Stochastic Modelling: Delivering real-life client outcomes to your cash flow planning
Apr 27, 2022 9:32:52 AM
This blog examines the shortcomings of deterministic models and why a stochastic model can offer you the edge when forecasting real-life outcomes as part of your clients’ financial plans.
Unless you are lucky enough to own a crystal ball, the science (or art) of predicting future economic events can be complicated. Without a robust and flexible asset model, the task of forecasting market behaviour in an ever-changing world can be not only challenging but, in most cases, almost impossible.
What is the challenge when it comes to modelling cash flow?
The challenge for most financial services companies, especially when it comes to retirement planning, is the ability to provide realistic forecasting that enables consumers to make better-informed choices about their future finances.
Traditionally, most financial planners have used deterministic models to project future investment returns. Although deterministic models benefit from simplicity, they rely on single assumptions about long-term average returns and inflation.
In reality, such outcomes, particularly when it comes to income drawdown, can be easily upset by the unexpected implications of sequencing risk, with no allowance for markets being complex, irregular and ever-changing. All of which renders deterministic models inadequate and potentially misleading for long term planning decisions.
We provide an outline of the various types of cash flow forecasting models here.
Forecasting for different outcomes
To forecast potential outcomes for clients entering the decumulation phase of their financial lifecycle, specifically, income drawdown is vital. However, it will require a different approach to individuals investing for accumulation.
There are many reasons for this:
The objective for drawdown is different – retirees will need a sustainable income during retirement compared to the accumulation of wealth
The measure of risk is consequently different – variability of income as opposed to volatility in accumulation outcome
When entering drawdown in retirement, you will need to seek a return better than bonds to overcome mortality drag. While a high return is required to overcome the negative effect of mortality drag, the high volatility associated with a substantial equity weighting leads to a more rapid depletion of the capital supporting regular fixed income withdrawal.
The following factors also need to be considered:
The amount of income that is needed
The length of time for which the client requires the income (life expectancy reduced by less than a year for each year survived, which means the client requires the income for a more extended period than initially anticipated)
The volatility of investment markets
If a retirement planning tool cannot consider the above factors or model the effect of any market downturn in the early years of income withdrawal, the tool is unsuitable. Likewise, if the technology you use cannot show you a range of possible outcomes from which you can effectively plan, it’s not a helpful planning tool.
Benefits of a stochastic model
The advantage of using a stochastic model is that it can reflect real-world economic scenarios that provide a range of possible outcomes that an investor may experience and the relative likelihood of each, particularly when in the decumulation phase.
By running thousands of calculations, using many different estimates of future economic conditions, stochastic models predict a range of possible future investment results showing the potential upside and downsides.
By avoiding any significant shortfalls inherent in deterministic models, stochastic models provide realistic, robust forecasts that demonstrate suitability and enable consumers to make well informed and sensible investment choices, directly impacting their future wealth prospects and lifestyle.
We know that future returns are unknown at the beginning of an investor’s journey. Yet, deterministic models assume investment returns will be the same every year, ignoring inherent randomness in the markets, giving consumers the impression of certainty where none exists.
One way to help consumers see prospective outcomes in terms of the probability of successfully meeting their financial objectives is through a range of engaging charts and graphics, helping crystallise their capacity for loss.
Providing information in this way enables stochastic models to offer more significant potential than deterministic forecasts for analysing risk and allowing the investors to make informed decisions.
Want to learn more about stochastic modelling?
A complete, real-time picture of all the potential outcomes makes a difference to realistic outcome planning. And that’s the difference between a deterministic model and a stochastic model.