Lifetime Cash Flow Modelling
Most Financial Planners put lifetime cash flow modelling at the heart of what they do. It’s essential to their work and the advice they give their clients.
Not everyone agrees though this may be because there is still some mystique about what cash flow modelling is. This section explains what cash flow modelling is, the benefits of using it with clients, as well as the drawbacks.
In its simplest form, a cash flow model is a linear projection showing money and money out and the resulting cash balance.
A simple model can be constructed using a financial calculator but if you want to plot numerous points then you’ll probably need to use a spreadsheet.
Today, simple spreadsheet calculators can seem pedestrian alongside the advanced cash flow modelling software that is readily available. Even ‘free’ tools targeted direct to consumers are more comprehensive than many of the spreadsheets being used by Financial Planners just a few years ago.
Direct to consumer modelling tools aren’t able to compete with the most sophisticated cash flow modelling software available to Financial Advisers. Today’s software will allow an adviser to model all but the most complex of client situations and to adjust the model going forward – incorporating changes to an increasingly complex tax code, ever changing pension legislation, and different savings and investment solutions.
Taking this complexity and being able to distil it into a pictorial representation of a person’s lifetime cash flow is a valuable tool for Financial Planners and their clients.
Benefit
To simplify and forecast a complex lifetime stream of money in and money out, whilst accounting for things like inflation, taxation, and investment growth, gives clients huge advantages when it comes to making financial decisions.
Working with a Financial Planner who uses cash flow modelling to its fullest extent provides clients with the following:
- A clear and comprehensive summary of financial arrangements.
- An income and expenditure analysis, and the planning assumptions used.
- An understanding of where any shortfalls might occur and make appropriate plans.
- Defined goals and objectives, and putting a value on them – how much is enough?
- An understanding of what they need to do financially to achieve and maintain financial independence.
- Adequate provision for dependents in the event of death or disability.
- A consideration of the tax consequences of different strategies.
- The development of appropriate investment strategies for capital and surplus income taking account of their attitude to risk and the need for flexibility/ accessibility.
Clients will benefit from greater clarity about their financial situation, enabling them to make better informed decisions.
Information
The starting point for any cash flow model is the data that is fed into it. Garbage in, garbage out.
Whether using a sophisticated software package or making “back of the envelope” projections, the accuracy of the data used in the model is crucial.
It doesn’t mean you need to analyse expenditure down to each item, a consolidated expenditure figure will work well. When working with a client for the first time it’s probably better to ask for data in its simplest form to avoid overwhelming them with the amount of detail being asked for.
To ensure financial goals are going to be achieved it is important for clients to be specific. Saying “I want to have enough money to retire comfortably” isn’t a specific enough goal and you need to ask enough questions to discover how much income will be needed in retirement. The same applies for any other objectives they may have – they need to be specific. The more specific the information, the better the plan.
It’s not only client data that needs to be accurate, the assumptions used to model the data are equally important. The default assumptions built into some software tools used differ significantly to those you and the client might be comfortable with.
Assumptions
All planning and analysis tools require the use of assumptions, and Financial Planning tools are no different.
Assumptions like inflation and investment growth rates are uncertain and can change over time. A client’s plans may also change and this can significantly alter the planning assumptions used.
Using the wrong assumptions may lead to a financial plan that is unrealistic and unable to meet a client’s desired goals and objectives. There are no set rules about which assumptions you should use but there are many commonly accepted rules of thumb and historical data from organisations like the Office for National Statistics:
Inflation Rate Assumptions – Inflation affects both income and expenses. Typically, Financial Planners assume an annual inflation rate of 3% for basic models though older clients often experience a higher personal inflation rate than the rest of the population. More complex models may use several different rates of inflation for different types of income and expenditure.
Investment Returns – To calculate the growth of your investments over time you will need to apply an estimated rate of return. Returns vary across different asset classes and the underlying tax structure they are held. Cash is generally lower than bonds, which are generally lower than equities. Growth rates that might have seemed appropriate 10 years ago might be considered high by today’s standards.
Life Expectancy – People tend to underestimate their life expectancy, and will often anchor on the age a parent or grandparent died. Life expectancy has been increasing over the past few decades and the average life expectancy is often higher than the age a client has in mind.
Tax Rates and Allowances – The government has repeatedly shown that you cannot rely on things to stay the same, especially when dealing with tax rates and allowances. Despite personal allowances and tax bands being frozen for some years, most assumptions allow for annual increases in line with inflation. Tax rates are typically held at current rates for planning purposes, but if the government decides to change rates the planning assumptions also need to change.
Drawbacks
A significant drawback with lifetime cash flow modelling is everything is assumed to travel in a straight line. Assumptions are averages that remain constant throughout time with no accounting for periods of negative investment returns or abnormally high inflation. To some extent this can be dealt with by Monte Carlo simulations, but there is little evidence to suggest that Monte Carlo simulations are routine.
The assumptions used for growth rates, income and expenditure, taxes and so on, which are used as the basis of any cash flow modelling will always will always ultimately be wrong. Regular reviews and are required to ensure the client remains on track. It is particularly problematic the further out the projections are being made. Like a flight plan that needs constant adjustment to account for changing weather conditions, side winds and headwinds, a cash flow model needs to be adjusted each year to take account of any financial turbulence and changes in direction. The model is only ever a guide and reflects a snapshot in time. There are too many variables subject to change which prevent the model from accurately predicting future outcomes. The model is only as good as the information available at the time it is produced, it must be kept updated with the inevitable changes to a client’s circumstances.
Tools
There are several cash flow modelling tools available to purchase (usually on a subscription model) but it is possible to construct simple models using a spreadsheet like Microsoft Excel. The most comprehensive tools available to Financial Planners are Truth and Voyant but there are others like MoneyScope which are cheaper and simpler to use.
Tools like MoneyHub and RetireEasy are available direct to consumers, and whilst not as comprehensive as Truth or Voyant they provide an indication as to whether a client’s objectives are likely to be met and allow them to track progress over time.
There are also tools available from Product Providers that can be used to model specific events, such as retirement.
Presentation
The power of these tools is in their ability to handle a lot of complex information and to turn it into a simple graphical output. For most clients’ the simpler the output the better, but for those that want to interrogate the numbers it is possible to churn out reports running to a hundred pages or more.
If we want to use cash flow modelling to help clients take better decisions, the idea should be to present information as simply as possible. Using a single chart to show clients whether they will run out of money if they continue with their current plan is enough to start a conversation about making changes to improve the outcome.
Many Financial Planning tools have user groups where best practices can be shared and discussed, including the best ways to present plans and information to clients. Simple changes to the way information is presented can lead to greater engagement with clients.
