SCOTTISH WIDOWS RETIREMENT PORTFOLIO FUNDS GUIDE TO BACK-TESTING AND MODELLING MANAGING SIGNIFICANT VOLATILITY TO HELP A PENSION POT LAST LONGER This information is for UK financial adviser use only and should not be distributed to or relied upon by any other person.
ANALYSIS OF HOW THE RETIREMENT PORTFOLIO FUNDS COULD RESPOND TO DIFFERENT MARKET CONDITIONS The Scottish Widows Retirement Portfolio Funds have been designed to manage significant market volatility to help a pension pot last longer. As part of the design process, the funds were tested against different historic market conditions as well as thousands of potential future scenarios to see how the funds might cope with different situations and affect the outcome for investors. The back-testing looked at a range of different historic market conditions, including some of the biggest market events in the last 20 years. This was to see how a fund with Dynamic Volatility Management (DVM) might have compared, if it had been available at the time, to a fund with the same asset allocation but without any volatility management. The testing of future outcomes used stochastic simulation to assess how a fund with DVM would compare with an equivalent fund without volatility management in 5,000 different potential scenarios. The funds are designed to be used by clients in drawdown, so the analysis assumed money would continue to be withdrawn from the fund regardless of prevailing market conditions. Although the DVM only applies to the equity allocation of the Retirement Portfolio Funds, these modelling and back-tested scenarios looked at how the overall fund with and without DVM might have performed, depending on differing returns from differing asset classes. 1
BACK-TESTING BACK-TESTING AGAINST HISTORIC MARKET CONDITIONS The following scenarios show how a fund with DVM would have compared to a fund with the same asset allocation but without DVM. The fund used in these scenarios is the Retirement Portfolio 50-80 Fund, which currently has 70% allocated to equities and the remaining 30% allocated to corporate bonds. This fund was chosen because we believe its asset mix means it is likely to be of interest to a number of potential clients using income drawdown, and the large equity allocation is better able to demonstrate the impact of the DVM. The modelling assumes a client has a starting fund of 100,000 and withdraws 4,000 in the first year, with the amount withdrawn rising according to the rate of inflation at the time. The performance figures include an annual charge of 0.2% for the fund with DVM. The assumed charge for the fund without DVM is 0.1%, which is the annual fund charge for a client invested in Pension Portfolio Funds through Retirement Account. No product charges have been taken into account for these calculations. Each Retirement Portfolio s asset allocation is the same as the equivalent Pension Portfolio Fund, making this comparative modelling as accurate as possible. The fund used for these illustrations is the Retirement Portfolio 50-80 Fund, which currently has 70% allocated to equities and the remaining 30% allocated to corporate bonds. The modelling assumes a client has a starting fund of 100,000 and withdraws 4,000 in the first year, with the amount withdrawn rising according to the rate of inflation at the time. 2
THE DOT.COM BUBBLE At the end of 1999, stock markets around the world hit valuations they would not see again until 2015, driven by what we now know to be the sky-high valuations of the new generation of internet companies and overly optimistic estimations of future earnings. When the market euphoria evaporated during 2000, a prolonged sell-off in equities saw many stock markets lose around 50% of their value over the next three years. The chart below shows the period between January 2000 and January 2004, which includes the biggest losses during 2001 and 2002. The graph shows how a fund with DVM could have compared to the performance of an equivalent fund without DVM. The periods of significant volatility are shaded in pale orange and indicate how much of the equity content would have been de-risked. The Dot.Com Bubble 120 100 100% Fund Value,000 80 60 40 1 80% 2 60% 40% % Equity De-Risked % Equity De-Risked With DVM Without DVM 20 20% 0 0% Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 During this four-year period, the FTSE 100 fell 50.4% before recovering to end the period down about 36% from its peak. At the lowest market point, a fund with DVM which started this time period with a value of 100,000 would have had a value of 77,470, after charges and income withdrawal. A fund without DVM would have had a value of 63,711. At the bottom of the market in March 2003 (marked as 1 in the graph), the fund with DVM would have been worth 22% more than the equivalent fund without volatility management. The fund without DVM would have recovered its value faster than a fund with DVM and by the end of the period the difference in value between the two funds would have been 9% (2). The total actual income taken from each fund over the 4 year period would have been 16,664. 3
THE GLOBAL FINANCIAL CRISIS Another stockmarket crash was caused by the Global Financial Crisis, where between October 2007 and March 2009 the FTSE 100 dropped 45% in less than 18 months. The graph below shows how a fund with DVM might have performed compared to a fund without DVM during this period. The speed of the market crash in October 2008 means the DVM would not have been triggered initially and both funds would have seen a similar initial drop in value. Events show that as the sell-off continued the fund with DVM would have had a reduced loss compared to the worst of the drop in value. When the market hit its lowest value, in March 2009 (3), the fund with DVM would have been worth 15% more than the equivalent fund without volatility management. The sharp recovery in the value in equities accompanied by high levels of volatility means the fund without DVM would have seen a faster recovery in its value than the fund with DVM (4). The Financial Crisis 120 100 80 100% 4 80% Fund Value,000 60 40 3 60% 40% % Equity De-Risked % Equity De-Risked With DVM Without DVM 20 20% 0 0% 01/07 05/07 09/07 01/08 05/08 09/08 01/09 05/09 09/09 01/10 Income withdrawn from each fund would have been 12,595 and at the end of this period the fund with DVM would have been worth 67,872, while an equivalent fund without DVM would have been worth 77,914. 4
A STEADILY RISING MARKET When there is no significant market volatility, we would expect the funds to behave in a similar manner to equivalent funds without DVM, because the DVM would not be triggered. We would therefore expect them to follow the general market trend, whether that is a steady decline in values or a steady increase. This is because, when volatility is more stable and within acceptable limits, the DVM process effectively remains dormant. In the example below, between August 2012 and November 2015 equity markets grew steadily while volatility remained low. As shown below, as the DVM was not active, the fund with DVM would have tracked the performance of the fund without DVM. A Rising Market 130 120 110 With DVM Without DVM 100 90 08/12 11/12 02/13 Fund Value,000 05/13 08/13 11/13 02/14 05/14 08/14 11/14 02/15 05/15 08/15 11/15 Over this period the total withdrawal from each of the funds would have been 14,117. As DVM would not have been active, the only difference in performance would have been due to the higher charges of the fund with DVM. If both funds started this period with a value of 100,000, by November 2015 the fund with DVM would have been valued at 114,538 compared to 114,945 for a fund without DVM, a difference of 407. 5
THE LAST 20 YEARS The example below shows the possible performance of a fund with and without DVM between 1997 and 2017. This period included several periods of significant volatility, including the bursting of the dot.com bubble and the financial crisis from late 2007 to 2009. The periods of volatility highlighted in orange show the percentage of equity de-risking that would have happened as part of the DVM mechanism. This scenario shows the possible outcome for someone who entered drawdown in January 1997. If drawdown commenced at a different date the investor could have experienced a substantially different outcome. A 20 Year History 250 200 Fund Value,000 150 100 100% % Equity De-Risked % Equity De-Risked With DVM Without DVM 50 50% 0 0% 01/01/1997 01/01/1999 01/01/2001 01/01/2003 01/01/2005 01/01/2007 01/01/2009 01/01/2011 01/01/2013 01/01/2015 01/01/2017 Over the course of 20 years a total of 108,942 would have been withdrawn as income from each fund, with both funds ending the period with a considerably higher value than at the start. The fund with DVM would have had a value of 197,000 at the end of the 20 years and the fund without DVM would have been worth 15% more at 227,000. While the fund with DVM would have ended the period with a lower value, the table below shows DVM would have reduced overall volatility and helped to protect the value of the fund from the worst falls in value during the dot.com bubble and financial crisis. If drawdown had commenced shortly before one of these falls the investor could have a substantially different outcome, due to the effect of sequence risk. Fund with DVM Fund without DVM Net average annual return 3.36% 4.06% Average annual volatility 9.17% 11.75% Worst fall in value -22.06% -31.75% Table shows simulated past performance, not actual returns Data for period covering 1st January 1997 to 1st January 2017 Source: Scottish Widows 6
FUTURE SCENARIOS TESTING AGAINST POTENTIAL FUTURE SCENARIOS The back-testing looked at how a fund with DVM would have performed in specific historic market conditions. To take account of the wide range of potential future market conditions, the Retirement Portfolio Funds were tested in 5,000 theoretical scenarios involving varied investment market conditions and the performance of the different asset classes. As with the back-testing, the future scenarios here use the Retirement Portfolio 50-80 Fund. The same assumptions are also used, with the starting value of the funds at 100,000, with an annual withdrawal of 4,000 in the first year rising by inflation assumed to be 2% a year. The fund with DVM has a charge of 0.2% a year and the fund without DVM is assumed to have a charge of 0.1%. No product charges have been taken into account for these calculations. The modelling data, graphics and findings in this document are derived from stochastic modelling. This modelling used assumptions for long term returns on asset classes and levels of volatility. The assumptions used were Aberdeen Standard Investments standard assumptions. Each fund is made up of a combination of asset types, so assumptions for long term returns and levels of volatility were applied for each of these different asset types. The modelling results did not use a single overall growth rate for each fund and were not based on FCA growth rates so cannot be seen as an alternative to an illustration and should not be used as the basis for a client s decision. 7
EQUITY MARKET FALLS IN THE EARLY YEARS OF RETIREMENT Scottish Widows Retirement Portfolio Funds have been designed to help reduce the risk of investment losses during periods of significant volatility to a client in drawdown. This is particularly relevant in the early years of retirement because the potential sequence of returns risk can reduce how long a client s pension pot may last and their ability to sustain the withdrawals they require. The graph below shows the potential performance of a fund with DVM compared with a fund with the same asset allocation but without DVM. In this hypothetical scenario, representing a classic sequence of return risk problem, the funds see a fall in the value of their investments in the early years, followed by a second drop in value after around 10 years. Equity market falls in the early years 160 140 120 100 80 60 With DVM Without DVM 40 20 0 Feb-17 Feb-20 Feb-23 Feb-26 Fund Value,000 Feb-29 Feb-32 Feb-35 Feb-38 Feb-41 Feb-44 Feb-47 Both funds start with the same initial value of 100,000 and each sees withdrawals of 162,272 over the 30-year period. In this scenario, at the end of the 30-year period the fund with DVM would be worth 110,870, while the fund without DVM would be worth 52,198. The difference in value is 58,672. This is a clear example of the damage that could be caused by sequence of return risk and the long term damage early losses may have on the value of a pension pot, and how long it may last. 8
SIGNIFICANT FALL IN EQUITY MARKETS IN EARLY YEARS OF RETIREMENT The previous example shows how a fund with DVM could help protect the value of a client s investments during falling equity markets. This similar scenario shows a more significant drop in early retirement. A sharp fall in markets in the early years of retirement could have an even more severe impact on a client s ability to sustain the level of income they need and may result in a client s funding running out sooner than expected. The following scenario uses hypothetical data to show how a fund with DVM and one with the same asset allocation but without DVM could compare when faced with a significant drop in equity markets in the early years of retirement. Significant Equity market falls in the early years 120 100 80 60 40 With DVM Without DVM 20 0 Feb-17 Feb-20 Feb-23 Feb-26 Fund Value,000 Feb-29 Feb-32 Feb-35 Feb-38 Feb-41 Feb-44 Feb-47 In this scenario, the fund without DVM was exhausted after 23 years, while the fund with DVM lasted for more than 28 years, more than 5 years longer. This demonstrates the impact of reducing losses early in retirement. The total income withdrawn from the fund without DVM was 109,196 compared with 149,544 for the fund with DVM, a difference of 40,348 or 37% more. 9
STEADILY RISING MARKETS IN THE FUTURE The previous scenarios show how a fund with DVM could compare to an equivalent fund without DVM in volatile and falling markets. The scenario modelling also assessed simulated scenarios where investment markets steadily rise or fall, but are not accompanied by significant volatility. Historically steady market change has been accompanied by lower levels of volatility and the scenario below shows how a fund with DVM could behave when compared to an equivalent fund without DVM in these conditions. A Steady Rising Market (Simulation) 140 120 100 Fund Value,000 80 60 40 With DVM Without DVM 20 0 Jan-21 Mar-21 May-21 Jul-21 Sep-21 Nov-21 Jan-22 Mar-22 May-22 Jul-22 Sep-22 Nov-22 Jan-23 Mar-23 May-23 With volatility remaining within acceptable levels, the DVM would remain inactive and the fund with DVM would remain very similar to the fund with the same asset allocation but without volatility management. The difference in the two funds performance in this scenario is due to the higher annual charge for the fund with DVM (the fund with DVM is assumed to have an annual charge of 0.2%, higher than the 0.1% of the fund without DVM). At the end of this scenario the fund with DVM would be worth 119,466 (after income withdrawals of 4,000 in the first year rising by inflation assumed to be 2% a year and charges) while a fund without DVM would be worth 119,998. 10
A SUDDEN SHARP DROP IN VALUE While there are scenarios where the DVM could be effective, there are some situations where DVM would be less effective and in some cases would not work any better than an equivalent fund without volatility management. If a market fall happens very suddenly and has not been signalled by increased volatility beforehand, there would have been no alert (along with the rest of the market) to start the de-risking process. This means there could be a delayed start to reducing the equity exposure. A similar example from history would be the Black Monday stock market crash of October 1987. The hypothetical scenario below shows the potential comparative performance of a fund with DVM and a fund with the same asset allocation but without DVM. A Sudden Sharp Fall 120 100 80 60 40 With DVM Without DVM 20 0 Feb-17 Feb-20 Feb-23 Feb-26 Feb-29 Fund Value,000 Feb-32 Feb-35 Feb-38 Feb-41 Feb-44 Feb-47 The speed of the drop and lack of volatility in the run up means the DVM would have had no signal of increased volatility, and in this example would not be triggered until further into the equity market fall and both funds experience very similar drops in value. The fund without DVM would run out after 20 years and 16 weeks, while the fund with DVM would last 21 years and 7 weeks. The income taken from the fund without DVM would be 99,019, compared with 103,949 for the fund with DVM. 11
RANGE TRADING Another situation where DVM would be less effective is Range trading. This is when there is high volatility in equity markets over a prolonged period, but over that period markets neither trend upwards nor downwards. This is the key scenario in which there is a risk that the fund with DVM could underperform the fund without DVM. The following hypothetical scenario compares two funds with the same asset allocation and same income being withdrawn, one with DVM and one without DVM. The graph covers the funds during and after a period of around 10 years of range trading, a decade of significant volatility and a series of short falls and rises in value for equity markets. The period of range trading is highlighted. Looking at historic market data we have been unable to identify a particular time in history when markets have performed this way over an extended period of time, but it is a possibility. Range Trading 120 Range trading period 100 80 60 40 With DVM Without DVM 20 0 Feb-17 Feb-20 Feb-23 Fund Value,000 Feb-26 Feb-29 Feb-32 Feb-35 Feb-38 Feb-41 Feb-44 Feb-47 The fund with DVM would have run out after 24 years, while the fund without DVM would have become exhausted after 26 years and 27 weeks. The total income taken from the fund with DVM would be 122,059 compared with 138,159 for the fund without DVM. 12
COMPARING THE FUNDS ACCORDING TO RISK AND EQUITY ALLOCATION Both Scottish Widows and an established industry risk assessment company believe that the inclusion of DVM in the Retirement Portfolio Funds helps to manage volatility, resulting in a lower level of assessed risk. Based on risk ratings supplied by Distribution Technology (DT), each Retirement Portfolio Fund currently has a lower risk rating, by one level, compared to a fund with the same current strategic equity allocation but without DVM. This provides more cautious investors with an option to access a fund with a higher equity exposure and potential for higher returns, without having to select a fund with a higher risk rating (as defined by Distribution Technology). Likewise, investors who wish to invest in funds with higher equity allocations can choose a Retirement Portfolio Fund with a lower DT risk rating than a fund with the same equity allocation but no DVM. The tables below compare Retirement Portfolio Funds (RPF) and Pension Portfolio Funds (PPF), demonstrating how Retirement Portfolio Funds currently offer the same equity allocation at a lower DT risk rating. The tables provide a direct comparison with PPF funds with the same DT risk rating as the Retirement Portfolio Funds and also with PPF funds that have the same equity allocation. Retirement Portfolio Funds Allocated Equity Exposure Either Pension Portfolio Funds Or HIGHER DT Risk Rating SAME Equity Allocation DT Risk Rating SAME DT Risk Rating LOWER Equity Allocation The tables show a range of metrics that are derived from stochastic modelling of 5,000 different scenarios projected over 30 years from February 2017. In each case the starting value of the investment is 100,000 with an initial annual withdrawal rate of 4%, rising in line with inflation each year. The figures are net of transaction costs but do not include the annual management charge, fund expenses or product charges. Please note that the data in these tables is all based on hypothetical modelling: the figures are not guaranteed and actual performance could be very different. For Retirement Portfolio Fund 10 40 there is no fund with a lower equity allocation available for comparison from the Pension Portfolio Fund range. 13
RETIREMENT PORTFOLIO 10 40 Lower Equity Allocation Same DT Risk Rating Same Equity Allocation Higher DT Risk Rating Retirement Portfolio 10 40 N/A Pension Portfolio C Construction: Volatility management approach Automated system None Asset allocation (equity exposure) 30% No fund available with a 30% lower equity allocation DVM 3 7 Risk rating DT 3 Higher DT 4 Metrics: Average annualised return 3.48% 3.65% Average annual volatility 6.10% 6.80% Sharpe ratio 0.66 0.63 Average maximum fall in value -15.90% -19.26% RETIREMENT PORTFOLIO 30 60 Lower Equity Allocation Same DT Risk Rating Same Equity Allocation Higher DT Risk Rating Retirement Portfolio 30 60 Pension Portfolio C Pension Portfolio B Construction: Volatility management approach Automated system Reduced equity exposure None Asset allocation (equity exposure) 50% 30% 50% DVM 3 7 7 Risk rating DT 4 Same DT 4 Higher DT 5 Metrics: Average annualised return 3.98% 3.65% 4.25% Average annual volatility 7.40% 6.80% 8.80% Sharpe ratio 0.59 0.63 0.53 Average maximum fall in value -19.42% -19.26% -27.53% 14
RETIREMENT PORTFOLIO 50 80 Lower Equity Allocation Same DT Risk Rating Same Equity Allocation Higher DT Risk Rating Retirement Portfolio 50 80 Pension Portfolio B Pension Portfolio 3 Construction: Volatility management approach Automated system Reduced equity exposure None Asset allocation (equity exposure) 70% 50% 70% DVM 3 7 7 Risk rating DT 5 Same DT 5 Higher DT 6 Metrics: Average annualised return 4.49% 4.25% 4.85% Average annual volatility 9.40% 8.80% 11.50% Sharpe ratio 0.48 0.53 0.42 Average maximum fall in value -26.11% -27.53% -37.28% RETIREMENT PORTFOLIO 70 100 Lower Equity Allocation Same DT Risk Rating Same Equity Allocation Higher DT Risk Rating Retirement Portfolio 70 100 Pension Portfolio 3 Pension Portfolio 2 Construction: Volatility management approach Automated system Lower equity exposure None Asset allocation (equity exposure) 85% 70% 85% DVM 3 7 7 Risk rating DT 6 Same DT 6 Higher DT 7 Metrics: Average annualised return 4.88% 4.85% 5.30% Average annual volatility 11.20% 11.50% 13.80% Sharpe ratio 0.41 0.42 0.36 Average maximum fall in value -32.40% -37.28% -44.56% 15
FURTHER READING For a more detailed explanation of Retirement Portfolio Funds and the design of the Dynamic Volatility Management process, please read the adviser guide to the funds http://www.scottishwidows.co.uk/extranet/literature/doc/56357 FOR HELP AND SUPPORT: Contact our dedicated Retirement Account IFA servicing team directly on 08000 964 364 16
Scottish Widows Limited. Registered in England and Wales No. 3196171. Registered office in the United Kingdom at 25 Gresham Street, London EC2V 7HN. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Financial Services Register number 181655. 56378 02/18