Cash flow planning: How can you best use it today for your clients?

Dynamic Planner CEO Ben Goss explores the complexity of effectively planning for retirement in 2020. How has today’s landscape changed in only the last 10 years? What key ‘unknowns’ should you consider today for a client entering retirement? How does cash flow planning software help?

How has ‘stress testing’ a client’s investment portfolio helped? What are the dangers of relying upon that? And, finally, what is the solution?

Covid-19 has this year spotlighted many areas of our lives. A commonality which has impacted everyone is the complexity faced when our expected norms are disrupted.

The simplest of everyday tasks – going food shopping; going for a drink with friends; going to school or work – have been made much more complex and stressful in 2020.

In the world of pensions and investments, we can have some sympathy for the approximately 2.5million people expected to reach retirement in the next five years. Not only must they plan through the current crisis, they must also consider their financial needs long-term and how their portfolio will support them in retirement.

How has the world of cash flow modelling and drawdown calculation changed?

Rewind a decade, before pension freedoms in 2015 and the problem was never simple, but it was simpler. Upon retirement, you purchased an annuity at a price fixed and lived off a fixed income in absolute or in relative terms. Your retirement date was known and perceived wisdom was that increasingly in the build-up, your portfolio would be strategically rebalanced to take less risk and manage volatility. Today, there are more unknowns.

1. When will you retire?
2. What about crystalising different pensions, or portions of pensions, at different times?
3. What about changes to lifestyle in retirement; longevity; health; and care costs?

As a result, a client’s needs are more likely to vary over time and therefore, so are the demands placed on their pensions and investments, which all the while remain vulnerable to market volatility and risk. How do you financially plan long-term, given such variables?

For a long time, the skill of cash flow planning has been pivotal in helping clients devise a suitable investment strategy and access their portfolio for income in retirement. Most tools to date have adopted ‘straight line’ or deterministic assumptions around how portfolios will behave.

Some work backwards from expenditure required to calculate net return needed and then build a portfolio designed to deliver that return. While simple and helpful in respect of a client’s understanding, the problem of course is that this approach does not consider the risk of investments experiencing returns which are not fixed over time. To overcome that, different cash flow modelling tools have introduced stress testing portfolios. ‘What if?’ markets crashed here, similar to 1987 or 2008. Stress testing, granted, is good, but there are issues with doing it:

1. First, it doesn’t reflect the risk level of the client’s portfolio. Is it a risk profile 2 or a risk profile 9 on a 1-10 scale, a system like Dynamic Planner, can adopt, for example? As a result, potential losses modelled may significantly under or overstate real risk to the client.
2. Second, stress testing only simulates a repeat of a given event or time and not the numerous and more complex range of factors, each different, which can impact a portfolio over time.
3. Finally, if, while markets are falling, a client is withdrawing money from their investments each month, to provide an income, sequencing risk, or the acceleration in portfolio losses, may be significantly underplayed.

That said, how then do you plan effectively and accurately with your client, given that complexity and uncertainty?

How does cash flow planning software help?

The answer lies in highlighting to a client a range of reasonable outcomes they can expect, given their risk profile and the timeframe. A Monte Carlo model – like Dynamic Planner’s – can help here by taking thousands of random potential outcomes for a period being modelled aligned to risk within their portfolio. How does that help?

1. First, it links back to their portfolio, its asset allocation and its value at risk, all previously agreed with the client. Its risk profile drives the expected average return and volatility, including the likelihood of bigger losses being suffered than have been experienced historically.
2. Second, it can model thousands [a statistically large and robust enough number] of the almost infinite number of performance paths the portfolio might take each month over the course of a cash flow plan.
   Some might look similar to previous market downturns, but the majority will not. The client can therefore plan for an expected average result, while also being aware of and prepared for a series of poor returns from their investments – the average of the worst 5% or be pleasantly surprised by higher than average returns.
3. Third, monthly Monte Carlo cash flow modelling can consider the reality of the impact of monthly cash flows, whether this is income drawn down from investments or charges or tax being applied, resulting in a much more accurate assessment of the probable range of outcomes and assets ultimately left available to meet future expenditure.

Considering and then being able to clearly visualise different scenarios in a cash flow plan provides a powerful platform for advisers to engage with clients around a realistic assessment of returns likely from their portfolio. Forewarned is forearmed. As a result, advisers and clients will be better equipped to navigate the choppy waters we all now face.

Find out more about new Dynamic Planner Cash flow