Do we need a cash flow modelling standard?

Cash flow modelling is the number one mechanism for bringing your client’s financial plan to life, according to three-quarters of advice professionals. That’s music to the ear of any providers offering models.

A recent survey, conducted by the Lang Cat, aimed to better understand how much the adviser market has adopted cash flow modelling as a way of informing their retirement clients in drawdown.

At first glance, the results of the survey of 130 advice professionals, appear encouraging. As a fintech company with our own model, we understand the role cashflow projections play when helping clients meet and understand their objectives, especially for drawdown. But these results should be setting off klaxons left, right and centre.

It’s for this reason: 84 per cent of advisers believe it is important that cashflow model projections for drawdown clients are realistic and that they should consider ongoing variables that will affect the plan over time, such as sequencing risk and volatility. These are the very things that are absent from the vast majority of the current crop of cashflow models.

57 per cent of respondents feel providers should do more to ensure projections are more realistic. Yet retirees relying on cashflow projections using deterministic or simple stochastic models – in other words, most currently available models – are likely anchoring their financial futures on an unrealistic set of outcomes, putting them at risk of outliving their retirement pots.

The recent, turbulent economic environment has highlighted the value of realistic cashflow modelling, with one adviser in the survey commenting that it is even more important “now that we’ve really experienced the dangers”.

The answer, cash flow modelling 

We believe the answer is the stochastic economic scenario generator model. It enables forecast on a more realistic set of outcomes. Investment markets, other than a handful of blips, have been on a solid upward trajectory since the 2008 financial crisis. But this is rare. In fact, the period from 2009 to 2020 has been credited as the longest-running bull market in history. It’s far more common for markets to be significantly more volatile; the current pandemic serves to highlight how economic disasters can come out of leftfield.

Read our accompanying blog Stochastic vs Deterministic Models: Understand the Pros and Cons to learn more the difference between the different type of cash flow models on the market.

Other cash flow factors to consider

The argument for cashflow models to capture this volatility, as well as accommodating other factors such as pound cost ravaging and sequencing risk to present a more realistic projection is surely made and won? Apparently not.

Let’s be honest here, realistic projections can present a more challenging picture than the rosy hue of assuming a fixed rate of investment return throughout retirement. For the sake of balance, I should add 9 per cent of respondents thought fixed rates were fine. Perhaps that’s the real stumbling block for providers.

Other data from the survey, meanwhile, uncovered further issues. Almost two-thirds of advisers said they require a simple deterministic projection to enable like-for-like comparisons with other plans. And therein lies the problem. If only a small number adopt a stochastic economic scenario generator model, it stymies access to realistic projections and makes comparisons nigh on impossible.

And what does the regulator say?

The FCA is yet to issue its stance on the suitability of cashflow models. The absence of regulation could be one reason why providers have little incentive to up their game. But history has proven the regulator is prepared to, if not quite shake up, at least review investment forecasting when necessary.

Prior to April 2014, client investment illustrations for pensions and ISAs projected growth figures of 5 per cent, 7 per cent and 9 per cent. So, both before, during and after the 2008 financial crisis, the lowest growth figure financial advisers were illustrating for their clients was 5 per cent. Quite astonishing. The regulator has since reduced these to 2 per cent, 5 per cent, and 8 per cent. But we all know portfolios generally do not rise on a consistent trajectory; that’s not how markets and economies behave.

It raises questions of whether we as an industry should be striving for minimum standards. The situation with professional qualifications offers a solid case in point here. Increasing numbers of advisers are opting to go beyond the minimum Level 4 requirement and attaining chartered status.

Parallel themes can be drawn between qualifications and cash flow modelling. Even if the regulator feels simplistic models are doing an adequate job, the sector should be aiming higher. We need to be doing the best possible job for consumers. At the same time, we reduce the hassle of comparisons for advisers by adopting realistic projections across the board, rosy or not.

*As featured in Money Marketing on Wednesday 7th October 2020*

So what next?

We provide an outline of the various types of cash flow forecasting models here. A complete, real-time picture of all the potential outcomes makes all the difference to realistic outcome cash flow planning. And that’s the difference between a deterministic model and a stochastic model. 

Find out more about stochastic forecasting and why we believe it’s the most credible model by reading our eBook, Modelling Future Outcomes: Why Stochastic is the Credible Choice?