CheckRisk, the UK-based risk consultancy with an Australian office run by former super fund CEO Denis Carroll, has published new research on post-retirement modelling that shows just how much retirees are likely to fall short of their goals.
Ross Pepperell, director of research at CheckRisk, who led the research team on the project says: “Our research has exposed that there is a significant risk of retirees running out of money before death – the ‘Death or Bust’ problem.
“Urgent attention is required by the industry and regulators to deal with the cause of this fundamental problem by considering the current methods used by the financial industry in post-retirement calculations.”
Nick Bullman, founder and chairman of CheckRisk, and a frequent visitor to Australia, said: “There is too little or no pre-retirement interaction with advisors and yet retirees are then expected to be fully informed rational investors post
retirement. With an aging population the risk of surviving longer than your pension pot is increasing.
“The use of non-fit for purpose models to calculate post retirement funding is common place. Retirees must be made aware of the issues in terms that allow them to make responsible and informed investment decisions.”
The issue is pressing as the population ages, and greater numbers reach over 90 years old. According to a UK Government paper, between 2015 and 2020, a period when the general population is expected to rise 3 per cent in the UK (and more than that in Australia), the number aged over 65 is anticipated to increase by 12 per cent (1.1 million). The number aged over 85 will increase by 18 per cent (300,000) and the number of centenarians by 40 per cent (7,000).
Early findings from the report show:
- There are various techniques used to plan for income in the post-retirement years. Some of the models are not fit for purpose and may be giving a false sense of security. A lack of consistency exists across the pension planning industry.
- Simple methodologies and rules of thumb lead to poor outcomes. Specifically deterministic projections that use fixed rates of return (for example a 5 per cent constant rate of fund growth) for illustrations do not adequately express the risk to clients and may give a false sense of security.
- Simple analytic formula and historical backtesting are poorly suited to income risk modelling as they are unable to accurately model the stochastic nature of portfolio returns by underestimating the risk (probability) of ruin (running out of money) and the age at which this happens. In the case of analytic formulae, they are too simplistic and distort the perception of reality in to predictable behaviour by the use of average returns. The world does not work like this.
- As for historical backtesting, one issue is that you have no way of knowing whether the future will be like the past – so-called ‘Knightian uncertainty’. The other issue is that backtests can be manipulated to give results that suit the experimenter’s own bias. This may be subconscious, but is easily and commonly done. The sample size on which the backtest is performed is key.
- Both of these methods also do not take into account the ‘sequence of returns’ risk. This is the risk of achieving a string of poor returns, especially in the first 10 years post-retirement, that has a significant impact on the size of the pension fund and future expectations of income. In the case of historical backtesting, you only see the sequence of returns of the past. Unfortunately, both of these methods are still routinely used and misused in the financial industry.
- The risk to retirees of surviving longer than their pensions appears to be much higher than previously estimated. § Product providers have a role in innovating new ideas to help clients and advisers to achieve better outcomes, and in mitigating these risks.
- The consequences to society of getting post-retirement income calculations wrong are severe.
- Regulators should, as a matter of urgency, set model boundaries within the current framework of competition, to ensure that the risks to retirees are not being misrepresented. Regulators may wish to review the use of non-fit for purpose methodologies which are in use and often common place.