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The stoch market

Retirement planning. Steven Whalley, head of marketing for investment products at Aegon Scottish Equitable, looks at how stochastic modelling can be used to consider the possible scenarios for investors taking regular income in retirement.

Wouldn’t it be nice if there was no volatility in the stockmarket and equities grew constantly at 7 per cent each year?

If this were the case, investors could invest their retirement savings in an equity-based fund, safe in the knowledge that they could take a decent level of regular income each year until they die. The investor would not run the risk of outliving their savings.

However, we all know that this doesn’t happen.

We would expect the stockmarket to show a reasonable positive return on average over the longer term but in the short term it tends to have its ups and downs – hence the phrase equity volatility.

What is the impact of equity volatility? If people are investing money over the long term, for their retirement for example, equity volatility is likely to have a limited impact.

The value of their investment may endure periods of ups and downs but we would expect the ups to outweigh the downs, resulting in positive growth.

Investors may choose to reduce their exposure to equity volatility as they approach the eventual encashment date.

When it comes to taking a long-term regular income, that is, in retirement, from an equity-backed fund, the idea of equity volatility suddenly becomes far more important. Equity volatility and the resulting path of investment returns become crucial in determining how long an investor’s money will last. 7 per cent a year flat growth.

A set of returns which produce an average annualised return of 7 per cent a year, with higher returns in the early years and lower returns in the later years. A mirror image of the returns in scenario two, such that the average annualised return is still 7 per cent a year. Negative returns initially but ending with high positive returns.

If an individual invests £100,000 and takes no income, under all three scenarios, the fund grows to £387,000 after 20 years – that is, the path of invest ment returns does not matter. However, if we now assume that the investor takes £5,000 (or 5 per cent) a year income, we see the following:

l Under scenario one, the fund is equal to £168,000 after 20 years. Under scenario two, the fund is equal to £247,000 after 20 years. And in scenario three, the fund runs out after 17 years.

So, with the introduction of a regular income, equity volatility – and in particular the timing of the ups and downs – can have a significant impact on how long the investor’s money lasts.

The above example was based on three artificially constructed scenarios. However, we cannot base any conclusions on three different scenarios because there are so many different ways that the stockmarket could move in the future. We need to consider a wide range of possible future investment scenarios.

When it comes to modelling uncertain future outcomes and the likelihood of these outcomes, the industry-standard approach is to use stochastic modelling. So we can use stochastic modelling to consider future investment returns. The stochastic model will consist of a range of parameters which, when combined, allow you to project the expected future returns on various asset classes, such as equities and fixed interest, and the expected variability in these returns.

These parameters are set by looking at current and past market data and are constantly updated to ensure that a realistic model is maintained.

The model is then run a large number of times (typically 1,000-plus), to generate a range of possible scenarios. For example, we could generate possible scenarios for the path of investment returns over the next 60 years.

Let us consider what happens if we use a stochastic model to generate 1,000 different scenarios for the future investment returns on a 50/50 fund (50 per cent equities/50 per cent fixed interest) held within a bond.

For a given investment, we can then assess (using industry-standard mortality rates PA92 mid cohort), in how many of these 1,000 scenarios the investor would run out of money before they die if they continue to take a regular income of 5 per cent of their original investment each year.

This shows us that for a 60-year-old male, in onethird of the scenarios they would run out of money before death. For a 60-yearold female, in 40 per cent of the scenarios they would run out of money before death.

In recognition of the risks faced by investors taking a regular income from an equity-backed savings contract, we have seen in recent years the development of savings contracts with optional income guarantees.

These contracts allow investors to continue to enjoy the flexibility and upside potential offered by a balanced equity fund, with the added security of income guarantees either for a limited period, for example, 20 years, or for life.

Following successful introductions in the US and the Far East, these products are just arriving in the UK. With ongoing improvements in mortality and the ongoing risk associated with equity volatility, these new guaranteed products look set to provide a valuable addition to the UK retirement income market.

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