How does the Affordability calculation work?

Affordability relates to the total investible assets – both pension and non-pension, and investible assets managed elsewhere.

The Affordability calculation assumes that returns follow a lognormal distribution centred on an expected long-term average.

We also take cashflows into account. The end balance for each year is the portfolio’s growth (or loss) since the start of the year, plus net cashflows (i.e. income less spending). The normal/good/bad outcomes come from using the 50th/95th/5th percentiles of the returns’ distribution at each point in time.

The expected return comes from an assumption of a constant Sharpe ratio (reflecting a reasonable long-term risk-return combination for an efficient multi-asset-class well-diversified portfolio) multiplied by the risk level of the portfolio.

Please note that our definition of risk is not historical volatility but the annualised standard deviation of ex-ante 10-year returns. The risk estimate for each portfolio is derived from our risk mapping methodology, which simulates tens of thousands of forward-looking, long-term outcomes for a given asset allocation.