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.
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.
Mr Percival said the regulator had revisited this area and is expected to comment on it in next month’s policy statement on DB transfers.
It had already warned in its consultation paper in June last year clients may be confused by stochastic cash-flow plans as well as deterministic key features illustrations.
Others too have pointed to risks in the way advisers are using the tools, including a so-called ‘confirmation bias’, which means advisers could be relying too heavily on the output while failing to understand that “both approaches suffer from false accuracy”.
Richard Allum, managing director of outsourcing firm The Paraplanners, said: “Many advisers think the more complex the tool the more accurate it is. In my experience many advisers using stochastic tools don’t actually know how they work or where the data comes from but are advising clients based on the output.”
Greg Davies, behavioural finance expert at Oxford Risk, agreed.
“A simple model, and a strong client relationship, that allows responses to events as they occur is much more important than making sophisticated guesses about the distant future,” he said.
The most important thing when using any tool was to ensure it fit within an adviser’s business model and advice process, said Chris Pitt, head of market analysis at IRESS.
He explained having a tool that can be integrated with an adviser’s customer relationship management system eliminated inherent risks in re-keying data and preparing models.
Garry Hale, owner of HK Wealth, has been using Truth on a deterministic basis for years and has now added a stochastic investment calculator, which the tool offers on a stand alone basis.
He said: “It’s just a guide based on lots of assumptions that will probably be wrong, but it’s still better than not using it.
“Quality planning alongside the tool helps with decision making and provides peace of mind when the adviser and client agree with the assumptions used.”
But he added it was important to review and update the assumptions used at least annually to ensure the plan stays on track.
carmen.reichman@ft.com
