviser. On the second and third points, financial advisers have access to budgeting tools that work out expected expenditure levels and superannuation calculators that work out how long client savings will last for a certain set of assumptions. Projections done this way follow what is called a deterministic approach. It is the fourth piece, risk, which is the weak point in the advice currently being offered to clients. Simulations Allow for Uncertainty One way to improve the communication of risk to clients is to use a simulation approach, called Stochastic modelling that allows for the reality that the future is uncertain. Unlike deterministic modelling which produces the same outcome for a certain set of inputs, these models include a random component that can produce different outcomes for the same set of inputs; just like in real life. By repeating the process thousands of times, the model shows thousands of possible outcomes.
As this approach produces many possible outcomes, it lends itself to a visual presentation of the results and therefore makes it a powerful means of communicating risk to clients. The benefits of using this approach are best illustrated using an example. Example Barry is a 65 year old retiree with $400,000 in retirement savings. His financial adviser has helped him work out that he needs approximately $40,000 pa to live comfortably and that he is expected to live to age 84. Two retail investment options are put forward: a balanced investment strategy that has 70% growth assets and a more aggressive investment strategy that is 100% invested in growth assets. Barry would like to know how long his savings will last under these two options if he sticks to his budgeted $40,000 pa. Using the standard deterministic approach, Barry’s savings are expected to last until age 77.3 if invested in the balanced strategy and until age 78.4 if the more aggressive strategy is adopted. Generally, investing more aggressively involves more investment risk, but this approach does not quantify or illustrate this principle in any way. In addition, both results falsely convey the message that Barry’s funds will not last to age 84. Using a stochastic approach, the results can be presented in a manner that allows Barry to “see” the risk or variation associated with each strategy. This is demonstrated in the charts below. Balanced Strategy Distribution Aggressive Strategy Distribution The charts show clearly the trade-off between risk and return. The more aggressive strategy is more likely to generate returns that will provide Barry with income into his 80s but also exposes him to a greater chance of his savings running out before the age of 75. It also shows that there is a chance that his funds will last to his 84th birthday. However, the chance of money remaining after age 84 under the Balanced strategy is less than 2% while the chance under the Aggressive strategy is around 12%. Additional Benefits of Using Stochastic Simulations In addition to the client advice benefits, using a simulation approach also benefits financial advisers by:
Given these benefits: “Why isn’t this being adopted across the industry?” The next financial modelling article in This e-mail address is being protected from spambots. You need JavaScript enabled to view it will look at the hurdles involved in adopting a simulation approach and what limitations exist.
Thach Huynh |
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