Life Stochastic Portfolio Planning - the Future of Investment and Pension Advice
Author: Johan Strydom
The current ‘deterministic’ modeling techniques used in standard point of sale illustrations today simply provide predictions of what a pension will offer in terms of an income in retirement based on five, seven or nine per cent average growth rates. They do not provide the odds of success or failure in achieving these predictions or indeed work any variables or inherent uncertainties into these calculations. Presented with three numbers most investors will look at the middle one and think this is broadly where they are likely to end up. They will check the lower one and think that’s about as bad as it will get and then they will glance at the top one and hope!
In this context the current five, seven and nine per cent approach can be very misleading. For example, if the investor invests in equities, the range of outcomes will typically be much wider than five to nine per cent. So the investor is unlikely to really appreciate his downside risk. On the other hand, if he invests in government bonds at current yields, the range of outcomes is likely to be much smaller than with equities but he is unlikely even to hit the lower, five per cent growth projection figure.
The solution is stochastic (also known as "monte carlo") modeling. How is it different?
* A stochastic model will generate hundreds or thousands of projections instead of just three
* The assumptions for each projection will be generated by an underlying economic model designed to mimic the real investment world.
By analysing the range of answers produced, the stochastic model can predict probabilities to any given outcome. This means we can actually cater for an individual's risk appetite! For some, their pension income is their only income in retirement. They would want to plan with high certainty for the future. For others, their pension will be in addition to income they generate from other assets. They might be happy to take significant downside risks with the prospect of very favourable outcomes. Stochastic portfolio planning gives advisors who understands the statistical concepts a tool to give individually tailored, risk sensitive advice.
With Final Salary pensions schemes - where benefits in retirement is guaranteed - becoming very rare, individuals are left to the task to build an investment pot for retirement and do it in a responsible way. Individuals are becoming aware of the need to take personal responsibility for their retirement. For how long will they be happy to accept crude predictions of five, seven or nine percent to make decisions? With this in mind SIPPs (Self Investment Pension Plans) are becoming more and more popular as individuals demand the flexibility to invest in assets tailored to their needs.
I believe its the combination of stochastic models and the flexibility of SIPPs which will give individuals the ability to make individually tailored and responsible investment decisions. The problem is there is not enough financial advisors out there with the skills and tools to offer this service.
'Stochastic illustrations are still a fledgling area... only a select few technology, investment management and actuarial firms, currently have the skills to implement them.' Christopher Read, Chairman, Dunstan Thomas
My hope is that more analytical people such as actuaries enter the world of financial advice to serve the public in an increasingly complex financial world where pension reform is still continuing for quite some time to come.
About the Author:
Johan A. Strydom B.Comm FIA CertPFS
Actuary and Independant Financial Advisor