Stress-testing at the core of suitable retirement income planning

It seemed like an age awaiting and anticipating the outcome of the FCA’s retirement income thematic review, and let’s be honest – the messaging emanating from Endeavour Square was surprisingly basic, a stern wake-up call about risk profiling and capacity for loss – pretty fundamental stuff. The regulator has set out some major requirements for all those involved in advising consumers on drawing down money from their retirement assets to maintain a decent lifestyle.

Apart from a strong call to firms to act on the basis that advised investors have explicitly different requirements in decumulation versus accumulation, the regulator directed that work is immediately needed regarding risk profiling and capacity for loss, and how income withdrawals are defined and set. Specifically, the FCA focused on cashflow modelling, suggesting some helpful “points to consider when undertaking modelling to help firms deliver suitable advice and aid consumer understanding.”

At EV, we’ve always felt that in-depth cashflow modelling of a client’s income withdrawal plan is the right approach for many advised clients. The FCA has now instructed firms to do this modelling properly and carry out due diligence on their cashflow modelling tools.

As they point out in their publication Undertaking cashflow modelling to demonstrate suitability of retirement-related advice, “Cashflow modelling … helps clients make effective decisions and take appropriate action. [But] foreseeable harm can be caused if firms · do not consider how clients will interpret the output · project forward using unjustified returns and don’t result in realistic outcomes · do not consider the inputs and outputs objectively.”

The regulator goes on to say, “Each of these has a profound impact on client understanding and could impact the suitability of any recommendation based on the model.”

Specifically, the FCA states that a model:

• should make assumptions about future rates of return which are not based solely on specific patterns of past returns
• may use constant rates of return for different funds or asset types, so long as there is appropriate stress testing (see below)
• should consider the differential between gross returns for different types of funds or assets and inflation
• should undertake regular reviews of the assumptions used, taking into account wider economic circumstances
• should be careful about presuming their ability to predict variable future rates of return (and inflation) to avoid the impression of accuracy
• should be able to explain to clients the justification for any assumptions and why they are reasonable.

These are the bare minimum requirements for a sensible model to use for cashflow forecasts. It is telling that many cashflow models fall short of these requirements, and the FCA has felt the need to set some basic hygiene standards.

Stress-testing: doing it wrong

Stress testing provides a very good way of achieving ‘proper’ cashflow modelling because it aids in understanding how various situations, such as less favourable investment outcomes, may affect the client’s income withdrawal plan and lifestyle in retirement. Done correctly, this testing can lead to informative and invaluable conversations with clients. How inflation intersects with investment returns is also critical. On top of accounting for different income streams and how portfolios are invested in the withdrawal plan, it’s vital to comprehend how inflation will affect outgoings.

Now, here’s the rub: how not to stress-test an income withdrawal plan needs to be understood. Simply testing via an assumption that there’ll be a, say, 10% or 20% drop in investment markets is virtually useless and totally unrealistic. Why useless? This ignores the likelihood of such a drop actually occurring, which, in turn, depends on present investment market heights. For instance, a 10% fall is not especially unlikely after a period of solidly rising markets but could be very unlikely if a sizeable fall has already happened.

And why is it unrealistic? Markets tend to recover over time, and both the likelihood and timing of recovery are highly relevant factors affecting the severity of the impact of sequencing risk. It’s also essential to interpret the inflationary outlook—particularly what the real returns might be in the future, year on year.

Any forecasts must fully account for the asset mix supporting the income withdrawal plan. Doing this right is more complex. There will often be more than one pension pot to consider, along with other sources of income and holdings to incorporate to fund retirement, perhaps including a partner’s finances. Moreover, the client’s income requirements may include particular outgoings to cover the lifestyle they seek, along with other personal financial objectives.

Truly, forecasting just by rather crudely decreasing the value of investments by a nominal amount is, to be blunt, useless because this risks significantly overstating or understating the impact on the client’s income withdrawal plan.

Stress-testing: doing it properly

This is where stochastic modelling comes to the fore. This modelling generates a large number of potential future economic scenarios encompassing varying investment returns and rates of inflation. Aided by visual representations, the adviser and client can have a meaningful discussion about the chances of unfavourable outcomes occurring and the impact these would have on their withdrawal plan.

The great advantage here is that each possibility looked at will automatically account for the potential recovery of markets and not overstate or understate the effect of sequencing risk.

To sum up, well-calibrated stress testing is a powerful and educative way of meeting the FCA’s call to firms to assess capacity for loss. When combined with realistic cashflow modelling, it can point to the chances of a problem arising down the track and portray the extent of a potential downside. Clients get a graphic view of the impact on their plans to withdraw their money in retirement.

Performed properly, clients will be able to understand the positives and negatives of certain actions and how best to mitigate risks. Realistic modelling will enable them to decide to recast their priorities and reduce downside risk by, for example, abandoning an early goal or putting it off until affordability is more certain. This and multiple other possible tweaks can be decided upon rationally, making a big difference in income sustainability.

Ultimately, given the mission-criticality of stress testing, realistic stochastic cashflow modelling should be at the centre of retirement income planning.

Chet Velani

Managing Director, EV

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