Punter Southall Wealth win Adviser Firm of the Year for the South East in the Professional Adviser Awards 2021
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The cash flow forecast is used by businesses to ensure that they remain solvent and maintain a sufficient level of liquidity at all times. It can serve a similar purpose on an individual level and has become an important part of the financial planning process in recent years.
Cash flow modelling can be used in several different ways, and one area in which it regularly plays a role is that of retirement planning.
Retirement planning advice should always begin by establishing the individual’s objectives; the age at which they would like to retire and the level of income that they would like to receive each year after finishing work. These goals also form the starting point for cash flow modelling.
When discussing someone’s retirement income target, cash flow models will often differentiate between an income ‘need’ and an income ‘want’. A ‘need’ is the minimum level of income required to satisfy their anticipated expenditure. In contrast, an income ‘want’ will be a higher figure, perhaps allowing for the cost of an overseas holiday each year up to a certain age. Separate models could be carried out based on each of these figures.
The next step is to identify the assets available that will be used to meet these retirement objectives.
Most people will have accrued some entitlement to a State Pension, and this represents a guaranteed inflation-protected source of income that will rise each year throughout retirement at a pre-determined rate. There may also be final salary pensions which will be paid each year, irrespective of wider investment market performance.
Some individuals are in a fortunate position whereby their retirement income goals can be fully satisfied by guaranteed sources such as these. In such instances, the use of cash flow would be of little value.
The reality for most people, however, is that they will need to draw upon other invested assets in order to make up their income shortfall and achieve their retirement objectives. The cash flow forecast can be a very useful tool in these circumstances.
The portfolio on which someone can draw in retirement will not necessarily just comprise their pension arrangements.
At the point of retirement, many individuals will have accumulated an investment portfolio from which drawings can be made to supplement any income from pensions. Examples might include ISAs which provide a tax-free income, or Investment Accounts which can be drawn down to make use of the Capital Gains Tax annual exemption.
Broadly, a cash flow modeller can be used to provide an indication of whether the projected capital value of these assets will be able to sustainably generate the income that someone requires in retirement.
Cash flow modelling provides broad information that helps our clients better understand their positions. The models can form the basis of a discussion with them about how different rates of investment growth (determined by their attitude to risk) and levels of saving, are likely to impact upon the funds available in retirement.
In a similar vein, a modeller might be used to demonstrate how a market crash in the years leading up to retirement could affect how they achieve their objectives. If it suggests that such an event could have a detrimental effect on them in the future, action could be taken now in order to mitigate this. Possible solutions might be to lower the level of risk being adopted or increase the rate of saving, where possible.
Cash flow modelling is an excellent, visual way of helping our clients understand how their various capital and income sources can be employed to meet their objectives. However, we never rely upon it in isolation.
The models will typically forecast over a number of years and often decades. The likelihood of the various underlying assumptions, for example investment growth or rates of inflation being borne out in reality, is minimal. This is why we use these tools as more of an indication of a direction of travel.
We also regularly review and update our cash flow models when we meet our clients in order to take account of changes to their objectives, circumstances or the wider economic landscape.
Provided that these caveats are remembered, cash flow modelling represents an effective tool in the provision of holistic financial advice for our clients. Whilst I’ve focused on its use for retirement planning, it can also be employed in other ways. In fact, there’s another article within Insights (click here:) that considers the role it can play in Estate Planning and in particular, charitable gifting.