Personal Pension  

Life is too complex to give simple advice

Life is too complex to give simple advice

Have you seen the film Moneyball? It shows the application of modern mathematics to baseball.

Basically it introduces probability theory, which underpins actuarial science, into the analysis of sport. To take a simple example, take a batsman who is a compulsive hooker of short pitched balls. To counter him, they compile statistics which show, for example, that nine times out of fifteen he will hit it for four or six, twice he will miss it altogether, once top-edge it for six and thrice he will give catches in the deep. Three times out of four those catches will be caught. For the bowling side there is a risk and reward analysis: 40 in 60 chance of being hit for a four or a six, nine in 60 of getting him out. Whether it is worthwhile to bowl short-pitched deliveries to him depends upon who the batsman and the bowler are and the state of the game. In the old days seasoned pros did this sort of analysis instinctively. Today we have detailed analysis to corroborate or correct our instincts; the latter more often than you may think.

Over the last decade or two, similar probabilistic approach has been used by actuaries to assist the boards of life insurance companies and trustees of pension schemes. It enables them to consider various alternative strategies, specifically but not exclusively investment strategies. Indeed the regulators in assessing the capital adequacy of a company have a rule that the probability of ruin must be less than 0.5 per cent.

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Probability of ruin is a deliberately frightening expression. What it means is that the chance of the company running out of capital must be less than one in 200. The actuary builds financial models looking at various scenarios.

He no longer says that assets are X and liabilities Y. The assets are still X as for publication purposes market values are used but a range of values is given for Y under various scenarios.

The board can look at the impact for example of investing in equities rather than gilts to see if the extra rewards come at an acceptable degree of risk.

I think the time has come to apply this technique when giving advice to individuals. Life is too complex and the outcome too uncertain to give a simplistic advice. Secondly, it helps to make the customer aware of how uncertain the future is and get his involvement in plotting his future. Consider what variables you have to consider when advising a man of 45:

1. Spending versus savings issues

2. Profile of financial commitments and its evolution over future years

3. Profile of current and future income and their evolution over time

4. Current portfolio

5. Likely future investment scenarios