predict-future

We’d all like to be able to predict with certainty our future finances, particularly in retirement. That’s why defined benefit pensions are often called ‘gold-plated’. But uncertainty is an inescapable fact of life. There are many things we cannot know for sure, such as:

  • How long we’ll live
  • Future inflation
  • Interest rates
  • Our future health
  • How well our investments will perform

Tools used by financial advisers

Part of the job of a financial adviser is to help clients with retirement planning. This means looking into the future. The adviser need to be able to predict whether or not a client’s spending is sustainable throughout retirement. Given the inevitable uncertainties, you might assume that professionals would all be using tools that take uncertainty into account. But a 2018 article in FT Adviser reported that 42% of the advisers surveyed relied on deterministic cashflow modelling tools. Such tools ignore uncertainty, and try to predict the future exactly. For example, such a tool might assume that stocks will grow at a rate of 8% a year; not as an average, but as a fixed growth rate. Another typical feature of deterministic tools is that you need to tell it how many years your money needs to last; in other words how long you’re going to live.

On the plus side, deterministic tools are simple to understand. But on the minus side, they’re just wrong! If you put in realistic averages for things like growth rates, inflation rates and life expectancy, a deterministic tool will predict an over-optimistic future. Some advisers try to compensate for this by making pessimistic assumptions, like trimming growth rates, or inflating life expectancies. But this is just guesswork.

Project rather than predict

In the FT Adviser survey, 58% of advisers thought stochastic tools were a better option. A stochastic tool is one that takes uncertainty into account; it doesn’t predict the future, but instead calculates the probabilities of different possible futures. To do this it needs to simulate random events, and make projections into the future over and over again. The outcomes will be different each time: some will be better than average, some worse. But with enough projections it’s possible to assess the risk of bad outcomes, and the likelihood of good outcomes.

Not all stochastic tools are the same, but they all avoid the folly of trying to predict the future with certainty. Some use the last 100 years of market data, simulating starting points at each of the last 100 years. One weakness of this approach is that it effectively uses a sample size of just 100, which is small from a statistical point of view. It’s also based exclusively on cases in which history repeats itself, which we know doesn’t happen in practice.

Other tools use Monte Carlo simulation. This is based on estimates of the probability distribution for one of more random variables. With this approach it’s possible to increase the sample size considerably, typically into the many thousands. This approach is therefore preferable, provided that the probability distribution estimates are soundly based and are consistent with history.

When choosing a financial adviser, we’d always recommend looking for one who uses stochastic tools for cashflow modelling.

Choosing a tool for personal use

Whether deterministic or stochastic, most tools used by financial advisers are expensive; and many are only sold to professional advisers. But there are many online retirement calculators available to the public. The ones provided by large financial product vendors tend to be over-simplistic, and are primarily designed to encourage you to use their services.

There are a few independent tools available that do a better job than the simplistic calculators. But most of these are deterministic, which we believe is a major flaw. When we designed our own online calculator, our goal was to replicate the power of professional tools, but present it in a way that anyone could understand. This is not meant to deter users from seeking professional advice; it’s meant to enable users to engage more productively with their advisers from a position of knowledge.

A unique feature of EvolveMyRetirement® is its ability to optimise your plan. It doesn’t tell you what investments to make; but it does help you with things like a drawdown strategy, investment risk and (most importantly) how much discretionary spending you can afford. You can compare this with your financial adviser’s suggestions, which should be an invaluable cross-check.

Can You Predict Your Financial Future?
Tagged on:             

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.

Follow Us: Facebook X (Twitter) LinkedIn