- make assumptions about future rates of return that are not based solely on specific patterns of past returns;
- potentially use constant rates of return for different funds or asset types, so long as there is appropriate stress testing;
- consider the differential between gross returns for different types of funds or assets, and inflation;
- undertake regular reviews of the assumptions used, considering wider economic circumstances;
- be careful about presuming their ability to predict variable future rates of return (and inflation) to avoid the impression of accuracy; and
- be able explain to clients the justification for any assumptions and why they are reasonable.
Charges have an impact on how long retirement income can be withdrawn from an investment, in the same way that a higher withdrawal rate does.
When undertaking cash flow modelling, firms should include all foreseeable product and adviser charges.
They should also consider how they communicate the overall cost so that the client understands how the level of charges affects the sustainability of their funds, ie how long they are likely, and can make an effective decision on whether to proceed.
Planning for uncertainty
Cash flow modelling is based on assumptions, and the FCA review found that some firms have explained this poorly to clients.
Cash flow modelling can be a useful tool to help clients plan for their future.
If a client understands that returns are based on assumptions about how the market will perform (and their investment value may go up or down) they are less likely to withdraw more than they can afford from their pension or investments.
Firms are required to assess the client’s knowledge and experience of the recommended investment and to check the client’s understanding of risk. If the firm does not explain cash flow modelling clearly, its recommendation may not align with the customer’s risk tolerance and capacity for loss.
Customers could be misled about the sustainability of their pension.
Firms can help their customers understanding; generally, consumers understand their current levels of income and expenditure, net of tax, and by expressing future income and expenditure in today’s terms, firms can help their clients understand how their lifestyle in retirement could compare to their current lifestyle.
To facilitate this understanding, firms should:
- illustrate net of tax income and expenditure in real terms (representing annual inflationary increases as a constant real amount);
- check whether inputs are in nominal or real terms and ensure they convert any inputs made in nominal terms to appropriate real terms;
- be clear whether quoted returns are gross or net of inflation;
- review the rate(s) of inflation they use on a regular basis; and
- show the effect of alternative rate(s) of inflation to ensure clients understand the effect of inflation on their investment.
Half of consumers will live longer than average.
Firms who use a cash flow model should carry out projections that go beyond average life expectancy.
The Office for National Statistics provide a life expectancy calculator that shows the probabilities of males and females surviving to older ages.
Firms should also:
- remember that consumers generally underestimate their own life expectancy;
- focus on the probability of survival rather than life expectancy, to address clients’ misperceptions and the potential harm of running out of money;
- when advising couples, consider the probability of survival for both parties;
- consider how income needs may change in later life; and
- only take account of limited life expectancy when there is strong evidence that it will be borne out in practice.
When undertaking cash flow modelling, there is a risk that clients perceive a detailed projection of their financial affairs as a certainty.
Undertaking an element of stress testing and showing plausible alternative scenarios gives firms some evidence that the risk they are proposing is in line with the client’s risk tolerance and capacity for loss.
It also gives clients an indication of the risks of the recommended proposal and what different outcomes might mean for their income throughout their retirement. Firms should consider:
- illustrating a rare but feasible fall in asset values at the start of any income withdrawal period, such as actual drops in benchmarks for the recommended investments;
- reducing net of inflation rates of return to show the impact on how long funds will last;
- highlighting the lower percentile outcomes in stochastic modelling output; and
- showing how higher withdrawals will deplete the fund sooner.
Consumer understanding
When they get advice, clients may receive several communications from firms that refer to future outcomes.
Using multiple growth rates across different communications is likely to confuse clients and lead to misunderstanding if not explained.
