Why choosing the right cash flow model for drawdown matters
Mar 31, 2021 9:30:00 AM
The growth of cash flow modelling is one of the most favourable financial advice developments over the past few years. While the presence of an accurate and graphical forecast of an investor’s financial future is a noteworthy upgrade from the spreadsheets or pen and paper diagrams used in yesteryear.
Why it's vital to have an accurate cash flow model
As an industry, we’ve got more work to do in this area. As noted above, fundamental to the efficacy of any cashflow modelling tool is its accuracy. Most client investment strategies include high equity allocations, and equity markets, as we’ve witnessed in the past year, tend to be unpredictable. Therefore, forecasting models must possess a degree of randomness and consider a range of different factors, including interest rates and inflation. An accurate cash flow model enables the adviser to articulate potential investment volatility and calculate capacity for loss.
This is particularly important for those in decumulation. In fact, recent research found that 84 per cent of advisers flagged the importance of cash flow model projections for drawdown clients to be realistic and account for the various risks - such as the sequencing of returns and volatility - affecting the plan over time.
Sequencing of returns
Simply put, sequencing of returns or sequencing risk is the danger of your client’s pension savings pot being exposed to the worst returns at the worst possible time. This risk will be at its highest in the final few years before retirement and as they begin to drawdown income from their pension pot.
As your client begins to withdraw an income, they are more vulnerable to market volatility – the higher the volatility, the worse the effect. This is known as “pound cost ravaging”, whereby periods of high price volatility reduces the level of sustainable income afforded to be withdrawn.
Unfortunately yes, many of the models being used are far too simplistic to deal with the risks mentioned above. This is something that must change to ensure clients receive accurate projections.
We provide an outline of the various types of cash flow forecasting models here.
Although not as well documented, the use and importance of cash flow modelling when establishing capacity for loss also extends to the accumulation phase. While often, investors’ sole objective is to provide capital growth, few are prepared to take significantly high risks to achieve this growth. Clients who appreciate the potential fluctuations within their investment strategy will be less likely to hit the panic button during periods when markets fall.
While the FCA hasn’t dedicated a specific study to risk and loss for a decade, its stance on assessing suitability is frequently reaffirmed. And with more and more people entering decumulation every year, we must ensure that the tools provided to help advisers gather this critical information are up to scratch, enabling their clients to draw income in confidence.
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 cashflow planning. And that’s the difference between a deterministic model and a stochastic model.