The financial planning and advice industry is undergoing a period of significant upheaval. Poor market performance and ongoing market volatility continue to highlight the significant risks that investors face as they approach retirement. With the transition to defined contribution retirement savings schemes, now more than ever investors have the need for holistic financial advice to help them make the right decisions during both the wealth accumulation and post retirement phases.
Advisors are having to understand new product innovations that are designed to meet the changing needs and risk preferences of the market. At the same time, the government is forcing change on the industry through the move away from commission based sales towards fee for advice business models. As a consequence, financial advice frameworks, tool and business models are undergoing revolutionary change.
We at Milliman are actively working with advisors, financial advice networks, platform providers, distributors and product providers such as insurance and asset management companies to implement these frameworks, tools and new business models.
Current planning and illustration frameworks are lacking
The financial planning advice frameworks in popular use today have been developed largely to meet the needs of the wealth accumulation market. After all, this has been the defining need of the baby boomer generation over the last 30 years, in conjunction with the move from state sponsored to private retirement provision systems. These frameworks and the investment philosophy underlying them are primarily focused with the single objective of maximising financial wealth at retirement. Current financial illustrations tend to focus primarily on the build-up of wealth in the pre-retirement phase, with little to no focus on risk.
When it comes to the concept of risk, this has typically been defined solely in terms of the volatility of returns of the portfolio, with the implicit assumption being that investors have symmetric risk preferences. However the limitations of these assumptions, concepts and objectives have been radically and painfully highlighted over the last few years.
The 2008-2009 market experience showed that consumers and investors are significantly more averse to negative returns than they are to positive returns. Those nearing retirement felt this more than most as a 20% fall in their retirement pots combined with historically low interest rates, has led them having to revaluate their working retirement date and retirement income and thus lifestyle expectations. Clearly the concept of risk to such people needs to consider all those factors that can influence whether they are likely to achieve their retirement lifestyle objectives, not just the volatility of returns. This includes the risk of equity markets and interest rates falling (leading to a reduction in sustainable post-retirement income), the risk of living longer than expected or outliving ones partner, the risk of inflation reducing future purchasing power, the risk of deteriorating health, and the risk of having insufficient liquid funds to deal with an emergency. With many of these elements traditionally ignored by financial planning frameworks, investors and their advisors have struggled to adapt with prevailing market conditions. However this is now changing, with Milliman being at the forefront of developments in this field.
A new holistic and risk focused framework is required supported by appropriate analytics
A new holistic framework is needed to address the above limitations. Such a framework needs to consider the full financial lifecycle of a person, rather than just a single dimension such as pre-retirement financial wealth. The figure below illustrates the components of the holistic lifecycle framework as developed in the Milliman research paper "A Holistic Framework for Life Cycle Financial Planning."
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The central feature of the framework is the transition of human capital into financial capital which acts as the medium for the transfer of consumption from the pre-retirement to the post-retirement phase. Human capital represents the economic value of a person and can be measured in terms of the present value of the sum of a person’s expected future after tax income. Human capital is the asset that is protected when a person buys a traditional term or whole of life insurance product. It is also the asset that provides security to a bank when a person takes out a loan or mortgage. It's value is determined by education and work experience, and like a car, it depreciates over time if not maintained. Most importantly, it provides a natural limit on total income and consumption over both the pre and post retirement phases, notwithstanding the potential impact of extreme investment strategies.
This framework enables a person's lifestyle goals to be framed in terms of the income required to support the consumption patterns. This then enables various investment and insurance strategies to be analysed in terms of their ability to generate the income required, as well as the risks the person is exposed to. Such risks include not just market risks, but also inflation risk, employment risk, mortality/longevity risks, health risks, behavioural risks and legislative risks. In this way, a person is able to understand and assess benefits, costs and risks as they directly relate to their lifestyle consumption goals.
In order to communicate the potential outcomes and risks of each potential strategy, it is necessary to move beyond the traditional deterministic projection tools to more sophisticated stochastic based ones. These tools illustrate the range of potential outcome over a large number of random scenarios of market returns and interest rates. This enables the impact of asymmetric benefits to be clearly illustrated and assessed, such as those provided by guarantees or protected products. These illustrations can be for both wealth accumulation and income generation products, and facilitate direct comparison of one strategy or product against another. The figure below provides an example illustration of the 10th, 50th and 90th percentile income outcomes for a GMWB for life product relative to a systematic pension withdrawal product. 1
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Importantly, whilst the tools used to do this analysis are necessarily more sophisticated than what is currently used, the presentation and communication of results can be made to be very intuitive and easy to understand by the advisor and consumer. Indeed, the presentation and communication of financial outcomes and how these influence the decision making process is a topic of considerable complexity. However significant advances have been made in recent years in this area, with insights in the behavioural finance field providing guidance as to how the industry can best address these issues.
Implementing the next generation of solutions
The adoption of a holistic framework will facilitate the transition towards fee for advice business models. It provides advisors with the ability to align the advice process directly to customer needs, not just what they are now, but with a clear view as to what they are likely to be in the future. It thus enables advisors to establish and foster long term relationships with their clients, to address their needs and risks before they become problems, to establish regular dialogue via periodic reviews, and to deal clearly and calmly with the financial consequences of events relative to the plan established to deal with the risk.
The use of planning and illustration tools is becoming central to the advice process, as it not only aids in the communication process, but it also helps demonstrate the value the advisor adding, thus earning their advice fee. The current standard for delivery and use of these tools is via the web, provided on an outsourced basis. This enables the centralisation of the expertise needed to build, implement and maintain and software and hardware infrastructure, thus alleviating the burden of this activity from the advisor, distributor and product manufacturer. Milliman is a market leader in this field, having the tools, systems, and expertise necessary to deliver a solution to meet the specific needs of advisors, distributors, and product providers. We have the ability to offer bespoke solutions to meet your internal needs, as well as completely hosted solutions requiring minimal technology integration with your business.