Clients tend to view the value of the proprietary Fowler Drew modelling as a function of the stage they are at in life, rather than whether the economic or capital-market context is one that makes decisions easier or harder. As model builders, we know that the context in which financial choices must be made can be just as important. This has been the case for much of the time we have been helping clients plan their goals, in an environment where the real risk-free rates that competed with equities were very low, eventually reaching -2%. In just over one year, rates have moved back to over 1%. This makes a big difference, at almost any life stage, to goal planning.
Until the recent normalisation of real rates, market conditions made high-level financial decisions unnaturally easy. That was probably a function of the unorthodox monetary policy known as Quantitative Easing (QE). For new Fowler Drew clients planning spending goals since the Global Financial Crisis, and particularly more recently when real risk-free rates were negative, there was virtually no constraint on how much risk to take, other than how much volatility they could tolerate. That aberration is over, killed by higher risk-free rates.
It is back to the ‘old normal’, where decisions are harder, involving much tougher tradeoffs for investors trying to satisfy their financial objectives without breaching downside constraints or assigning more resources. As a general principle, this means the potential value of modelling will be greater, not less.
The change in context will certainly affect clients more where they have choices to make that have significant consequences, and that is often a function of the stage of life they are at. But only young accumulators, and ‘surplus’ goals managed for the next generation, are likely to be immune from tradeoffs involving risk and resources. Everyone else is necessarily engaged in a continuous process of rebalancing not just their portfolio but the plan itself, a process which will be informed by the numbers generated by our modelling. Whether in accumulation or already in draw, what we call ‘spending goals’ need to be reviewed, in case choices that were made when tradeoffs were exceptionally easy are no longer optimal.
In the attached paper we sent to clients, Financial planning just got harder, we illustrate the scale of the change using an updated version of our ‘breakeven year’ chart, showing the number of years away where the ILG yield, being the true real risk-free rate for clients with real-terms wants and needs to fund, is equal to or exceeds the worst-case expected real equity return. We defined ‘worst-case’ as the time-dependent return at the 95th percentile. Having dropped to an exceptional 7 years, it is now back to 15 years. The ‘normalised’ breakeven year (assuming all markets and currencies are fairly valued and a normal ILG yield of 1%), is 25 years. In other words, only liabilities greater than 25 years out can be matched with equities without risk of shortfall against the risk free rate. In fact, at 25 years the current ILG yield curve has a rate of 1.45%, higher than our historic assumption of normal real yields. This makes sense given the deterioration in public finances since the Global Financial Crisis and Covid but may also reflect the planned change to using CPIH instead of RPI for inflation indexation.
In the paper we point to some of the other exceptional welfare gains that were available that capital markets would not normally permit and were only available in part because of government intervention in the form of QE. They include Defined Benefit pension transfers (about which we wrote much here at the time) and lifetime mortgages.
QE also led us to make some changes in the risk-free portion of our portfolios that hold both risky assets (bets) and risk-free assets (hedges). Depending on the level of risk aversion, short- and some medium-duration cash-flow liabilities (planned spending or draw) call to be matched by risk-free assets. Normally we would hold ILGs as the matching risk-free asset, for their inflation protection, for duration beyond about 3 years. With QE we held much more in cash form, up to about 7 years. For the last year or so, there has been no reason not to match all but the shortest of liabilities with ILGs and even short-dated nominal gilts have been a good substitute for cash.
The article is quite highly specific to our liability-based approach to planning and managing goals and to the use of models. This has proved an approach ideally suited to the unusual conditions in capital markets over the last 15 years.