It is also worth bearing in mind something called dynamic correlation. For example, if you have a booth next to a beach, you can sell both umbrellas and ice cream – it does not matter what the weather is doing, you will still make sales. That is diversification. But dynamic correlation is when the diversification effect is reduced as factors move in the same direction, such as no one turning up to the beach at all. The downside of dynamic correlation often happens in times of crisis, where when one thing goes wrong, pretty much everything goes wrong, and your diversification does not work as well as you thought it would.
The other thing to think about is annuity pricing. Again, deterministic assumptions tend to be based on current yields. But as we know, it is a yield 'curve' rather than a flat line, which means you have to consider how the annuity prices will change in the future.
So it is worth being aware of those limitations and building in some inherent randomness or uncertainty through stochastic/Monte Carlo modelling.
To get to a probability, we run 1,000 simulations. If there is an expense shortfall each and every time, the probability is then less than 5 per cent. Clearly, this indicates there is not any capacity for loss for this person. Likewise, if there is a scenario where expenses are met every year, and this is run 1,000 times, you end up with a more than 95 per cent likelihood that expenses will be met. More often, the result will be somewhere in between and then there is a decision as to whether the chance is sufficient for the client to be happy.
These results can be combined with the answers from the client and the fact-find to give you a capacity for loss figure. But it does not show how much spare capacity there is or how big the potential issue is. For that, we need another metric.
Expenses met
For this measure of capacity for loss, once you have understood whether a client could meet their standard of living, it is about identifying how good or bad the situation is. For example, would they fail to meet any of their expenses or, could they meet, say, 80 per cent? What is the worst that could happen? Let us look at some examples:
Archie is 60-years-old, has £500,000 in his pot and wants to take £16,000 income through drawdown. Taking an average outcome, with a 50 per cent chance of getting less than the target income, 75 per cent of essential spending is covered. So far, so good. But given there is only drawdown and no secure income, once the money runs out there is nothing left at all. As a result, none of the expenses from that point forward will be covered.
