Financial modelling in uncertain times

Clark Street Mercantile Qnkhzjpkfd8 Unsplash

For financial professionals only

Many senior planners will remember ‘current cost accounting’. In the 70s, inflation got so bad that big companies had to publish their accounts in inflation adjusted terms – so investors could compare corporate yearly profits without distortion. By 1986 the problem passed and the requirement was dropped. With inflation now heading to 10% we could be entering a similar phase where last year’s financial plan makes little sense today. What does this mean for cash flow models and clients?

CPIH Annual Rate

Source: ONS

Budgeting

Expenditure is the foundation of a financial plan. The ‘cost of living crisis’ makes it very hard to predict how much your clients will spend over the next 12 months, let alone the next 30 years. It’s likely the overall mix of goods and services in people’s expenditure basket won’t really change – unless the negative factors we’re facing put a hard squeeze on discretionary spending, such as travel and entertainment. But will your client’s personal inflation rate match the headline figure?

Everyone’s personal spending basket won’t necessarily match the components weighting in the Consumer Price Index (CPI) or Retail Price Index (RPI) basket. For example, the food weighting in the  CPIH (the acronym for CPI including housing costs) is 9.3%. In my retirement plan it’s more like 20%. The CPIH weighting for household costs is 30%, while mine’s about 25%. My view is simply inflating the 2022 estimate for 2023 spending by 9% might not be sensible. To get a reasonable estimate, you may have to get into the detail for an individual household. You can find indices for sub-components of the expenditure basket on the ONS website, where you’ll see for example annual inflation in communications costs to April 2022 is running at only 2.7%.

Inflation forecasts

After tackling the short-term, the next challenge is how long elevated price changes need to be factored into your client’s plan. It’s been safe enough over the last 10 years to treat inflation as a constant at around 2%. That’s not where we are today. In building a model you have to judge when things will come back down to more manageable levels. From a research point of view, one approach is looking at the implied future inflation curves supplied by the Bank of England, found here.

Chart 2

Source: BofE

Note: implied inflation curves reflect market expectations for the Retail Price Index – not the more favoured Consumer Price Index. But neither are perfect reflections of spending cost changes for retired people or the spending basket of the more affluent.

This data shows that the market doesn’t expect inflation to fall below 2% within a generation. So after a bump over the next couple of years, it might be prudent to consider a figure for long-term planning over 3% for someone leaving work soon or already enjoying their retirement.

Impact on returns

Increasing inflation expectations will impact all return assumptions and is really subjective. Most modelling is done for long-term retirement planning with a lower risk investment strategy. To plan for your client’s required income in old age you often need a measure of dependability. If they’re not extremely rich and extremely frugal, you may look to mix bonds and equity into their portfolio. Their likely returns are interlinked. Equities are modelled by actuaries to show over the long-term a combination of the likely bonds return, accounting for expected inflation, and an ‘equity risk premium’. This is one of the reasons why modelling for retirement on an ‘after inflation’ or ‘constant £’ basis makes things easier to understand – you remove the inflation impact before presenting the result. We wrote about this last month. 

Looking at stochastics

What will happen to my clients’ investments? Assuming our retirement investment returns will be a complex mix of bond returns, inflation compensation and equity returns (to the extent they have capacity to take equity risk), there’s no simple answer. We face a range of possibilities. Capital market studies show We see bond returns likely remaining negative in real terms for a decade, while the inflation component of equity returns may heighten our experience of equity volatility. There’s also some possibility the equity risk premium (generally seen as a relatively fixed measure) may change. For example, it was depressed in the 1970s.

You can look at an actuarial, stochastic forecast in our simple to use Income Manager Tool (IMT). Just ask your Regional Sales Manager to activate it on your Parmenion account. It offers a clear picture of individual life expectancies and central view of likely portfolio returns, independently researched by Club Vita

Who’s most affected?

Some people facing a more hostile outlook will take prudent action and push their retirement decision out a while. This will be more difficult for those who have switched out of index-linked or semi-indexed pensions through pension transfer and kicked off their drawdown withdrawals (assuming a 5% real return after costs from a balanced portfolio). Everyone in or near retirement should be advised to examine their spending very carefully. Those heavily dependent on drawdown should also review their lifestyle and discretionary spending while the outlook is uncertain. Clients not having to work through these challenges alone is just one of the advantages of having an adviser’s support.

This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.  

Speak to us and find out how we can help your business thrive.