Cashflow modelling should be at the heart of advice

Cashflow modelling should be the most powerful tool in financial planning, but many advisers need to get much better at doing it.

Almost eight out of 10 financial advisers say they are now using cashflow modelling and three-quarters of these claim to carry out the exercise each year for clients in retirement, according to research by Platforum earlier this year. However, other data shows that some of their practices and approaches could be improved.

Cashflow modelling ought to be at the heart of virtually all financial planning. First and foremost, it can stimulate clients to think about their futures. Most of us find thinking about the future can be rather uncomfortable. It is hard to predict how much we will want to spend and even where we will want to spend our money. We mostly don’t know how long we will remain in reasonable health and certainly we don’t know how long we will live.

The future of cashflow modelling

So it is helpful to have a tool that almost forces us to confront the issues of where we will want to live, how long we will want to keep working – if at all – and how we will spend our time and money.

Setting a budget is an iterative process and it may need working through several scenarios.

Realistic projections

Another key purpose of cashflow modelling is to assess how realistic clients’ projected expenditure is in relation to their resources. Will the income be enough to cover their expected and desired levels of expenditure?

Finally, cashflow modelling is probably the only reliable way to assess a client’s capacity for loss. There’s not much point in asking a client whether they could cope with, say, a 20 per cent drop in the value of their portfolio unless they can see and understand its implications for their future income and standard of living.

But this valuable technique will live up to its considerable promise only if it is carried out with a good deal more skill and logic than are often apparent today. Critics point to several serious weaknesses in how many – possibly most – advisers do cashflow modelling.

Cashflow modelling is potentially misleading if the adviser bases the projections on a scarily optimistic estimate of how long the client might live. That shouldn’t be the median life expectancy; half the population will live longer than the median. A healthy 65-year-old has a fair chance of living to age 95 or even 100. The only safe method is to project to age 105 or later.

The old approach is to aggregate clients’ expenditure to see if the income will be enough to cover it. A more useful approach is to analyse expenditure according to how much is core and what proportion is more discretionary.

Projecting unrealistic growth rates is another serious criticism of much caseload modelling practice. The temptation is to project a fixed and arbitrary rate – often an annual 4 per cent. A frighteningly high proportion of advisers project growth rates at this level or higher.

Some advisers also make the elementary mistake of applying this somewhat optimistic expected growth rate regardless of the portfolio in which the client is actually invested. An extreme example could be a very low-risk client who is invested in a portfolio that almost entirely consists of bonds or cash. Clearly such an investment strategy would generate a long-term growth rate that would be very different from a portfolio that mainly consisted of equities.

First rules

So the first rule of cashflow modelling is to align the expected return for the model to the expected return from the portfolio in which the client is actually invested. And the second rule is to be realistic about the expected returns.

Likewise with inflation. The government is aiming for CPI inflation of 2 per cent. It is even achieving that at present – and it seems a reasonable rate for now. But a key criticism of most cashflow modelling is that in its traditional form it is based on a single set of assumptions with a single simple outcome: the client either seems to have enough money throughout their life or they don’t.

Leader: Cashflow modelling must offer answers, not just questions

This approach can be varied with some useful alternative scenarios that might, for instance, involve a big early loss or a lower growth rate – but it won’t provide an idea of the probability of meeting the client’s aims.

Stochastic modelling isn’t perfect; nothing that aims to make predictions about the future can be. But it does give an indication of the likelihood of an outcome in percentage terms rather than as an apparently deterministic forecast.

So a client can get a feel for how much a particular course, such as cutting the equity weighting in a portfolio or making a lump-sum lifetime gift to a granddaughter, will increase their chances of running out of money before they die.

Cashflow modelling has the capacity to be the core tool for most financial planning – but only if advisers can up their game.

Danby Bloch is  head of editorial strategy at Platforum