The introduction of the Appropriate Pension Transfer Analysis (APTA) has made the inclusion of cash flow forecasting an all but mandatory part of Defined Benefit reviews. Obviously, this is the higher risk area in advice but we see cash flow being used in more and more areas of planning.
The FCA asks that advisers know how their cash flow tools work and are, in particular, aware of the limitations of these. We know cash flow forecasting can never be an exact answer or provide definitive overviews of the suitability of a particular piece of advice but I just wanted to use this to highlight a couple of areas where a very small change in the behind the scenes inputs can have a dramatic effect on the projected financial position.
There are always clients and individuals who are able to save as much of their surplus income as possible while there are also those who have little in the way of savings despite having a much lower committed expenditure relative to net income. Catering for each in a cash flow forecast can provide a much better visualisation of a client�s potential future position.
If we take the following (highly simplistic) client scenario:
- Single individual age 55 and looking to retire at 65
- Earns an income of �2,000 per month net
- Has �7,500 on deposit and �100,000 in a Personal Pension
- Has committed the expenditure of �1,500 pre-retirement
- Is aiming to spend �1,850 per month from 65 to age 85 with this than reducing to the �core/essential� spending requirement of �1,100 per month
- Has a Defined Benefit pension projected to pay �650 per month from age 65
- Investment returns are based on the historical returns of the IA Mixed Investment 0% – 35% sector.
If the assumption is that this client is able to save all surplus income, which represents the period from age 55 to age 65, liquid assets are forecast to last through to age 100:
On the basis surplus income is saved, the client appears here to have enough cash and pension funds to last their lifetime. Retirees are able to calculate this themselves thanks to IRA calculator services from the likes of SoFi and similar, to see if they will be financially stable for their lifetime.
If we assume that only 50% is saved, which allows for more unforeseen expenditure, liquid assets reduce substantially:
If it seems more likely that the client cannot or is simply unable to save, and we, therefore, go with a zero surplus being saved rate, the client has no liquid assets after age 80:
On a 100% saving rate, it would seem that the level of core and discretionary spending required in retirement could be met quite comfortably. With no surplus income being saved, the position is reversed.
In this case, the client has a surplus income of �6,000 each year but only �7,500 on deposit. If the annual surplus were due to a recent change in income or expenditure, it might make sense to consider further what an appropriate savings rate should be. If the income and expenditure has been relatively stable for a number of years, then clearly something closer to zero would give a much better reflection of what is actually happening.
This kind of analysis can spur action. With these charts in hand, a savings plan of �200 net per month to the pension immediately and until age 65 might be agreed. Dedicating some of the �500 per month surplus to this, and leaving the remainder as �unsaved excess income� can provide a much better outcome:
Another important aspect is accounting for and including charges. As mentioned the IA Mixed Investment 0% – 30% sector historical returns have been used in these forecasts
These returns should reflect any underlying fund costs but would not take into account provider/platform costs or ongoing adviser fees. If we factor in a 1.25% ongoing charge to account for these, we�re back at a shortfall after age 80:
Accounting for the extra charges as well as realistic saving rates should provide a more reliable indicator of a client�s forecast, which can provide more certainty in what is recommended and more security in terms of taking action to remedy any shortfalls.
To recap, we can compare the results of the first forecast with an identical version but one which includes ongoing charges and one which has no surplus income being saved:
100% of surplus income saved, no additional charges added
No surplus income saved, 1.25% product and adviser charges included
Assumptions over how much surplus income is saved, and accounting for charges in the forecast, are things we see sometimes overlooked. Accurately representing both, particularly as part of the APTA, should give a much greater indication over the potential sustainability of the aims and objectives of the client.