Written by Chet Velani, Managing Director at EV
Chet Velani, Managing Director of EV, considers the growing importance for advisers to stress test financial plans in light of the ‘avoiding foreseeable harm’ requirement of Consumer Duty.
Our brain makes around 35,000 decisions each day. Some of these are simple and straightforward considerations, such as ‘what’s for lunch?’ Every now and then however, we make more material decisions, such as the purchase of a new car, where there are several questions that we may ask ourselves before buying – e.g. ‘how reliable is the car?’ ‘Petrol vs diesel vs electric vs hybrid?’ ‘Will it support a growing family?’ ‘What is the depreciation likely to be?’ ‘What will the insurance costs be?’ ‘What are maintenance costs likely to be over the time of ownership?’ Essentially, we are stress-testing the purchase across several different considerations – some of which are currently unknown, for which we make assumptions.
Although the questions are different, when creating a real-world financial plan there’s a long list of considerations that should be factored in, some of which we mention below, and this is exactly the message being pushed out by the FCA, namely that stress-testing financial plans should be considered a vital component part of the advisers’ Consumer Duty.
It stands to reason that when advice firms undertake planning for the future, with investors’ financial well-being at the centre of everything, they must consider how things may evolve in the future, including things which could go wrong. And determine what potential scenarios should be included when discussing investment approaches and options with their clients. Investment decisions are founded on realism, with the client better informed about the risk-versus-reward pivot underlying each option.
This is how stress-testing financial plans helps the client and the firm. It is bound up with avoiding foreseeable harm, which, as the regulator has made clear, is focused on the need to take account of what can be anticipated today rather than harm that happens to occur down the track that is genuinely impossible to foresee.
The next question is how does the adviser stress-test possible scenarios while collecting important evidence showing they have considered foreseeable harm and taken steps to reduce risks to client outcomes? As with numerous aspects of professional advice these days, the answer is found in technology.
Brain versus machine
Of course, it would be so easy and stress-free if advisers could rely on human brainpower to predict the future of financial performance based on what’s happened in the past. Drawing on the past does have its merits. But a quick study of the enormous range of market variables and happenings over past decades demonstrates how rapidly one would be overwhelmed in considering “everything possible everywhere” when conducting financial planning.
At the heart of any robust financial strategy is, of course, accurate forecasting, along with frequent reviews. Some client objectives, particularly a comfortable retirement, require advisers to look many years, often tens of years, into the future for their clients, making assumptions about those changing variables such as investment volatility, interest rates and inflation. The accuracy of these forecasts is crucial in helping clients understand what action needs to be taken today to reach their financial goals ‘tomorrow’. Hence the reason the best forecasting models have had to become more technically sophisticated – moving far beyond the computing capacity of our personal grey matter.
We only need to cast our minds back a couple of decades to remember when investment illustrations used nominal fixed growth rates to indicate to clients what their investments might be worth five, 10 or 20 years down the line. This was unsatisfactory, as history tells us that investment growth is far from linear. The inherent nature of asset-backed investments means volatility will always lurk if not currently present. Therefore, if we want to ensure clients are serviced fairly, any forecast made on their behalf should include a degree of randomness to closely mirror the real behaviour of national economies and financial markets.
This is where forecasting models that are significantly more sophisticated than the outdated linear approach come in. The most advanced of these are ‘stochastic’ models, which employ an element of real-life unpredictability and randomness to predict potential outcomes. If the term stochastic jars with you, just think of it as ‘realistic’.
Getting realistic about risk
The upshot here is that while it’s impossible to know for sure how the future will unfold, the right stochastic forecasting tool should consider hundreds of potential outcomes, allowing for various potential factors such as market crashes, periods of high inflation and interest rate variability, to name a few. This helps to understand how a client’s specific portfolio would hold up should certain what-if scenarios occur. And stress-testing clients’ investment choices because of these various risk-laden scenarios can go a long way in justifying their choices – or signposting alternatives.
By crunching multiple potential scenarios, the tech behind the tool sheds light on a client’s capacity to bear financial loss. The great thing about such an advanced cashflow model is that these what-if scenarios can be baked into the assumptions, with their potential impact properly stress-tested on the client’s portfolio.
A last word for now
Over the years, we’ve seen an increase in the number of advisers using stochastic modelling to create realistic plans. However, there are some barriers for others owing to their familiarity with more commonly available deterministic models. As an advocate of stress-testing, especially as it is greatly helpful under Consumer Duty, I would like to see more information flowing to the profession about the usefulness of stochastic (a.k.a. realistic) forecasting tools as part of the advice sector’s endeavour to be as real-world as possible when discussing potential investment and retirement outcomes with clients.
It’s all about avoiding foreseeable harm backed up by evidence.
