Currently, individuals have little choice over what they can do with the money they have saved in a pension when they reach retirement. They can usually take up to 25% of their pension pot as tax free cash with the rest being used to provide them with a pension. This is normally done by purchasing an annuity (a type of insurance policy that provides a regular income in exchange for a lump sum).
But times are changing and, from April 2015, the Government plans to allow pensioners with Defined Contribution (DC) pensions greater flexibility in what they can do with their pension pot at retirement. Not only will they no longer be required to buy an annuity at retirement, but the new proposals will mean that, provided they are aged at least 55, they will have the option to withdraw the whole of their pension fund as cash when they retire and spend it or invest it as they see fit. They will still be able to take up to 25% of their pension pot tax free but the remainder will be subject to income tax.
Given this new flexibility how can you help your clients make informed decisions about the best use of their retirement savings?
For many, a dream retirement is about having both the luxury of time and enough money to do the things that they have always wanted to do yet could never do whilst they were working. But how will your clients know if they are likely to have enough income in retirement to fulfil that dream?
Luckily, a method known as stochastic forecasting can help. It provides a way of foretelling what your clients’ retirement income might be in the future.
How does stochastic forecasting work?
Many events, such as what an individual’s future retirement income will be, are not known with total certainty. The best we can say is how likely they are to happen. This is the basis of stochastic forecasting. It does not try to predict what an individual’s future retirement income will be but instead provides a range of different possible future outcomes, all with varying likelihoods of happening.
A stochastic forecast is basically just an estimate of the future state of the economy. It is created by making assumptions about the current state of the economy based on observations such as the rate of inflation, for example. A large number of forecasts are run based on slightly different assumptions to see what difference this will make to the outcomes.
By comparing the resulting forecasts, the chance of a particular investment outcome occurring can be seen. If the forecasts vary a lot, then there is a lot of uncertainty about what the economy will actually do, but if the forecasts are all very similar then there is more confidence in predicting a particular event.
Using this knowledge you can help your clients to make informed decisions and sensible choices about their future finances.
Not getting the whole story?
On the other hand, trying to predict investment outcomes without using stochastic forecasting could be a bit like walking down the street with blinkers on. Your clients will only be able to see what is directly ahead of them. Because of the blinkers they won’t notice the excited children playing across the street, and will be unaware of the ball hurtling at great speed towards them. They will be unable to spot the puddles on the road, and so will not take evasive action and manoeuvre themselves out of the way to prevent being splashed by passing traffic. So long as the street directly in front of them is clear, they will valiantly keep going but will end up at the mercy of the bouncy ball and the wet and muddy puddles both of which, undoubtedly, are likely to lead to a rather wet, hurt and exasperated individual.
But it doesn’t have to be all doom and gloom! Stochastic forecasting takes away the blinkers that many of us may be wearing when we think of our investment future. Rather than having a narrow view of how your clients’ pension or investments may do in the future (by looking at how they have performed in the past) stochastic forecasting shines a light on the different factors that may affect the outcome.
Stochastic forecasting will help you to give your clients a clearer picture of the possible hazards that may cross their investment path. Taking account of the varied and influencing factors that can affect the economy in the future, helps forecast possible future outcomes and thereby provides a steer on any investment decisions your clients make.
You may not have a crystal ball to foretell your clients’ future pension position but stochastic forecasting goes a long way to help!
If you like this blog why not explore EValue’s Pensions Freedom Solutions.