"How big will my pension pot be when I reach retirement?” is the inevitable question that clients ask advisers throughout the accumulation phase.
When it comes to retirement, the question becomes a more pointed one: “What kind of income will my pension pot give me?”.
The answer will be incredibly important. Clients have saved for many years, balancing the temptation to ‘live now’ with the wisdom of ‘saving for later’. Though retirement may no longer be a clean cut from the world of work, they may have dreams and expectations of getting off the treadmill and pursuing their own agenda.
Living the dream, or living in a dream?
It is likely that clients thinking about retirement now started saving into a pension around the 1980s. Back then, advisers would have been using the FSA’s prescribed rates of return for pension firms, with projections based on 5%, 7% and 9%, which were later revised to 2%, 5% and 8%.
Though pension illustrations now also have to factor in inflation at 2.5% (the impact of which could be further compounded by charges), the expectation in clients’ minds as to what their pension pot may be, could be considerably higher than what they will end up with in reality.
Though the industry regulator’s goal is to make sure customers are not given exaggerated or potentially misleading information, the majority of clients, starting decumulation with less than they expect, may feel disgruntled.
Challenges for advisers
So when it comes to decumulation, advisers have their work cut out. The typical client is likely to have big expectations, but a relatively small pension pot.
Clients will be looking to our profession to give them a realistic projection of the income they can expect in retirement. So are the tools and models we have available up to the task?
Broadly, these fall into two categories:
Cashflow (deterministic) – projections based on fixed assumptions around investment growth rates
- Stochastic (probabilistic) – showing a range of potential outcomes based on an asset and risk model
A number of advisers agree that cashflow models are limited, useful for giving clients an idea of what could happen. But projecting ahead with any confidence could be imprudent as they rely on assumptions and work on averages. In reality, we know there are so many more factors involved.
In addition, in the world of post pension freedoms, decumulation is not a one-off event where advisers help clients weigh up returns from several annuity options. It is an ongoing process, influenced by clients’ changing needs and wider economic factors.
Income planning needs to become more sophisticated if our profession is to give clients realistic projections of their retirement income. As well as projections, our hand has been guided by the FCA’s focus on risk-based suitability too.
For example, it’s not easy to demonstrate drawdown opportunities using cashflow tools due to the number of variables and unknowns. Similarly, it’s difficult to show the risks around the sequencing of poor returns while continuing to withdraw money.
Stochastic tools allow us to bring more variables into play, so we can trade off investment, risk and reward. As such, they are perhaps more valuable as they use all observable historic data, not just investment performance in the past.
Such models are flexible too, allowing clients to develop plans for meeting all their retirement goals and to better understand the chances of achieving these goals.
Again, using the tool is part of an ongoing process. Advisers can use the tool every six or 12 months to check that clients are on track, and that the investment risk is still suitable.
To be accurate, it is vital that the data used by stochastic tools is updated regularly. There should be no in-built product bias either; it should drive advice, not product sales.
Income modelling – just the start
The new pension freedoms put the onus on our profession to develop tailored solutions for our retirement income clients. It’s a big responsibility, but modelling is here to help us.
In the USA, pension freedoms have been around for decades. According to Michael Kitces, the renowned retirement income planner from the United States, a realisation is dawning in the UK that is already well understood in the US – that retirement income modelling can be the most important calculation done for a client.
As retirement looms large, more clients than ever before will turn to our profession in the wake of the pension changes. Income modelling will become a bigger tool in our toolbox if we are to succeed.
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