I am a huge advocate of cashflow modelling. Not any particular modeller, but the process. This is because I believe it is essential to show clients how their income will be affected by spreading their fund over several years. A pension fund value of £250,000 might look like a huge amount of money to most people, but it looks a lot smaller if it is spread over 30 years.
Cashflow modelling also allows you to factor in known expenses and answer common questions such as: what happens if I retire earlier? Can I afford to spend more in the early years? When will my income run out?
It might only be an estimate, but it provides much more realism than simply expecting the fund to run down gradually. People’s lives do not run smoothly and their spending habits will change as they age and as they experience different life events.
3. Set an investment strategy
Another key variable that must be factored into cashflow modelling is the performance of the underlying investments, so the next step is to set an investment strategy and analyse how clients' assets are likely to perform in practice. Consideration must be given for short-term cash and income requirements. This will likely be held in lower risk/return assets to mitigate sequencing risk, with any balance invested across a range of funds and assets to match a client’s attitude to investment risk, investment term and level of dependency on their pension in relation to other assets.
Quite simply, everyone’s needs will be different and hence their investment strategy and cashflow models should reflect that.
The cashflow model is more effective where it can include all of the client’s sources of income in retirement and use different growth assumptions where appropriate. Furthermore, the model can be used to illustrate their vulnerability to unplanned events such as a market crash.
Pulling all of this together, Chart A shows how a client’s income needs may be met using the different income sources available to them (figures are adjusted for inflation).
4. Consider longevity insurance
Ultimately, the best way to ensure money does not run out while the client is still alive is to purchase longevity insurance, the most common form of which is still an annuity purchase. Unfortunately, the well-documented fall in annuity rates, together with their relative inflexibility, means they are less suitable for young retirees. There comes a point though for most people where this situation changes. Then the advantages of security outweigh the disadvantage of uncertainty.
