ESGs, on the other hand, model the economy and investment markets from today’s current conditions into the future. An ESG models the ‘investment journey’ and is, therefore, the appropriate type of model for forecasting retirement income outcomes from drawdown. The chances of low returns in the early years of drawdown can be seen, and plans can take this risk into account. MVC models provide no information about market movements from year to year.
Because they ignore the ups and downs of investment cycles, MVC models are not suitable for use with pensioners wishing to plan income withdrawals. Furthermore, MVC models can give wildly different views of the future depending on the assumption set used for projections. By contrast, because ESGs start from the same place – current market conditions – and chart a course into the future (which may be different depending on the model used), the differences in forecasts produced by different ESGs are less pronounced.
While the technical details of stochastic models are for many readers a complete turn-off, they do matter, and using the wrong model will potentially have very damaging consequences for pensioners. For an easy way to see why MVC models are not suitable for constructing drawdown plans, one simply has to look at the product bias that they can produce. All the models illustrated below are real models used in the UK. The diagrams below show the median (‘best estimate’) and the low forecasts. The optimistic outcome is not shown because to make the decision between income drawdown and annuity, the important comparisons are the best estimate (that is, what is the most likely) outcome and the worst outcome (if things go badly).
‘Normal’ conditions
What the diagrams show is that, depending on the assumptions used in the MVC model, that is, based on (a) long-term ‘normal’ conditions or (b) based on current market conditions, very different conclusions on the relative attractiveness of annuities and drawdown would be reached. In the first example, assuming long-term normal conditions prevail into the future, there appears to be considerable upside in using drawdown and little downside compared to an annuity. The bias is clearly towards using drawdown for delivering retirement income. If current market conditions are assumed in the MVC model, precisely the opposite conclusion would be reached. There is no upside on a best-estimate basis and considerable downside if the worst case scenario occurs – an income of £25,000 will exhaust pension savings by age 75.
As can be seen, the two ESGs give a more balanced picture and the differences between models tend to be less extreme. On a best estimate forecast there is some upside to balance the risk that the income of £25,000 a year can only be sustained until age 75. The choice between drawdown and annuity is therefore driven by the amount of risk the pensioner is prepared to take.
