Planning to higher confidence levels can result in safer and more robust financial plans, and more confident and satisfied clients.
Clients, particularly those in or approaching retirement, are mostly looking for one thing from their adviser. Certainty.
Certainty that their savings won’t run out, that their family will be ok if something happens to them, or that they’ll be able to enjoy a particular standard of living well into retirement. With this certainty comes peace of mind, confidence and the ability to sleep soundly at night, ultimately helping them to enjoy and thrive through life.
But providing certainty is easier said than done. With so many variables at play, even the most comprehensive plan can get knocked off course. How can advisers address this and give clients confidence that they’ll achieve their objectives?
Is 50% good enough?
Most financial plans today are built on a foundation of averages. Average returns, average volatility and average life expectancy. Relying on averages to forecast outcomes (also known as deterministic modelling) is relatively simple, and importantly, easy to communicate to clients.
While averages have their advantages, they also have drawbacks. Averages can fail to show the impact of extreme values (like major market corrections) and time series data (like returns over time). Averages use one set of specific values and offer only one simplistic answer. With a deterministic model, the uncertain factors are external to the model and ignored.
Relying on averages when building a plan can be problematic and may result in poor client outcomes. Half the time the client is better off and half the time they’re worse off. Sometimes much worse. Clients deserve better than the flip of a coin.
The dramatic impact of volatility and higher confidence levels
Introducing volatility and higher confidence levels into financial modelling can provide a broader and more accurate range out possible outcomes, allowing advisers to build more robust plans and help clients prepare for a more sustainable and realistic retirement.
The table below looks at the same retirement portfolio modelled two different ways:
¹ In this example a 2% return represents the expected return at a 90% confidence level.
Relying on simple averages and ignoring variability in returns via a deterministic model (scenario 1) is the most common approach across the industry. But as you can see, although it offers the average outcome, it fails to represent the range of possible outcomes.
The outcome for scenario 2 is at the 90% confidence level. This means that 90% of the time you can expect a better outcome and a worse outcome only 10% of the time. In this scenario we factor in volatility of returns (7% standard deviation of returns instead of 0%) as well as the 90% confidence level (rather than 50%) which results in a lower average return (2% instead of 6%).
We see that the portfolio’s ending balance is far less than what we expected from the average model. Naturally, this means that the assets will not last nearly as long as expected.
The average returns modelling simply fails to provide a picture of what could potentially happen. If this possible outcome is unacceptable, then the portfolio needs to be adjusted.
Increase confidence levels and achieve better client outcomes
Advisers who deliver advice based on higher confidence levels are in a stronger position to create and maintain highly satisfied clients. They can more easily manage client expectations, weather periods of volatility, reduce litigation and compliance risks, and enjoy ongoing referrals from happy clients.
Three steps to implementing higher confidence levels
1. Embrace stochastic modelling
Stochastic modelling, compared to deterministic modelling, is a more complex but potentially a more accurate method of modelling financial objectives. It forecasts the probability of a range of hypothetical outcomes under varying economic scenarios. Put simply, it considers the impact of changing market conditions over time by using predictions and various assumptions that may potentially occur over time.
The benefit of this approach is being able to identify a range of possible outcomes that could potentially occur; and the likelihood of each outcome occurring based on various confidence levels. Compared to deterministic modelling which is based on averages and provides only one outcome of 50% probability, stochastic modelling may be considered the superior approach.
Stochastic modelling requires significant computing power to run large numbers of complex calculations. Until recently this has been out of reach for many advisers, however forward thinking platforms and third parties are now offering powerful and cost effective solutions.
2. Use the right tools
Choosing the right tools to model outcomes and input into advice documents is critical. They can empower you to provide accurate and high quality advice, as well as bring efficiencies to your practice.
Take the time to find a sophisticated tool that provides stochastic modelling to ensure you are taking into account the extremes of the market.
Sequencing risk and its impact on portfolio longevity needs to be factored into financial plans – especially for clients in or approaching retirement. The right tools can help advisers achieve this.
3. Use the right products
A number of innovative financial products have come into the market in recent years. Many of these products have been built to address concerns like sequencing risk, volatility and portfolio longevity. These products can be used in portfolios to help achieve financial outcomes at higher confidence levels.
When exploring products, it’s important to consider their ability to honour their commitments, the regulatory regime they fall under and the underlying investment structure. Some of the most powerful and innovative products challenge convention and require a little time investment to understand and embrace. In most cases the effort is worthwhile.
Future Safe as a solution
Future Safe is an innovative investment product built to give advisers and their clients more certainty and confidence in retirement. It does this by addressing the challenges volatility and market shocks can bring to retirees and their portfolios.
Future Safe offers access to sharemarket-linked returns up to a selected cap, while offering protection options that limit losses. It has the potential to generate income and growth while offering protection from market downturns.
Retirement Portfolio Illustration Tool
The Retirement Portfolio Illustration Tool, developed in partnership with Investfit, is a stochastic modelling tool that runs hundreds of different portfolios through thousands of various market scenarios. The result is an illustration of how Future Safe can be used within a retirement portfolio.
The tool offers a more accurate understanding of the level of income retirees can sustainably withdraw leading to higher confidence levels when planning their financial goals.