The use of stochastic models is a more effective method in addressing issues such as longevity and sequencing risk when attempting to formulate optimal financial plans for individuals in retirement, according to a specialist SMSF actuary.
“Stochastic models are ones that tell you about the range of outcomes you might experience [in retirement]. It consists of several thousand ‘what if’ scenarios against each of the unknown risks,” Bendzulla actuarial analyst Melanie Dunn told delegates at the 2014 SMSF Professionals’ Association of Australia State Technical Conference in Perth last Monday.
“So stochastic models are a way to stress test a household’s retirement objectives.
“Instead of modelling just one set of assumptions, they look at the range of outcomes likely across each of the unknown risks.”
Due to its multi-scenario approach, Dunn said that type of modelling allowed financial advisers to better understand the full range of outcomes their clients might experience and in turn would help them address issues such as outliving one’s savings and the effect of significant poor market performance.
She stressed stochastic models were far more robust than the deterministic models most advisers were still relying on to predict what might happen to their clients during retirement.
“They involve setting a constant fixed set of assumptions that are assumed to be achieved each year off the forecast of our models,” she said.
“The benefits of using these simple fixed assumptions is that it’s quite easy to develop a model of retirement to illustrate a scenario to our clients.
“However, we know retirees are facing complex decisions that affect their quality of life, so we need more robust and holistic models that can assess Australia’s retirement system and enable retirees to assess whether they can meet their retirement objectives.”
