Using the correct tools
Creating a suitable financial plan for clients in drawdown starts with an accurate assessment of risk.
As part of its thematic review, the FCA emphasised attitude to risk and capacity for loss as key elements of risk profiling, but it found none of the 24 companies in the sample it reviewed showed a clear distinction between accumulation or decumulation in their risk-profiling approach.
It identified concerns around risk profiling, including the risk of clients being invested in solutions that are not aligned with their risk tolerance, which could result in their incurring financial loss.
Using an ATR questionnaire designed for drawdown is crucial to understanding the client’s attitude to income risk. It needs to draw out how the client feels about the risk of not achieving their planned income.
Evaluating capacity for loss of income is also essential — FCA guidance issued in 2011 recommends separate assessments for attitude to risk and capacity for loss to avoid conflating the outputs.
Again, capacity for loss should be viewed through the lens of decumulation. Whereas in accumulation, capacity for loss is generally concerned with the risk of capital loss, when taking an income the risk of it not covering essential costs or the desired lifestyle in retirement is a more important consideration.
Once assessed, the income risk profiles need to be tested, and potentially adjusted, against capacity for loss. I would argue that the best way to do this is to use cash flow modelling, but to generate valid results the assumptions must be realistic.
The FCA’s thematic review found flaws in the assumptions used by many of the companies it reviewed and in response, it issued an article on cash flow modelling setting out points for companies to consider when preparing and using a cash flow model. This article, published alongside the review, states that companies:
- should make assumptions about future rates of return that are not based solely on specific patterns of past returns;
- may use constant rates of return for different funds or asset types, so long as there is appropriate stress testing;
- should consider the differential between gross returns for different types of funds or assets, and inflation;
- should undertake regular reviews of the assumptions used, taking into account wider economic circumstances;
- should be careful about presuming their ability to predict variable future rates of return (and inflation) to avoid the impression of accuracy;
- should be able to explain to clients the justification for any assumptions and why they are reasonable.
With deterministic cash flow models, which rely on single assumptions about long-term average returns and inflation, the relative performance of different asset classes and inflation makes setting realistic assumptions challenging. More difficult still is coming up with a realistic downside to test the robustness of an income plan.
A robustly constructed stochastic model, on the other hand, reflects a range of real-world economic scenarios and provides the probability of different outcomes occurring, including the likelihood of the client’s desired level of income being sustainable over the long term.
