Financial planners need to look beyond straightforward forecasting if they are to effectively meet the needs of their clients.
Cash flow modelling caused some excitement in the financial planning industry when it first appeared in the early 2000s1. In theory, it is a reliable method to calculate how much people would need to save or earn (for example from investments or other assets) for their retirement.
However, nobody can predict the future. Cash flow models simply create a baseline projection; further steps will need to be taken to customise that projection, based both on general principles that apply to retired people, based on experience, and also tailored to the client on a more individual basis.
The model is also open to macroeconomic criticism. Aside from potentially failing to predict what a specific individual will do, the model will be based on assumptions about interest rates, economic growth, geopolitical events, oil prices, technological changes and a host of other factors which, in aggregate, are almost impossible to accurately predict.
Planning for retirement requires more nuance than a flat forecast, i.e. planning to spend the same amount of money each year for the whole period of retirement. Spending tends to taper down in retirement, with large amounts spent on holidays and travel early on, decreasing gradually over time. Typically, retirees can expect a 20% reduction in spending every five years as they become less active in later life.
However, many people also require three or more years of care in later life2– a period when costs can increase considerably. The median period from admission to a residential care home to death is 15 months3.
The importance of flexibility
Cash flow forecasts need to be as accurate as possible. The real life implications of a miscalculation could be serious: too optimistic and the client could be forced to sell off assets such as the family home to raise cash; too pessimistic and the client might end their days having lived an overly-constrained lifestyle, only to leave excessive amounts of savings unused.
This is where tailoring the model to the individual as far as possible becomes so important. For example, the standard approach to the investment portfolio is to gradually run it down towards zero by the time the client reaches the age of 95 – long beyond the life expectancy of most people, which as of the latest available data published in September 2017 by the Office for National Statistics stands at 79.2 for men and 82.9 for women4.
In reality though people are individuals, not averages; specifics must be taken into account. For example, if the client had parents who lived to be 107, it would be prudent to plan for the client’s needs well beyond the age of 95.
In addition, in the aftermath of the introduction of pension freedoms in 2015, which allowed pensions to be withdrawn at any time and in any amount, it is more important than ever before for people to plan adequately to ensure they don’t run out of money. Statistics suggest that almost one in three people could run out of money in retirement5. Meanwhile, the amount retirees can safely withdraw from their invested pension has dropped to just 1.9%6 per year6. High-earning individuals may be unsure whether or not they are saving enough to maintain their lifestyle. If you are not sure, it is always best to seek advice from a professional.
- Note – the term had been used in accounting before that but was new in financial planning. Voyant was one of the first firms to start offering a product around 2005.
- Age UK - Briefing: Health and Care of Older People in England 2017
- Age UK - Later Life in the United Kingdom August 2017
- Office of National Statistics - National life tables, UK: 2014 to 2016
- The Telegraph, 14 October 2017 - Using the pension freedoms? You could run out of money after just 16 years
- The Telegraph, 12 October 2017 - Amount retirees can 'safely' withdraw each year from an invested pension drops to just 1.9pc
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of publication.