How do we do it
When we risk rate a fund for income, we stochastically look at the sustainable income it could produce for 25 years and use the 500th result, which is the 1:2 chance.
At the same time we project forward three years and re run the same stochastic calculations and then use the 250th result, which is the 1:4 chance.
We then take these two sustainable income figures and from the difference we work out the risk rating.
For example:
A fund can produce an income with a 1:2 chance of £10,000pa.
After three years looking at the 1:4 chance, the possible income has reduced to £9,000pa.
That 10% drop is then used with the Risk levels that you are using, to provide a risk rating.
Why do you use three years to reassess?
We decided on three years as this seemed a sensible time period over which a review should be made. One year didn't seem long enough and five years too long. It also is in line with the Government Actuary Department(GAD) limits being reviewed every three years.
Why do you start with the 1:2 outcome and compare to the 1:4 outcome?
The reason for this is that we are trying to realistically show what the sustainable income could reduce to. We could have used the absolute worst outcome, but as this has a very low probability of happening we had to choose something that could happen, hence the outcome which has a 25% likelihood of happening.