Yet it is not always the case that an annuity will cover all of a client’s income target. For example, Charlie is also 60 with a £500,000 pot and the same £16,000 income target. Charlie chooses to buy an annuity with the whole pot as a cautious investor. In this scenario, there is not enough to cover all expenses in any year. But whatever happens to markets, even in the worst-case, 80 per cent of expenses are met.
To recap, when you look at the worst that could happen, the ‘materially detrimental effect’ is a lot bigger for Archie than for Charlie.
This expenses-met measure allows you to understand the worst drop and put a number on how it will affect the client. But when the client does have enough money, is it only just enough or is there sufficient to cover large potential issues? That is where the next process comes in.
Asset adequacy
You can look at the impact a single fall in value would have on a client’s assets, but this still only looks at one scenario and is highly dependent on the assumption about size and timing of a drop.
By using a stochastic/Monte Carlo forecast and backsolving to find the value you need in each product to give you sufficient probability of meeting your expenses, you can identify how good a plan actually is.
Asset adequacy is therefore the proportion of assets a client has compared with the assets they need, so that their expenses are met with a sufficient probability.
Here are a couple more examples:
Doreen has a £750,000 pot. Based on the same circumstances as the previous examples, she can cover her expenses with more than 95 per cent likelihood, and even in the worst year, 100 per cent of her expenses would still be met. However, we calculate that she has 107 per cent of the assets that she needs to meet her £16,000 target income with a good probability. That’s positive. But what if she experienced market falls of more than 7 per cent in a year? Doreen’s adviser would want to make sure they set her expectations appropriately for the worst-case scenario or change the plan slightly to give a higher figure for asset adequacy.
Eric has more money again – a £1m pot. Based on the same criteria as previously, his asset adequacy comes out at 143 per cent. This is great for Eric, and his adviser can set Eric’s expectations on that basis.
As well as helping you to set client expectations, this measure (combined with the other metrics) allows you to track asset adequacy over time and see whether a client’s assets are keeping up with their income requirements or not.
