Nestor: Shock Drop Scenario
The “shock drop” scenario refers to the investment return assumption used by Nestor for the growth portfolio when determining retirement income strategies, which involves lower return assumptions in the first two years.
The intention of using these assumptions is to build some conservatism into the plan, which is accomplished in two ways:
- Lower return assumption
- Lower return assumptions in the early years of retirement, instead of the later years. This creates a bigger “hit” to lifetime income because this is generally when savings are at their maximum value.
Speaking in statistical terms, the lower investment return assumptions are calculated as the mean return assumption for the applicable growth portfolio less a specified number of standard deviations as determined from historical returns. The mean and standard deviation of returns for each growth portfolio is as follows:
We derived standard deviations by examining historical weekly returns on the S&P 500 Index (for US Large Cap Stocks); the S&P Completion Index (for Mid & Small Cap Stocks); Barclay’s US Aggregate Bond Index (for US Bonds); and FTSE ex US Index (for Foreign Stocks).
The number of standard deviations that are deducted from the mean to calculate the “shock drop” return assumptions, vary by the level of risk tolerance associated with the financial strategy, as follows:
So, as you can from above, the “shock drop” adjustment to the mean return in year 2 is one-half of the adjustment that is made in year 1.
The reason for applying a larger “shock drop” for lower levels of risk tolerance is to provide a larger margin of safety through a more conservative assumption.
For years 3 and later, returns are set equal to the long term historical average returns for all levels of risk tolerance.
The resulting “shock drop” investment return assumptions are as follows: