Introduction
Many financial advisers use cashflow modelling software to evaluate the feasibility of client goals and objectives, given their assets and current and future incomes. Cashflow modelling has recently been featured in numerous financial advice-related publications after the Financial Conduct Authority (FCA) published its Thematic Review of Retirement Income Advice earlier this year and identified several areas where advisory firms could improve their cashflow modelling.
In this article, we first describe why we use cashflow modelling software, identify the strengths and weaknesses, and finally identify how we attempt to address these shortcomings.
Before reading this blog, we would recommend first reviewing:
Our analysis of the "4% rule" covers many of the topics in this blog.
Our blog on sequence risk which examines some less favourable historical outcomes.
Our overview of how we use risk-based guardrails with our clients.
Voyant - our preferred cashflow modelling software
We have been using Voyant for many years and consider it the best cashflow modelling software on the market. It may not be the cheapest offering and has a steep learning curve (we'd recommend Voyant Mastery to learn how to use the software efficiently), but we've yet to find a better option. I've even written a couple of articles for Voyant.
While building a financial plan using alternative tools such as a spreadsheet is possible, this can be time-consuming and prone to errors. James and I can vouch for this, as we had to build a financial plan in a spreadsheet for our Certified Financial Planner (CFP) case study assignment, which made us appreciate Voyant even more!
Voyant allows us to easily:
Create child/"what if" plans. For example, if a spouse dies before retirement, will the remaining spouse have a sustainable retirement?
Move key dates (e.g. retirement) in the plan and evaluate the impact.
Optimise lifetime taxation (e.g. Income Tax, Capital Gains Tax, Inheritance Tax).
Keep a history of financial plans and compare differences.
Cashflow modelling software shortcomings
While cashflow modelling software is valuable for retirement planning, we believe it often has significant shortcomings. To address these, we use another software product called Timeline, which uses historical market data to create a more realistic picture of potential retirement outcomes.
Shortcoming 1: Straight-line assumptions
Cashflow modelling software requires a set of assumptions to evaluate and forecast a financial plan's feasibility. The adviser can enter these assumptions and/or import them from a third party. Some example assumptions are shown below.
Assumptions should be:
Reasoned: The assumptions should be justified and backed up with references/proof.
Reasonable: If a group of 100 financial planners/peers were asked to give their assumptions, the assumptions should be within the same ballpark as the group average.
This was drilled into us when preparing for the CFP case study!
We use a test client in Voyant to calibrate our assumptions to Timeline (which, as mentioned previously, uses historical data, not forward-looking assumptions). While we won't give our reasoning here (our internal document is 20 pages long!), our default assumption for our test client is that they will retire at 60 and live to age 100 and their expenditure increases by 1% less than inflation each year. This scenario is broadly successful for our retiree, with the client's investment pot being exhausted in their mid to late 90s, assuming a starting withdrawal rate of 4.75% a year.
However, the big drawback with these linear assumptions is that the cashflow forecast doesn't show the wide range of outcomes the client may experience. Investments and inflation don't go up in a straight line, and not everyone dies at age 100. Timeline aims to provide some much-needed granularity.
If we examine the range of outcomes in Timeline using the same initial withdrawal rate of 4.75% with expenditure increase by 1% less than inflation each year, we can see that:
If our test client were unfortunate enough to retire in 1915, their funds would've been exhausted by age 75 (red line).
If our test client were fortunate enough to retire in 1981, their investment balance at age 100 would be worth almost eight times (in real terms) the starting amount (green line).
Unfortunately, we just don't know ahead of time whether a client will be as lucky as the 1981 retiree, as unlucky as the 1915 retiree, or most likely somewhere in the middle.
Timeline shows the chance of plan success (the portfolio not being depleted) of 76% if the client lives to age 100 (we discuss the impact of longevity on success rates below). It does this by calculating the successful scenarios (1981 is one example) as a percentage of the total scenarios.
We consider a 70-80% chance of success in Timeline a reasonable starting point for a client's retirement plan. Therefore, we are happy that our assumptions are adequate for building a client's financial plan in Voyant before moving on to Timeline.
We believe that relying on cashflow software alone can give the client a false sense of security as it doesn't identify how bad things can get and the impact on their retirement plan. Take a retiree who wants to front-load their retirement expenditures. They plan to withdraw 6% per annum for the first decade and 3% afterwards (increasing expenditure in line with inflation). As with our test client, Voyant shows that the plan is broadly successful.
At a high level, Timeline is equally positive, with a 78% success rate (2% more than our test client).
However, the worst case has the money running out within the first decade.
This may not necessarily be a problem, but we believe a retiree:
needs to be fully aware of the potential for poor outcomes.
fully understands the changes to spending that may be required and what events will trigger them.
before committing to a retirement plan, and it's tricky to do this using just Voyant.
While Voyant allows you to stress test the client plan with a "major loss" scenario, we feel this doesn't realistically reflect real-world scenarios that have historically put retirement plans under stress, which, along with periods of market volatility, also tended to feature sustained periods of high inflation (e.g. 1915, 1937 or 1969 retirees).
Voyant also allows Monte Carlo modelling, which attempts to give a range of potential outcomes. However, the downsides of this approach include:
The simulations produce just a range of investment returns, not allowing for variations in inflation or longevity.
The outputs can be very sensitive to the input parameters, and these input parameters are (educated) guesses.
Shortcoming 2: Not considering the impact of life expectancy on plan success
In our Voyant to Timeline calibration, we set life expectancy to the point where our test clients have a survival probability of 10% or less - in this case, age 100.
For our real-life plans, we are interested in the chance of the client outliving the money. We now have two variables to consider.
The chance of a retiree's portfolio running out at a given point in time.
The chance of the retiree being alive at this time.
For our Timeline test client, we can see that while the risk of running out of money at age 100 is 26%, the chance of being alive at this point is only 10%, which means the chance of being alive and running out of money at this point is 2.6% (rounded up to 3% in the screenshot below).
We can see this in graphical format, with the portfolio success rate at age 99 (76%) matching the percentage in the screenshot above.
This analysis has the potential to allow clients to be more confident to spend their retirement funds, knowing that the worst case (from a portfolio sustainability perspective) of living a very long time AND the portfolio performing poorly is much less than either happening.
Timeline shortcomings
As detailed above, cashflow modelling software has some potential shortcomings. No tool is perfect, and it's worth pointing out some shortcomings we believe the Timeline approach has.
Flaw One: Insufficient historical data
Our analysis of the "4% rule" identified the risks (see challenge 3) of relying on historical data - we only have around a century's worth, which many might consider insufficient. There is a chance that future scenarios will be worse than those encountered in our dataset.
Flaw Two: It takes financial planners more time to create plans in both Voyant and Timeline.
We'd love it if a software product that offered the functionality of both Voyant and Timeline were available to UK financial planners, saving us time and, therefore, our clients' money, but we don't believe that such an offering exists (yet!).
To maximise efficiency, we only use Timeline when we think the client's financial plan will likely be under stress. Therefore, we may not use Timeline if:
A client is very unlikely to run out of money based on their retirement pot and spending plans. For example, a client with a retirement pot of £2m plans to spend £20,000 annually.
A client has spending plans that might put their retirement pot under stress, but this spending is planned for the future and is discretionary (for example, gifting to the children). In this scenario, we would use Timeline at the appropriate time.
Flaw Three: Starting investment valuations are not taking into account
Known as the starting point paradox, this flaw is arguably shared with cashflow planning software, and we cover it in challenge four of our 4% rule analysis.
Conclusion
Nobel prize winner William Sharpe described decumulation as the nastiest, hardest problem in finance. A retiree has to deal with many dimensions of uncertainty, and the right software tools can help a retiree build confidence to spend money in retirement. However, it's always worth being aware of the limitations of these tools and understanding that even robust plans require monitoring to ensure they remain on track, especially during challenging periods.
Want to find out more?
Please contact us if you want to work with a retirement planning specialist who will help give you peace of mind during retirement.
About us
The team at Pyrford Financial Planning are highly qualified Independent Financial Advisers based in Weybridge, Surrey. We specialise in retirement planning and provide financial advice on pensions, investments, and inheritance tax.
Our office telephone number is 01932 645150.
Our office address is No 5, The Heights, Weybridge KT13 0NY.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
Although best efforts are made to ensure all information is accurate, you should not rely on this blog for your personal situation or planning.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
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