A lot of time and expertise have been applied in establishing a client’s true risk profile and corresponding suggested asset allocation.
Consequently, there has been less focus on specific consumers’ needs or their long-term expectations. With a completely new pension world soon to be upon us, it is vital consumers are given reasonable expectations of what financial products may provide for them in the future.
Advisers, therefore, need to ensure that their clients’ financial forecasts are as realistic as possible. This will not only help their clients understand the potential range of outcomes from different financial strategies, but will also allow them to make informed decisions.
If consumer expectations are not managed properly, it could lead to unwelcome surprises in the future if investments deliver less than anticipated. Successful and compliant advice processes are, therefore, becoming increasingly dependent upon the integrity and quality of the underlying asset model used for financial planning.
Asset models are built for a variety of uses and it is the responsibility of the builder of the asset model to ensure it is fit for its intended purpose.
In order to be robust and produce a realistic range of potential retail investment outcomes for the consumer, an asset model used for financial planning purposes needs to be built around the following four principles:
Real-world model
The asset model should be a comprehensive real-world asset model, such as an economic scenario generator (ESG), which seeks to model investment markets as accurately as possible. It should include appropriate and consistent risk premia between different asset classes.
It must also reflect real investment attributes, such as the term dependency of risk and return associated with different asset classes. For example, the expected variation of potential cash returns in the long term compared with their current levels. An ESG links economic variables, currencies and asset returns so that consistent, shorter, long-term forecasts of global investment markets and economic variables can be produced.
Interest rates and future income
Modelling interest rates is of fundamental importance when modelling return and risk over the long term. When interest rates increase, the market price of bonds will fall, but future expectations from that point onwards for cash and bond income will be higher.
In the long term, most clients will need to generate an income from their investments, which is linked for all asset classes to interest rates in various complicated but explainable ways.
To provide integrity, an asset model should have an internally consistent model of the potential evolution of bond yield curves and consequent interest rates. This is an area of ongoing research in the modelling community as models are updated to address the challenges of the current low interest rate environment.
Inflation
In order for clients to be able to relate the outcomes from an asset model to their investment goals, forecasts need to take account of inflation. Telling someone that £10,000 invested for 20 years could give them £25,000 sounds great, but it misses the point that £25,000 would only buy £15,000 worth of goods at today’s prices.
To be fit for purpose, the inflation used in the asset model needs to be coherently and consistently linked to the asset returns and other factors within the investment forecast.
Plausible and realistic scenarios
When an asset model is used to produce a range of long-term possible outcomes for a consumer, not only must the model be right on average, but each individual scenario that makes up the total range of forecasts must be capable of occurring.
An example of this is fixed interest bond yields, which, while very low, when modelled into the future cannot become significantly negative.
Bruce Moss is director of strategy at eValue
Asset models: Expert view
Bruce Moss, from eValue, explains why advisers need to understand what the asset model does:
“From April 2015, consumers will be given more control than ever before over their pension assets. However, with these new proposals comes a greater need [for advisers] to provide clients with realistic forecasts of what they may obtain in the future.
“One way to achieve this is for advisers to ensure that the underlying asset model used in financial forecasts is real world, takes account of both interest rates and inflation and produces plausible scenarios.
“In this way, advisers can be confident that they are providing their clients with the means to take sensible and informed financial decisions that make the most of their new-found pension freedom.”
