We‘re all familiar with the expression ‘garbage in, garbage out’ but is this true when it comes to cash flow modelling?
What tends to mess up financial models is people – people and their partners changing their mind about their lives and how they want to live them.
So, what is wrong with assuming that inflation will be 2%, (because that’s the target), balanced investment returns will be say, 5%, and that we’ll all die at 95? (Please don’t assume charges will be nil.)
What a drag
To answer that question, let’s first answer the more topical assumption: what will tax be like in future?
For a long time, Income Tax allowances have been adjusted annually for inflation. But those days are over. No one is expecting income tax allowances to rise for at least the next 4 years. It’s interesting to note that Inheritance Allowances have been held in nominal terms for over a decade. With the regulator emphasising the importance of modelling retirement in real (not nominal) terms, as stated in TR24/1, it’s essential to account for fiscal drag in a professional cash flow model. When modelling in real terms, accounting for fiscal drag involves reducing allowances each year in line with your inflation estimate.
What might that estimate be?
Inflation
The Bank of England are charged with keeping inflation in check – officially targeted at a rate of 2% for CPI. If you want to spend a wistful moment on their website, you can read all the Bank’s letters written to the Chancellor, explaining their failure to achieve this in every quarter going back to the middle of 2020. However, given that the future pattern of inflation is hugely important to public borrowing, the market’s estimates - derived from the prices set for index linked gilts - are also available on the Bank’s website.
The ‘instantaneous forward inflation’ curve in the latest yield curve data from BoE shows that inflation over the next 20 years is expected to average about 3% per year - a credible assumption.
Returns
Investment professionals are often hesitant to give estimates of what portfolio returns will be, because of the inherent uncertainties and serious risk of misinterpretation. But there is a ready market of consulting actuaries and investment houses who provide opinions on this topic, and these professionals are often employed by pension schemes.
Although these estimates change every year, often as interest rates fluctuate, sourcing returns from expert third parties is good practice. For example, at the start of the year, JP Morgan estimated a medium term return of 7% on a 60/40 portfolio, while Vanguard put it at 6.2%. These and similar estimates are easy to find online.
For a real terms return assumption, just subtract your estimate for inflation from the investment return number for the portfolio risk level that you’re modelling.
Longevity
Cash flow models are often used to answer the unanswerable question, will I run out of money if I retire now? From the perspective of longevity with perfect foresight, for 50% of 65-year-old men the answer is to have savings that can last 20 years. 25% will need to have 27 years’ worth of income covered. 3% will need money for 35 years, as they’ll live to 100.
So, what date should a simple retirement plan run? Instead of picking a round number or adding a standard number of years to the client’s age, consider a risk based, dynamic approach using the ONS life expectancy calculator. This allows you to adjust your model’s longevity horizon annually for a 95% life expectancy from that point in time.
Each year through retirement, this method gently reminds you to account for the tail risks of extreme longevity without putting off enjoying the go-go phase of retirement, simply for fear of living too long. It’s important to note that 25% of people in their mid-60s, both men and women, don’t make it to 80. And for couples there’s a similar chance of a bereavement before 80 as there is of one partner living to 95.
Striking a balance in these decisions is crucial. For most people, simply avoiding risk isn’t the same as living life to the full.
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.