Stochastic modelling and asset allocation after the crashChair: Rob HicksonIntermediary Sales Director, Prudential

Philip MowbrayHead of Product Risk, Barrie & Hibbert

Stochastic Modelling Post-2008Did we spot a Black Swan?Philip MowbrayHead of Product Risk, Barrie & Hibbert

Stochastic Modelling…

Stochastic Modelling – What is It?

• A stochastic model generates possible paths for the future behaviour of economic variables and asset returns, and assigns reasonable probabilities to each of these paths

• Modelling relationships between key risk factors:– Interest rates

– Inflation

– Credit default events and credit spreads

– Asset returns

– Currencies / FX rates

Stochastic Modelling – What is It?

Stochastic Modelling – What is It?

Stochastic Modelling – What is It?

…if your fund performs poorly, your income may fall to half your target level (£10,000 pa)

The path or sequence of these returns is key, not just the final outcome!!

…You have a 75% chance of meeting your target retirement income of £20,000 pa.

Stochastic Modelling – What is It?

Sequence of Returns Risk - Example

• Age 65 retirement fund £100,000

• Withdrawing income at £9,000 pa

• At what age will the money run out?

9

Sequence of Returns RiskReturn Sequence Ruin Age +/- months

Constant average 86.50

7%,-13%,+27%.... 83.33 -38

7%,+27%,-13% …. 89.50 +36

-13%,+7%,+27%... 81.08 -65

+27%,+7%,-13%... 94.92 +101

14 Year Gap

Why Stochastic Modelling?• Traditional asset

allocation cannot hedge all this risk

Why Stochastic Modelling?• Traditional asset

allocation cannot hedge all this risk

• Downside risk protection needed…

Why Stochastic Modelling?• Traditional asset allocation

cannot hedge all this risk

• Downside risk protection needed…

• Deterministic financial planning approaches don’t capture this risk

• Stochastic modelling is an essential tool for:

• Evaluating sophisticated product (risk-management) solutions

• Making appropriate product or investment decisions

Stochastic Modelling - Takeaways

• Most retail financial planning situations involve some sort of cashflow objective (contributions or withdrawals)

• Sequence of returns is key to understanding risk and return of different planning options

• Stochastic modelling is essential if retail advisors and customers are to make effective financial planning decisions

Reviewing Model Performance During and After 2008

Why is ‘Model Performance’ Important?• If the stochastic model does not assign appropriate

probabilities to extreme events (‘Black Swans’) then:

– When the model is used to illustrate possible outcomes, advisors and their customers significantly underestimate the potential losses in investment strategies containing ‘risky’ assets:

Customer makes inappropriate investment decisions:

• Strategic Asset Allocation

• Choice of product (e.g. Annuity vs. Drawdown vs. Third Way)

Customer experiences actual fund return below ‘Worst Case’

Model Review - Case Study (1)Asset Allocation

Stochastic Models During 2008 Case Study (1): Asset Allocation• Customer investing £100,000 on 31 December 2007

• Objective to repay mortgage of £125,000 in 5 years

• Financial planning requirements:• Targeting total return of 5% pa over 5 years

(i.e. Fund Value > £125k approx.)

• Client will tolerate maximum loss of 20% in any year

• Client expects very high chance (95% +) of getting money back

• Choosing between two investment strategies:

Strategy A Strategy B

Fixed Interest 80% 40%

Equity 20% 60%

Stochastic Models During 2008 Distribution of Outcomes Based on B&H Model (end-Dec 07)

1 Year Worst Case outcome > 20% loss

Asset Allocation A: 5% chance of loss

Asset Allocation B: ~15% chance of loss

Stochastic Models During 2008 Distribution of Outcomes Based on B&H Model (end-Dec 07)

Financial Planning Requirement: Asset Allocation A Asset Allocation B

Target fund value of £125,000 at 5 years

Max. loss in any year not to exceed 20%

< 5% chance of losing any money at 5 years

Stochastic Models During 2008 Did the model capture the 2008 event?

Stochastic Models During 2008 Did the model capture the 2008 event?

The B&H model assigned ~5% (1 in 20) probability to 2008 equity event

Stochastic Models During 2008 How did 2008 impact projected outcomes?

Entire distribution is lower for both Asset Allocation A and Asset Allocation B

lower interest rates

Stochastic Models During 2008 How did 2008 impact projected outcomes?

Downside risk at 1 year term has increased for Asset Allocation B

Higher short-term equity volatility at end Dec 08

Stochastic Model ChoiceAre All Stochastic Models Using Similar Assumptions?

Stochastic Model ChoiceAre All Stochastic Models Using Similar Assumptions?

Stochastic Model ChoiceAre All Stochastic Models Using Similar Assumptions?

Does the Model Matter?

Case Study (2): Retirement Planning

Case Study - Retirement Product ComparisonIncome Profiles at Age 75 (60 Year Old Retiring 31 December 2007)

Risk to income (value of guarantee)

is very different under these two

models

(one year on… at end 2008)

There is now a ~25% chance of

ending up with an income less than

£35,000

‘Worst Case’ outcome has fallen

from £35,000 to less than £25,000

Stochastic Models After 2008Conclusions

Stochastic Models After 2008• Most retail financial planning cases involve complex risks…• A robust stochastic projection model is…

– The only reliable way for investors to understand risk and make informed decisions– An essential tool to ensure robust financial planning

• A robust stochastic model should…– Have assigned a reasonable probability to the events in 2008– Assign a reasonable probability to other extreme events in future

• The impact of using unrealistic modelling assumptions is ‘wrong’ investment decisions– Painful outcomes for customers– Potential miss-selling problems for advisors

• The regularly updated calibration of a stochastic model involves significant volumes of market data, and specialist expertise

Questions?

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