Cash flow modelling – how to forecast your future finances with accuracy
Martin Holden, financial planning partner at our partner Tilney, explains the benefits of cash flow modelling in accurately forecasting your future finances.
Sensible, hard-working people don’t tend to run out of money. My long experience as a financial planner has shown me that.
But it has also taught me that many of us forego the retirement we really want because we’re worried about running out of money.
We don’t have the confidence to make big financial decisions, so we can be over-cautious – and, often, this means coming to the end of our lives with ‘too much’ money still in the bank.
This caution is understandable. None of us can predict the future, so it’s natural to play it safe – but what many people aren’t aware of is quite how accurate cash flow modelling can be in forecasting future finances.
This sophisticated technology, when driven by an experienced financial planner, can show you if you’ve got enough money to do what you want to do, which gives you the confidence to make important financial decisions.
This could mean retiring earlier, giving money to a child for a house deposit or realising that, with a bit of financial rejigging, you can afford to have more holidays than you thought!
Avoid homemade spreadsheets
In my experience, legal professionals are usually meticulous planners, who very often have everything set out in a spreadsheet.
But these spreadsheets don’t necessarily give them the confidence to make decisions, or they lead them to err on the side of caution, choosing the most conservative route.
This is because however sophisticated your spreadsheet is, it’s unlikely to take into account all the nuances and variables that can have a significant impact on how much money you may eventually still have in later life.
I’ve seen many spreadsheets belonging to clients over the years and most of them don’t include even basic factors such as inflation and tax rates, never mind the impact of the escalating cost of care or benefit crystallisation event 5A at age 75 on their pension lifetime allowance!
Cash flow modelling, on the other hand, is very detailed, with a huge number of calculations and formulae ‘under the bonnet’ and – while it’s not a crystal ball – it can forecast future finances with accuracy based on sensible assumptions in order to make considered decisions.
All the numbers in any forecast are also converted back into today’s money, making it much easier to understand.
The experience of the financial planner who is driving the cash flow modelling exercise is also an important factor.
Over the course of a career, financial planners will have had these conversations with thousands of clients and can guide people through the process, asking the right questions, showing different scenarios and stress testing everything to give real clarity.
Accurate data and realistic assumptions
As you’d expect, the first step in any cash flow model is to collect information about your finances, for example, your income, outgoings, pensions and other investments.
We then analyse this information along with your future goals and income requirements to forecast if you’re on track, have more than enough money or are likely to fall short.
We do this interactively with clients and can try out different scenarios, for example, bringing retirement forward or looking at the impact of taking a different level of risk with your investments.
We can also show the impact of events such as a fall in financial markets or receiving an inheritance.
Cash flow modelling always leads to fascinating conversations as our clients work through scenarios and think deeply about what really matters to them.
As I always say, this is a technical solution but it’s not a technical problem we’re trying to solve. This is about how you want to live your life.
There are always going to be trade-offs, but when people can visualise things they often come to realise that what they thought was important perhaps isn’t, if it means they can make gains elsewhere.
For example, downsizing to a smaller home with one less bedroom at age 80 may be a good compromise if it means retiring earlier or having more to spend during your active ‘golden years’ of retirement in your 60s and 70s.
Cash flow modelling gives you accurate data and personalised charts but, just as importantly, it also creates an agenda for a family conversation. You have the relevant facts and figures to make important decisions.
Cash flow modelling – a case study example
The clients: Julie and John
Julie and John want to understand if they have enough money for Julie to retire in the next couple of months rather than waiting a year as originally planned.
Julie is 62 and earns more than £150,000, working as a solicitor. Her husband, John, who is almost 62, is just about to retire after a lifelong career as a teacher. He earns £48,000.
John has recently received an inheritance of £320,000 from his mother who died last year and because his health is quite fragile, Julie and John are keen to enjoy some time together sooner rather than later.
Cash flow modelling is designed to give clarity in exactly these circumstances.
Julie and John’s finances
They have accumulated pensions of about £700,000, ISAs of about £310,000 and both expect to get a full state pension at the age of 66.
John will receive a teacher’s final salary pension and Julie has a small annuity.
Julie’s mother is still alive and, at a conservative estimate, she expects to inherit £180,000 in five years’ time.
Julie and John’s expenses
I have broken their retirement down into three stages to work out their expenses:
- phase one – this is the golden years of active retirement, so I have ear-marked £80,000 a year every year into their 80s
- phase two – their expenditure then drops to £60,000 a year as they become less active
- phase three – during their last five years, I have increased their expenditure to £100,000 a year to allow for possible extra care costs. When working out life expectancy, I tend to allow for a full innings, using what is called cohort +5. This is the average life expectancy of someone their age plus another five years
Costs such as house maintenance and new cars are also included.
Can they afford for Julie to retire?
In the first scenario, their money runs out at the age of 89. They still have their state pensions, teacher’s pension and annuity, together with a house worth £690,000.
John is not comfortable with this scenario, as his mother died at 91.
Julie resolved to stay working for another year but when we modelled this, it didn’t make much of a difference. They ran out of money at 90.
Julie and John were already planning to release £100,000 from their home at the age of 75 by downsizing but they now wanted to look at the impact of releasing £200,000, which they thought was doable because of plans to move to a different area with lower average house prices.
Julie also thought the opportunity to retire earlier was more attractive than driving a fancy car for the next 20 to 30 years, so she chose to look at the impact of reducing the cost of replacing her car from £40,000 every four years to £20,000.
Another change we looked at was increasing the growth rate assumptions for their investments. They were very conservative and we built the first two scenarios on an assumed growth rate of only 2% after costs. Following risk profiling, they were comfortable to take on slightly more risk, so we increased assumed growth to 3% per annum.
Having made these changes, cash flow modelling showed Julie and John that, at 93, they would still have £200,000, as well as a house worth £600,000.
This wasn’t their original plan but it created a way for Julie to retire at the same time as John and the accuracy of the forecasting gave them the confidence to follow it through.
Of course, we will review the plan with them in the ‘real world’ and make changes if and when necessary, but it is often the case that because we have used sensible and conservative assumptions, that clients find they are actually ‘ahead of the game’ as time goes on, so their confidence increases – as can their spending.
Cash flow modelling with Tilney
Tilney’s cash flow modelling webinar took place on 30 September, this webinar discussed the benefits of building a robust retirement cashflow plan and provided examples of how cashflow modelling can answer your retirement questions.
In the meantime, if you would like to speak to an expert, Tilney offer free consultations, which you can book online or by calling 020 7189 2400.
Tilney is a strategic partner of the Law Society.
The value of an investment may go down as well as up, and you may get back less than you originally invested.
This article does not constitute personal advice. If you are unsure as to any course of action, please talk to an adviser.
Issued by Tilney Financial Planning Limited. Authorised and regulated by the Financial Conduct Authority.