Clients could be getting very different at-retirement product recommendations, depending on the forecasting model used, industry experts told FTAdviser.
Andrew Storey, technical sales director at eValue explained that retirement income forecasts depend heavily on yields and returns assumptions, since both annuity rates and yields on other assets depend on market conditions.
Therefore to be useful for helping consumers to make decisions the asset model must explain how markets might change over time from where they are currently, said Mr Storey.
His firm is responsible to white-labelled modelling work behind around 80 per cent of providers’ retirement income calculator tools, most recently Aegon’s Retireready planner.
The eValue Economic Scenario Generator uses a model of economic activity to create possible scenarios from first principles and looks forwards from current market conditions.
The problem lies in using normative (long-term) assumptions, which may make an annuity look better than drawdown, because long-term returns are higher compared to the market on which the annuity is currently being priced, given the current low rates, Mr Storey said.
“You could instead use the assumptions based on current market conditions, which effectively reduces everything by about 2 per cent, because yields and inflation are both suppressed, and other returns use a risk premium plus risk free rate.
“This makes drawdown look pretty bad, because the forecast uses the currently low returns persisting for ever whilst the annuity has security of income of a similar sustainable level.”
He pointed out however, that they are both right but at different points in time.
“In reality you need to start from today’s conditions and move to the normative in the longer term. So advisers need to carry out due diligence to be aware of whether their forecast model does this.”
Mr Storey argued that only stochastic forecasts can show that the timing of returns is critical to the outcome.
“For example, income withdrawal during a period with a depressed fund value has a particularly large effect on the overall wealth needs to be considered when choosing your income options.”
Mr Storey explained that there are two types of stochastic model available.
Firstly, scenario-based, such as eValue’s model and secondly, distribution-based models, which are commonly used by fund managers for short term forecasts, which generally assumes that the past will be repeated into the future.
David Blake, director of the Pensions Institute at Cass Business School, told FTAdviser that he highlighted some of these issues in a paper written with Kevin Dowd a few years ago.
“I am much more concerned that we have stochastic projections for the outcomes under drawdown, than whether we use an economic scenario generator or mean-variance for producing the stochastic projections.
“The real danger to me is the use of deterministic projections of asset returns as allowed by the FCA, combined with cash flow modelling of income and expenditure,” he continued, stressing that this gives a false sense of certainty about the future and ignores the important issue of ‘sequence of return’ risk.”