Stochastically forecasting the impact of the drawdown on the investments will show if and when they are likely to run out of money in a poor investment scenario.
The level of risk can be dialled up or down until the low scenario provides money for a satisfactory duration.
If no level of risk is tolerable, it might be appropriate to look at annuities, or to delay retirement.
The risk levels at which the expenditure is covered in a poor investment scenario shows the capacity for loss risk level range.
The risk level selected is restricted to those in which the risk is affordable.
The actual risk level selected will then be decided both on the attitude to risk and the capacity for loss risk levels.
Cashflow tools
Showing risk within a cashflow is a new concept for some.
Many cashflow tools like to model a poor investment performance by simply removing a fixed percentage of the fund at a fixed time.
With simple deterministic tools or spreadsheets this is all that is possible, and it is fine provided the adviser is aware of the limitations, but more sophisticated tools should have a more sophisticated solution.
For example, the timing of the fall is important and has different implications for different scenarios.
For someone starting retirement, the first few months and years are crucial and the point in which investment falls have the most impact.
For someone accumulating, it is the end of the accumulating phase which is most sensitive to investment performance.
A good risk-based tool will take all investment scenarios into account and be able to demonstrate a poor performance regardless of where it could occur.
When it comes to the model and assumptions used in such a tool, there lies another potential pit-fall in cashflow forecasting.
Miscalibration of tools. If an adviser uses tool A to calculate attitude to risk, then opens up tool B to do a cashflow projection, then looks at tool C to find a product of the correct risk level, then the calibration chain is broken and the adviser is at risk of providing poor advice.
The only way to fix this is to ensure the assumptions across each process are consistent with each other.
Many cashflow tools are deterministic in their investment assumptions, it is up to the adviser to input a percentage growth rate.
This is fine when the growth rate matches that intended by the risk profiling tools, but a deterministic tool is unlikely to be able to accurately reflect the level of risk involved in the investment product.
