What is Cash Flow Modelling?
If you are using a financial adviser to assist you with your financial planning you may well have already been introduced to Cashflow Modelling.
When I joined the financial advice industry I was working for a single life assurance company and I was essentially selling life assurance based products and investments. Whilst the products were chosen which most closely suited the needs of my clients I generally looked for people to fit the products that were available to me.
Later in my career I set up my own business so that I could provide independent financial advice. Now I was able to choose the most competitive products from the whole market rather than simply using the products of one company. However, the emphasis was still on meeting the needs of my clients at any one time by choosing the most appropriate product.
A major change occurred in 2012 when The Financial Services Authority (FSA) banned financial advisers from receiving commission for selling investment products. This decision was something of a revolution for the financial advice industry and made firms rethink their relationship with clients who were now paying their fees directly. Financial advisers have begun to emphasise the financial planning aspects of their role over and above the recommendation of products. This has led to ‘financial lifestyle planning’ as a fundamental element of the advice service provided to clients. In order to aid the financial lifestyle planning process, cashflow planning tools are now available to show client goals using colourful charts.
The emphasis is no longer on products but on the client and how they want to live so that the financial planner can work out how to make this happen. Products will often be recommended but these are very much secondary to the client’s plan, simply tools to achieve the desired outcome.
Clients who were once confused or put off by seemingly complicated financial products now find that their financial advisers want to spend the bulk of their meeting time talking about the client’s aspirations rather than explaining the intricacies of particular products. Annual review meetings now centre around the progress of the client’s plan rather than simply discussing the performance of policies and investments. The product choice is still important but it is no longer the focus of the adviser’s relationship with his or her clients.
The importance of assumptions
Every cashflow model is just that – a model which relies on a range of assumptions. These may, or may not, prove to have been incorrect assumptions which is why the model needs to be revisited at regular intervals, usually as part of an annual review.
There will be assumptions for inflation; the point at which earned income will cease; the pensions you will receive and from which ages; how long current core expenditure and discretionary expenditure will be maintained; when your mortgage will be repaid; the investment growth on your various investments; when any capital sums will be required; and the total annual ongoing charges on your pension funds and investments, just to name the main assumptions.
Your advice firm will choose the assumptions having gathered input from a number of sources based on a long-term view that takes into account current values, past trends and future forecasts. However in order to be more helpful a number of charts will be produced showing the effect of, for example, an increase in inflation, a stockmarket crash, or a poorer than expected investment return.
The chart will usually shows a bar for each year of your life up to age 100.
The old adage KISS still applies
It is important that the assumptions used in the cashflow model are as accurate as possible. However, there is no point in being overly precise as that can be misleading. Any one of the assumptions being incorrect can make a big difference to the outcome. This is why annual reviews are necessary.
The old adage therefore, which is addressed to the adviser, KISS – Keep it simple stupid, still applies. I have seen cashflow models running to over 120 pages and I cannot believe that most clients would be bothered to study such a document and therefore its purpose is lost.
Your living expenses
If you ask most people to say what their total living expenses are for a year they won’t get anywhere near the true figure. It’s just not something we carry around in our head. It is, however, a vitally important figure if we want to be assured that our money will not run out during our lifetimes.
It is therefore worth spending a bit of time trying to get as accurate figure as possible. The best way to do this is to use something like the MoneyHelper Budget Planner
What are your goals?
Most people live from day to day without their goals and future aspirations at the forefront of their minds. One of the benefits of cashflow modelling is that it focuses your mind on what you really want out of life.
Some people struggling on in a job they find stressful or uninteresting are shocked to find that they could retire tomorrow without running out of money before age 100.
Hopefully you will now understand that there is little point in having a cash flow plan unless it is reviewed regularly. This is imperative in order to track actual progress against the projected forecast. As a result of the various estimates it should be obvious that the actual results will differ from the cash flow plan from day one and will increasingly diverge as time goes on. Reviews are therefore essential to update the plan with real performance upon which any required adjustments can be made.
A review of the cash flow plan doesn’t necessarily need to be every year but will probably need to be every two or three years as a minimum. Review frequency will depend on where you are in relation to the time when your earned income will cease. The closer you are to this point the more you will need annual reviews.
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