Models of money management
In April’s Wealth Confidential column by Waverton, we referred to “cash flow modelling”. That struck a chord with readers who are looking for reassurance that their goals and aspirations are achievable.
Cash flow modelling incorporates all sources of a subject’s income, including salaries and investment income, as well as liabilities and taxes, creating a comprehensive picture of their personal wealth.
The real value of cashflow modelling comes from its ability to plot future cash flows – both incoming and outgoing. Using projections allows people to make more informed financial decisions – allowing them to calculate whether their current and future financial and lifestyle objectives are achievable, such as planned retirement dates. The availability of this information is vital if the financial plan is to be of value, now and in the future.
Cash flow modelling allows a financial planner to identify areas of risk in the plan and allows for more targeted conversations about savings goals, such as, “if you save an extra £X per month you could retire at your target date, otherwise you may need to work an extra X years or increase your contributions”.
Significant lifestyle events such as a potential shortfall in the level of a targeted retirement fund, or a shortage of funds to cover an unplanned capital expense, such as a wedding or a house deposit for a child, would also be clearly highlighted.
By identifying any gaps early enough a financial planner can adapt the financial plan accordingly, by restructuring investment and savings strategy, or by providing new ideas on how to generate additional sources of tax-efficient income.
Even more importantly, cash flow modelling brings financial planning to life in a way that numbers in a written recommendation never could.
Let’s look at a simple example... Mr Client is aged 50:
◆ He earns £100,000 a year, contributing 5 per cent of this salary into his pension; his employer also contributes 5 per cent.
◆ His existing pension fund is currently valued at £500,000.
◆ His existing ISA portfolio is worth a further £100,000.
◆ He estimates that a £50,000 retirement annual income is sufficient to provide him with the retirement lifestyle he wants.
Mr Client is also interested in understanding what the impact of retiring at different ages would have on the quality of his lifestyle in retirement. Using cash flow modelling, we have been able to forecast two different retirement scenarios for Mr Client – one at age 55, and one at age 60.
At retirement age 60, the cash flow model confirms that Mr Client will have enough money to enjoy his desired annual income of £50,000 (rising with inflation) until he is aged 90.
In the graphs, it shows his ISAs (green bars) being used to fulfil his expenses before his pension gets drawn from age 63. The state pension (in teal) also starts from 68. However, if Mr Client chooses to retire at age 55, the cash flow model projects that his money will run out at age 77. He misses out on a further five years of pension contributions plus an additional five years of growth of his investments.
In this scenario, he would need to use investments to top up income to his target of £50,000. All of these financial factors will have a knock-on impact, which the cashflow model highlights. If 55 is still his desired target retirement age, then Mr Client’s planner could recommend and implement a strategy to meet that objective.
The above example is obviously simplistic, but it hopefully demonstrates the real power that being able to model your finances into the future can have. This becomes even more valuable – and complex – when more individuals and investment and pension accounts are involved.
Cash flow modelling should now be at the core of your financial planning to provide a holistic view of your current and future financial position.
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