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      How do you risk rate a fund for income?

      Stage 1 – The process

      1. Run 1000 economic scenarios to find the “median sustainable income*” over 25 years.
      2. Review the position after 3 years of the median sustainable income taken to see how much it might drop
        1. Re-run to find the new sustainable income based on a poor outcome for the remainder of the term (now 22 years) for which we mean the 250th worst result or equivalent to a 1 in 4 chance.
      3. Thirdly, work out the “Income at risk” by calculating the percentage drop between the two incomes.

      Definitions:

      • Median is the 500th result after the 1,000 possible outcomes in 1. have been ordered, or the equivalent to a 1 in 2 chance of that level of income
      • Sustainable income means the amount of income, before tax, that can be taken from a fund each year so that there is a 1 in 2 chance that all the money is used by the end of the term.

      An example:

      1. A fund worth £100,000 is calculated to produce an income with a 1 in 2 chance of £4,000pa.
      2. Three years later, £12,000 in total has been taken from the fund - look at the “poor outcome” (1 in 4 chance) - the new sustainable income has reduced to £3,500pa for the remainder of the term.
      3. The “income at risk” is the 12.5% drop from £4,000 p.a. to £3,500 p.a.
      4. This will be compared with the Risk benchmarks that you are using, to provide a risk rating for the fund.

      Question 1 - Why do you use three years to reassess?

      Answer 1 - It is in line with the Government Actuary Department (GAD) Drawdown limits being reviewed every 3 years.

      Question 2 - Why did you decide to compare to the 1 in 4 rather than the 1 in 20?

      Answer 2 - The 1in 4 is chosen rather than a 1 in 20 as it removes extremes and is more likely to happen. It sets the expectations for the client that a downside could happen for them as it has a 1 in 4 chance of happening.

      Question 3 – what “Risk benchmarks” should we consider using?

      Answer 3 – The funds need to be aligned to income risk profile benchmarks. These look at the potential drop in sustainable income and will vary from no drop on a suitable guaranteed income product through to the highest drop on a high-risk fund.