Undertaking cashflow modelling to demonstrate suitability of retirement-related advice

Where cashflow modelling is used it can provide a reasonable basis for giving advice if the firm uses complete, accurate and up-to-date information. Firms should check:

• they have a reasonable basis for the estimated expenditure in the cashflow modelling, both at present and in future, taking into account the client’s needs for the basic cost of living, desired lifestyle expenditure, discretionary expenditure and savings 
• how the client’s personal circumstances and lifestyle are likely to change throughout retirement and how this might affect future expenditure 
• they are using up-to-date salary information to calculate current net income and identify surplus/deficits in current household budgets
• the salary information takes proper account of the method for paying workplace pension contributions, eg net pay, salary sacrifice and relief at source
• they have included all sources of income up to and throughout retirement, such as employment earnings, benefits including child benefits, property rental income, share dividend income, reliable bonuses and other sources of regular income and pensions, including a justifiable estimate of state pension
• they have used up-to-date market values of all investible assets in the projection
• they can justify any estimated figures used in the projection
• they have taken into account whether the advice is being given on a single life or joint life basis 

The actual returns clients achieve will vary according to their investments. So, the base scenario for cashflow modelling for an individual client should:

• use future rates of return which are aligned with the investments which will be recommended
• be consistent across similar assets held in different wrappers
• apply appropriate tax rates 

It’s unlikely that future rates of return will mirror the pattern of past rates. When setting future rates of return for cashflow modelling, firms: 

• should make assumptions about future rates of return which are not based solely on specific patterns of past returns
• may use constant rates of return for different funds or asset types, so long as there is appropriate stress testing (see below)
• should consider the differential between gross returns for different types of funds or assets, and inflation
• should undertake regular reviews of the assumptions used, taking into account wider economic circumstances 
• should be careful about presuming their ability to predict variable future rates of return (and inflation) to avoid the impression of accuracy
• should be able explain to clients the justification for any assumptions and why they are reasonable

Charges have an impact on how long retirement income can be withdrawn from an investment, in the same way that a higher withdrawal rate does. When undertaking cashflow modelling, firms should consider:

• All foreseeable product and adviser charges. Product charges include platform fees, product/wrapper charges, fund charges, fees for managed portfolio services such as discretionary fund management or centralised investment propositions and any other fees for custody of or access to funds.
• The effect of the recommended solution’s charges on how long funds are likely to last (sustainability).
• How they communicate the overall cost so that the client: 
  • understands how the level of charges affects the sustainability of their funds and 
  • can make an effective decision on whether to proceed

Consumers generally understand their current levels of income and expenditure, net of tax. By expressing future income and expenditure in today’s terms, clients can understand how their lifestyle in retirement could compare to their current lifestyle. Firms should:

• illustrate net of tax income and expenditure in real terms (representing annual inflationary increases as a constant real amount)
• check whether inputs are in nominal or real terms and ensure they convert any inputs made in nominal terms to appropriate real terms
• be clear whether quoted returns are gross or net of inflation
• review the rate(s) of inflation they use on a regular basis
• show the effect of alternative rate(s) of inflation to ensure clients understand the effect of inflation on their investment 

Half of consumers will live longer than average. Firms who use a cashflow model should carry out projections that go beyond average life expectancy. The Office for National Statistics provide a life expectancy calculator[1] which shows the probabilities of males and females of surviving to older ages. The calculator takes account of how this might change for people born in different years. For example, a 65-year-old male has an average life expectancy of 85. However, they have a 1 in 4 chance of surviving to age 92 and a 3.1% chance of reaching 100. The figures are higher for a female of the same age. Firms should:

• remember that consumers generally underestimate their own life expectancy 
• focus on the probability of survival rather than life expectancy, to address clients’ misperceptions and the potential harm of running out of money
• when advising couples, consider the probability of survival for both parties
• consider how income needs may change in later life 
• only take account of limited life expectancy when there is strong evidence that it will be borne out in practice

There is a risk that clients perceive a detailed projection of their financial affairs as a certainty. Showing plausible alternative scenarios gives firms some evidence that the risk they are proposing is in line with the client’s risk tolerance and capacity for loss. It also gives clients an indication of the risks of the recommended proposal and what different outcomes might mean for their income throughout their retirement. Firms should consider:

• illustrating a rare but feasible fall in asset values at the start of any income withdrawal period, such as actual drops in benchmarks for the recommended investments
• reducing net of inflation rates of return to show the impact on how long funds will last
• highlighting the lower percentile outcomes in stochastic modelling output
• showing how higher withdrawals will deplete the fund sooner

When presenting cashflow modelling outcomes, firms should:

• be aware of differences in communications and the impact on consumer understanding of those differences 
• explain why the cashflow modelling outcomes differ from those in other communications, including the inherent uncertainty in all projections
• indicate how far the scenario outcomes are aligned with the client’s attitude to risk and capacity for loss
• be able to explain why different communications appear to show the client’s funds lasting for different amounts of time, if relevant

When reviewing the cashflow modelling output, firms should:

• Consider how long funds last under the base scenario.
• Review the stress testing scenarios and what they would mean for the client’s income in retirement against their expenditure needs.
• Consider how the model handles potential tax liabilities.
• Check how the software handles cases where expenditure is expected to increase in some years, for example for university funding or to meet specific expenses like mortgage repayment. The firm should consider whether there are surplus funds to meet such expenses. In particular, it should ensure the model does not presume the client can access pensions before the minimum pension age for these expenses. 
• Consider if there are benefits to the client paying more into a pension if affordable, for example to claim back child benefit, reduce their marginal rate of tax or to make early retirement more likely.
• Review whether aims such as paying off a mortgage can be met more efficiently by using tax-free cash or income from UFPLS withdrawals, for example.