Cash flow modelling has long been part of financial planning’s toolkit. For a wealth of reasons, it is today firmly on the rise. Here, Heather Richards – Head of Actuarial Insight at Dynamic Planner – looks closely at cash flow planning tools under a regulatory microscope.

She considers the strengths and weaknesses of different approaches, including stochastic and deterministic forecasting; fully testing a client’s capacity for risk; stress testing portfolios; miscalibration; and an answer to avoid these dangers

Cash flow planning can take many forms, from a simple spreadsheet showing annual income and expenditure, to a sophisticated, stochastic projection of the impact of contributions and withdrawals on a client’s capital.

There are multiple cash flow planning tools currently available and many more homemade spreadsheets. Of course, as with any financial advice, it is vital it is done well. However, some tools arguably would struggle to meet the regulatory demands of COBS, let alone the newer PROD rulebook, designed to help firms meet standards laid out in MiFID II.

COBS 4.5A 14 states any future projection must be based on appropriate assumptions, supported by objective data and not simulated past performance. If your current cash flow tool takes in a historical index of returns and creates a forecast by sampling returns from this index, without any model or assumptions for how this might change in the future, then the tool is using simulated past performance and cannot arguably be used for future performance.

Assuming your own growth rates – The dangers

A cash flow tool which asks you to input a percentage growth rate is making you answer a complex question – determining a future growth rate, including showing the impact of investment risk. A larger organisation, with expert internal resources, could potentially handle that demand, but it could be a challenge for smaller firms.

Entering a percentage growth rate may be fine when it matches what was intended by the risk profiling tool adopted by your firm. However, a deterministic cash flow is arguably unlikely to accurately reflect the level of risk within an investment.

In an ideal world, the tool you use for measuring clients’ attitude to risk also enables you to project cash flow plans, based on returns from a range of risk levels using the same model and assumptions. That can then be aligned to the risk level of recommended investments, again using the same assumptions.

Looking more closely at PROD, particularly within the context of cash flow planning, advisers are classed as ‘distributors’, recommending ‘investment services’ to their clients.

PROD 3.3.1 states that: “A distributor must: (1) understand the financial instruments it distributes to clients; (2) assess the compatibility of the financial instruments with the needs of the clients to whom it distributes investment services… and (3) ensure that financial instruments are distributed only when this is in the best interests of the client.”

A cash flow plan, done well, can show a client that a product is suitable in a range of circumstances, meets their needs and is in their best interests. PROD 3.3.11 further states distributers should consider how a recommendation fits with a client’s risk appetite. We can explore this now.

Cash flow planning and capacity for risk

Risk appetite – this is an area in which cash flow planning is arguably much underused. Measuring a client’s attitude to risk is often today done through a psychometric questionnaire. But there is an additional, vital element to someone’s suitable risk profile, their capacity for risk.

The FCA defines capacity for risk as an individual’s ‘ability to absorb falls in the value of their investment. If any loss would have a materially detrimental effect on their standard of living, this should be considered in assessing the risk they are able to take’.

The FCA has said capacity for risk should be considered mathematically and not be founded on a client’s feelings and what they think they can afford to lose. This could be interpreted as asking a client what they could afford to lose in terms of a percentage. But that raises issues.

First, most people simply wouldn’t accurately know in those terms. Second, such an unequivocal answer leaves little room for future manoeuvre. A client who states they can afford only to lose 5%, in terms of their overall portfolio value, might be unimpressed come their next annual review to learn of a 6% loss, even if materially it had no material impact ultimately on their standard of living.

How can cash flow planning help?

Accurate, risk-based cash flow planning can powerfully demonstrate the amount of loss a client can afford and therefore the level of risk they can take with their investments.

Take one example – a client entering drawdown must decide on the level of risk they should take with their portfolio. A cash flow plan, showing their future expenditure (likely to be higher in early and late retirement, and lower in mid-retirement) can be created, with income coming from drawdown of their investments.

Stochastically forecasting the impact of that will highlight when the client is likely to run out of money, particularly if investments returns are low – a worst-case scenario in crude or layman terms. However, using the right tool, the level of risk within their portfolio can quickly be dialled up or down until that worst-case scenario provides them with enough money to comfortably last them right through retirement. If no level of risk is tolerable, it might be appropriate to look at annuities, or even to delay retirement.

Stress testing. And miscalibration – The dangers

Highlighting risk within cash flow planning is new for some. Some tools forecast worst-case performance simply by removing a fixed percentage of a client’s portfolio at a fixed time – stress testing, as it has been termed.

Using deterministic forecasting, that is all that is possible, which of course may be fine, provided you are aware of the limitations of your projection. However, a more sophisticated tools can produce a more sophisticated answer.

For example, the timing of the drop in the value of a portfolio is important and has different implications in different scenarios. For someone beginning retirement, the initial months and years are crucial and the time when investment losses will cause the biggest damage. For a client still accumulating, it is the end of that phase which is most sensitive to market performance and sequencing risk.

Good, risk-based cash flow planning software will consider all investment scenarios and be able to demonstrate poor performance, regardless of when it occurs.

When it comes to the model and assumptions used by tools, a final important pitfall in the process must be negotiated. Miscalibration. If a firm uses tool A to measure attitude to risk, adopts tool B for cash flow planning and then turns to tool C to find a ‘suitable’ investment solution, the chain of assumptions you are adopting has been broken and the firm is at risk, ultimately, of giving clients bad advice.

How can you fix that? Adopt a single financial planning tool, which uses the same assumptions consistently throughout – allowing you and your client to plan accurately for the future, whatever it holds.

Dynamic Planner has launched its new Cash flow. How can it help you?