I saw this interesting image on Twitter (via @farnamstreet) the other day that I think financial planners should share with their clients.
It’s a graphic image of how clients think about their investments growing over time versus how their investments actual grow or if you like, Client’s Plans Vs The Market’s Plans for their money!
What worries me is that financial planners (and I mean that in the true sense of the term) may actually be contributing to this inaccurate perception of how investing works.
Case in point is the use of cashflow models. Many financial advisers have adopted cash flow modelling to guide in making decisions on a ‘safe’ withdrawal from their portfolio but I hate be the one who breaks it to all the cash flow modelling evangelists out there, the way these tools are used by vast majority of UK planners means the outcomes are far too rudimentary and risk misleading clients. Many planners rely on deterministic models, which treat returns as linear (i. e. average annualised returns over time) and ignore randomness of returns. One problem with this is that it underplays the dangers of negative sequence-of-return, and risk misleading clients.
To get a better understanding of sequencing risk, let take a look at Portfolio A with the yearly return in the table below. Imagine a second, Portfolio B, with the yearly return of 5.73%. Portfolio B represents what adviser model in their deterministic cashflow-forecasting tool by assuming average annualised return. If client has £100,000 in both portfolios and withdraws £5,000 a year from these portfolios starting from their 60th birthday, they’ll run out of money with Portfolio A on their 83th birthday, although Portfolio B continues to support the level of income withdrawal indefinitely.
The point here is that while average annualised return on both portfolios is exactly the same i.e. 5.73%, in reality the outcomes for the client couldn’t be more different under these scenarios. This drives home the point that, when in a drawdown the order in which returns occur is perhaps more important that the average return over a period of time.
Pound Cost Averaging In Reverse Gear
A negative sequence of market returns early in retirement can cause funds to erode to the point where what seemed like a reasonable income level quickly becomes unsustainable, even if portfolio performance recovers in later years. This is because taking income from a portfolio in a falling market leads to ‘reverse pound cost averaging’, where a client is essentially forced to sell units in their portfolio when prices are falling, in order to pay the required income.
Deterministic modelling tools hide the danger of negative sequence-of-return, especially in the early years of retirement.
Financial planners need to tread carefully as these tools ignore the fundamental principal of how real-life portfolio work – randomness of return. The reality is that with the new pension freedom, we are in unchartered territories as people who would have been advised to buy annuities in the past would now end up in drawdown.
For starters, we need better tools to model potential outcomes in retirement. The problem is that deterministic cash flow models treats expected outcomes as linear and do not consider the range of possible outcomes that client may experience. Deterministic models have approximately a 50% success rate; meaning that there is a 50% likelihood that client could run out of money. This is not good enough!.
Stochastic models (such as Monte Carlo simulations) are a major improvement on the deterministic models, which most planners currently use. Monte Carlo models accounts for randomness (not just of returns but other factors such as life expectancy, inflation, etc.) and expresses potential outcomes in terms of probability of clients meeting their objectives. This is valuable information for planners to consider, and communicate with their client. This goes right to the heart of communicating and demonstrating clients’ capacity for loss.
Table: Portfolio A Vs Portfolio B
|Portfolio A (Return)||Portfolio B (Return)||Age||Portfolio A (£100K Invested)||Portfolio B (£100K Invested)|