Key differences between cash flow modelling solutions include:
Deterministic vs stochastic modelling
- If we are using a deterministic cash flow modelling system, then we know that we need to be stress-testing our results for stock market turbulence and crashes.
- With a stochastic modeller, the volatility in investments is already captured, but we need to be able to explain this to our clients. Our results will also be presented as a range and we need to ensure they understand the potential losses as well as gains.
Risk-based vs fund-based modelling
- If we are using fund-based modelling, then we need to be sure that the current portfolio is representative of the portfolio we would expect our client to be in for the long-term, or enter a different asset allocation that is more representative.
- If we are using risk-based modelling, then the actual make-up of the portfolio matters less than the overall risk profile, which must be appropriate for the client for long-term investment.
Real vs nominal outputs
- We need to be sure of what we are looking at in our outputs. Real values will show a consistent level of purchasing power over the cash flow plan, but fund values will therefore look lower than if we are using nominal values.
- With nominal values, we must check that our client understands how inflation will affect the purchasing power of their fund at different points in time.
- For both forecasts, it is vital that we are using the appropriate expenses, either real or nominal, to match our portfolio values.
The process: building a plan
Cash flow modelling is built on data, with the entire process built around understanding what goals might look like for your client, as well as showing them the path their finances may take.
As we all know, trash in leads to trash out, so we need a robust solution to collect accurate incomes and expenditures now, as well as in the future.
We are therefore going to want to collect information on current levels of incomes and expenditures, including the day-to-day life costs and details of less frequent spending. Any anticipated changes to these income and expenditures also needs to be captured and modelled.
Once we have input current levels of incomes and expenditures, we also need to capture all of the clients’ investment, savings and debt products, including those not under advice. This gives us a clear view of the current situation.
From here, we need to take the client on a goal setting journey, to include all of those essential and ‘dream of’ expenses we are hoping to achieve over our lifetime. This will include a view of what retirement might look like, and the level of expenditure we are expecting.
The retirement standards published from PLSA might be a good place to start, if the client has no view over what they will need at retirement.
Once we have incomes, expenditures, products and goals set up, in our cash flow modelling solution we can examine the outputs to see if our goals have been met, adjust our goals or life phases, or see if we can meet any unmet goals in a different way.
The first look at a cash flow model is likely to include:
- Looking at surplus money to see if it can be put to better use.
- Looking at debts and shortfalls to see when they occur, and how they might be met.
- Ensure the most tax-efficient wrappers are being utilised in the cash flow plan, while maintaining the level of flexibility required by the client.
We can then move on to the impact of changing bigger things, like the age at which we are going to retire, or the expectations of spending in retirement, to see how this impacts our life plan.
You will want to revisit your client’s cash flow plan, at least yearly, to reassess the validity of the inputs to the model, but you may also want to look again during big life events, or before big purchases, to ensure that your client’s goals remain on track.
The role of the adviser
Throughout the process of cash flow modelling, the adviser sits alongside the client as a guide and a coach, highlighting where the client is doing well, and helping make tweaks to the plan where the client still has a way to go.
