Planning for retirement can be daunting. For many, it's a long-term process of organising their life's savings and investments to live comfortably after their career is over, making it a high-stakes decision.
It is no surprise then that the Financial Conduct Authority's (FCA) recent Retirement Income Review made it clear that ‘We expect firms to illustrate the longevity of income in a variety of scenarios as discussed with the customer'. This fits under the broader directive from the Consumer Duty Act to ‘avoid foreseeable harm' and to help clients ‘make informed decisions'.
Careful thought and consultation need to go into how to do this. Clients want to entrust their retirement plans to advisers that will help them prepare for all eventualities and maximise their savings and investments. Robust cashflow planning can help with this and also meet the FCA's standards that advise "consumers make the right decisions and secure good outcomes.
"Ultimately, all cashflows are forecasts and so will inevitably not match the unfolding reality. To manage this, best practice involves testing which variables the cashflow model is most sensitive to and then testing against other various scenarios. One scenario tested in isolation may present the model as a good outcome, which doesn't meet the FCA standard, so it's important that advisers model for a range of scenarios less commonly used.
Commonly tested scenarios
Variable vs constant growth rates – Some firms use constant growth rates to compare scenarios, but, ideally, these should also be compared to variable growth because constant growth rates are never true for risk-based investments. Variable rates should be both low and high around the time decumulation starts as this can dramatically alter wealth.
Market shocks – It is simple to model a market shock such as the 2008 global financial crisis. These Black Swan Events are rare but very impactful, so they are important to be factored in.
Retirement date – Some clients may have pre-conceived dates for retirement, based on what they think they need to do. It's prudent to test multiple dates, either for a possible earlier retirement or to plan for a career extension.
Longevity – This is debatable as some may use average mortality (mid-80s) and others 100 years of age to terminate their forecast. Both have their drawbacks as the requirements for being financially comfortable at 85 may be very different from the requirements at 100. Best practice will help clients prepare for both.
Less commonly tested scenarios
Inflation rates – Usually a flat inflation rate is used but as recent inflation rates highlight, inflation can be subject to fluctuations. In 20 years, a flat 4% inflation rate demands another 75% income to meet the same need compared to 2.5% inflation, a material difference. Inflation rates also differ among individuals based on their consumption patterns so a universal standard inflation rate may not apply.
Different expense patterns – Expense patterns are rarely flat over life yet that is often the easiest assumption. The FCA also noted that often capital expenditure is neglected. This is the crux of decumulation so the weaker this is modelled the more likely the model will provide misleading outputs.
Saving more or spending less – This sounds simple but can make a material difference over the long run, particularly if there are tax reliefs or tax deferrals, like pensions. Individuals' spending habits are expected to change over their lifetime so should be factored in.
Variable asset allocation glide paths – During accumulation, asset allocation tends to remain similar over long periods. In contrast, decumulation can have more dynamic asset allocation over time. For example, some retirement experts advocate a ‘smile' glide path around retirement – leading into retirement growth assets may be reduced but then 10 years into retirement start increasing again as longevity risk declines.
Loss of income from a partner/spouse – A difficult thought to entertain, but modelling for the loss of a partner can make an individual's financial plan more resilient. If a partner passes away and removes a source of income from the plan, the spouse might not be able to sustain their current level of expenditure to mortality. To ensure each will be ok this should be checked, particularly if one spouse has a significantly larger fixed income. This may also include Inheritance Tax leaving the estate.
Paying off a mortgage faster – With interest rates settling at higher amounts, interest saved may prove better than investments that can't match the interest rates after taxes and fees. Savings can then be invested.
Downsizing – This is a question worth asking as many may be happy to downsize, especially if they no longer live with any children they may have. On top of a potential net return on the change in property, downsizing may create a lot more flexibility in other aspects of lifestyle.
Protection and other unforeseen events – The cost of living crisis has tested the resilience of many households. Providing a safety net with protection policies is paramount to financially protect clients and their families.
These are some of the scenarios that can be checked, the options discussed with clients, and reviewed annually to create a fluid plan. Cashflow modelling can help do this in up to an hour from scratch and provide visuals to help communicate the variables with greater ease to clients.
Cashflow modelling can also help find the boundaries for some key financial parameters by testing how different scenarios can impact other outcomes. For example, if inflation rates hold for a certain time, the client may be in a better position to retire earlier.
All work can be stored as proof of due diligence done and value-added, with the model providing a track record to meet the FCA Retirement plan requirements and Consumer Duty Cross-cutting rules.
Meeting regulatory standards is of course a paramount concern for financial advisers. But of equal importance is providing the best retirement outcomes for clients, making sure that they can rest assured knowing their money is being used to its greatest potential and they can make the most of their retirement. Testing a comprehensive range of scenarios against each other with cashflow modelling is the best practice for ensuring both.
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Stephen Ford is Adviser Product Strategy Lead at FE fundinfo
This article first appeared in Professional Adviser on 22 April 2024
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