Stochastic tools favoured for cashflow planning

Stochastic tools favoured for cashflow planning

Stochastic cashflow modeling has emerged as the more popular choice for determining whether a client will run out of money in retirement, despite not being used by widely available adviser software.

A poll of 100 advisers by consultancy the Lang Cat, carried out for FT Adviser in February, revealed the majority (58 per cent) of respondents thought so-called 'stochastic' tools were a better option for adviser cashflow modelling than their ‘deterministic’ counterparts (42 per cent).

The research comes amid increased regulatory spotlight on the area as the Financial Conduct Authority is considering whether to make cashflow planning mandatory for defined benefit pension transfers.

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Stochastic tools such as those sold by Timeline and eValue, use lots of historical data to illustrate the likelihood that something will happen, such as the client running out of money. 

This means the tools, which are considered the more scientific of the two, will not produce a specific number but a range of possible outcomes. 

Deterministic tools arrive at a specific conclusion based on the values put in by the adviser. 

The latter method is used in some of the most popular adviser tools such as Truth, Cash Calc and Voyant and is considerably less complicated, although these three use stochastic modelling in some of their features.

Terry Huddart, market analysis manager at the Lang Cat, said: “The main reasons in favour of a stochastic approach is that it looks at more variables and is theoretically more valid. But deterministic clearly has its fans too and is what’s used in some of the leading software.”   

Mark Locke, communications director at the Lang Cat, who conducted the poll, added: “We have also polled a number of advisers on this subject on a more qualitative basis and those results do actually support the findings of the Twitter poll.”

But there was an overwhelming feeling either tool was only suited to help set client expectations and their output was of very little value without a conversation around risk capacity, the Lang Cat found.

Rory Percival, a consultant and former Financial Conduct Authority (FCA) technical specialist, explained stochastic tools better reflected the variation in possible returns in theory but could prove too complicated for some clients to understand in practice, when simpler tools may be more appropriate.

The most important thing for advisers was to ensure they used the tools in the right way, he said.

“Deterministic is easier to understand and hence may be more appropriate for some clients.

"However, the key problem with deterministic is that it doesn’t take account of sequence of return risk. Hence, if using, advisers need to build in those scenarios,” he said.

Sequence of returns risk describes the risks faced by an investor once they begin withdrawing money from their invested retirement fund. Changes to the economy or downturns in stock markets may mean have a particularly detrimental impact on a retirement portfolio when an investor needs to sell assets to makes withdrawals for a pension income.