Over the next few weeks I will be dealing extensively with financial planning for, at and during retirement. (This mini-series of columns is as relevant to a 21-year-old as it is to a 61-year-old.)
The reason for the mini-series is the remarkable change that is starting to take place in retirement planning. The financial services industry is moving (albeit too slowly in my opinion) away from simply selling products to creating properly considered investment structures that take account of your lifestyle, and the investment risks you can and cannot afford to take.
To start this mini-series I spoke to independent actuary Vernon Boulle, who delivered a paper entitled "Essays on products and planning" at the recent annual convention of the Actuarial Society of South Africa.
In one essay, Boulle explains the need to use what is called stochastic modelling (or Monte Carlo simulations) to get your retirement planning right. The Cambridge dictionary defines stochastic modelling as a process or system that is connected with random probability.
For a number of years, financial institutions have simulated different outcomes based on a variety of underlying factors, including economic conditions and investment market results, to manage pension funds, hedge investments and optimise portfolios.
Each scenario must be internally consistent and theoretically sound, as well as realistically possible if you are to get your retirement planning right.
Actuaries, who are the architects of many of the financial products on the market, have too often in the past not really considered how the design of their products will affect ordinary people. Instead, they have focused on the commissions these products will generate for the sales force and the profits they will create for the financial services company.
We have only to look at the traditional retirement annuity products of the life assurance industry, where company profits have been placed first, the interests of product sales people second, and you last.
Actuaries such as Rob Rusconi, who blew the whistle on the high cost of life assurance retirement products two years ago, and Boulle are doing all of us a tremendous service in making the industry sit up and think about what it has inflicted upon us.
New world of retirement
Boulle says you need to look at the history of retirement planning in South Africa to understand why a new approach based on stochastic simulations is required for how you plan for retirement.
He says retirement planning has, in general, moved from defined benefit pension schemes (where you were guaranteed a predetermined pension) to defined contribution schemes or personal retirement funding (where you are guaranteed only an unknown lump sum at retirement that you must use to purchase a pension).
Under a defined benefit scheme, you, as an employee, had the advantage of various experts advising your pension fund on things such as investments, while your employer provided the financial backing that your pension would be paid if the advice to the fund was wrong.
In moving to defined contribution schemes, employers have limited their financial commitment to you and, at the same time, withdrawn your implicit access to professionals to advise you on the correct investment choices to create a financially secure retirement. You now face increased uncertainty, decreas-ed support and less affordable access to professional, tailored advice.
In addition, your ability to antici-pate your future lifestyle both before and after retirement has changed. Job mobility has increased, while earnings patterns have become more volatile, because periods of self-employment and unemployment (and the grey area in-between) have become common.
Boulle says that to add to your confusion, you face an ever-greater diversity of investment vehicles and, once in retirement, the lure of living annuities (where you take the investment risk) have left you with a bewildering array of options.
"Your needs have not changed through this transition. There is still a requirement for access to funds before and after retirement that produce a reasonably stable standard of living," Boulle says.
You need sound advice
He says your financial vulnerability when saving for retirement and in retirement has increased. This means you need sound and responsible financial advice to deal adequately with the change from defined benefit to defined contribution funds, because the enhanced financial flexibility has also increased the risk that you will retire with insufficient money.
"The primary intention behind saving is to enable consumption at a later date. In other words, normal people (not the extremely wealthy) do not accumulate wealth simply to admire their personal balance sheet, but do so as because they recognise there will be a need for the accumulated savings in future, predominantly once they retire.
"Financial advice should be based on planning the accumulation of wealth and its subsequent consumption. This may be holistic in targeting the lifestyle you wish and are able to lead.
"It is not sufficient to simply adopt a fatalistic approach to finance, accumulating savings and then hoping you will be able to live on the proceeds at retirement.
"Financial planning should both assist you to come to terms with the constraints of your current wealth, income and expenses on your future lifestyle and make you aware of the risks to your future lifestyle from the investments you have purchased," Boulle says.
He says there is a double risk relating to your future consumption (in retirement). These risks are:
- Your current consumption (what you spend as opposed to what you save); and
- Inappropriate asset selection now that will inhibit your ability to consume in future.
Coming to terms with these risks will enable you to save the correct amount in the appropriate investment vehicles for your retirement.
Boulle says your financial/retirement planner needs to make proper financial projections to give you an idea of how your savings will evolve before and during retirement.
He says it is not good enough to make financial projections based on current circumstances.
"They simply show a single line of the accumulation of wealth and possibly its future consumption. This single line masks uncertainty around future investment returns and the risk that your investment will not meet its objectives.
"What is crucial to understand is the range of possible outcomes (results) for your particular investments to enable you to see the impact (upside and downside) of the level of savings and investment choice on your portfolio value and income available to fund your lifestyle," he says.
The range of outcomes will be wider for portfolios with higher equity content and narrower for those with higher bonds and cash components, Boulle says.
Range of outcomes
By considering a range of possible outcomes, you will be able to recognise the implications of choosing a particular investment strategy, including the trade-offs between accepting risk and the potential for higher returns.
For example, a pensioner will be able to see that a "conservative" investment (with a high cash content) may in fact be risky in the long run as the short-term certainty may lead to guaranteed poverty (because of low returns and inflation).
Boulle says that, most importantly, a range of possible outcomes creates reasonable expectations of what an investment may provide and it also enables you to balance your appetite for investment risk with your desired lifestyle.
He says the simulations can be used to illustrate a realistic range of possible outcomes for your investments and cash flows.
For you to properly understand the possible outcomes, he says, the projections should use what he calls "real" numbers.
"Real numbers allow for inflation, so that R1 000 in 10 years' time has the same value as R1 000 today. Some projections use nominal values, meaning that the number projected in 10 years' time cannot buy the same amount of goods as it could today, making it extremely difficult for you to comprehend what the investment is worth. Nominal projections provide impressively large numbers, but real projections provide more useful numbers."
Boulle says there is no reason why stochastic modelling should remain the preserve of institutional fund managers.
"The increased processing power of personal computers and laptops has meant that this methodology is now capable of being run by personal financial advisers."
Stochastic modelling:
- Provides you, in an affordable manner, with access to the decision processes and methodology previously available only to financial institutions; and
- Will be a substantial advancement in the financial planning process, because it enables you and your adviser to come to terms with investment risk. Your perception of what you are purchasing will be anchored in economic reality rather than over-simplified expectations. Your risk tolerance can be tested against a range of realistic possibilities, which will help find the right investment solution that suits your financial needs.
Boulle and his company are currently well advanced in providing stochastic tools for financial advisers. Make sure your adviser is providing you with the right advice by using the best tools available.