Articles - Cashflow and the great what ifs

When considering the question of the value delivered by financial advisers, it is difficult to beat the provision of a cashflow model which provides clients with a visual representation of what their retirement will look like, over a realistic life expectancy. That said, the model is just that, a view of the future based on a set of assumptions, and not a blueprint of what will definitely happen. It is therefore crucial to consider not just what the plan is intended to achieve, but also the things that mean it could go wrong.

 By Fiona Tait, Technical Director, Intelligent Pensions

 These ‘what if’ scenarios are equally essential to the long term financial plan.

 Clearly it is not possible to look at every possible permutation, but a good financial plan will take into account those which are most likely to be relevant based on the probability of them occurring and the impact if they did.

 Increases in the level of inflation have led many advisers to consider whether they should alter the assumptions they use as part of their modelling. If the impact of inflation is underestimated clients could find themselves having to reduce their spending in later life; on the other hand, overestimating it could mean the client suffers unnecessary hardship or misses out on the chance to fully enjoy their lifestyle while they are relatively young.

 Advisers rely on the expertise of the cashflow provider to guide our assumptions, they do after all have access to greater resources and specialist knowledge than we do and current opinion is still that inflation is unlikely to remain at current levels for the long term.

 We can however use a ‘what if’ scenario to explore what would happen without overriding the modeller’s main assumptions, and to put a ‘plan B’ in place if those assumptions prove to be wrong. For some clients it may make little difference; for others it opens their minds to the possibility that they may have to reduce their spending or utilise assets that they would like to preserve if possible.

 Early death, illness and redundancy
 Most clients assume they will be able to earn money until they retire, and that they will have a similar lifeline to their parents. This is not unreasonable; however we do have a duty to include some sensible adjustments and consider what could happen to completely disrupt the picture.

 Many people will have thought at some time about protecting their family if they should die earlier than expected, but not all of them will actually have done something about it. Fewer still are likely to have planned for a situation where they are unable to work for long periods of time due to redundancy or illness.

 ‘What if’ models help to make this more ‘real’ by illustrating the potentially devastating impact of these events. More importantly, they can also be used to show the effectiveness of the financial plan by comparing ‘before’ and ‘after’ scenarios.

 In the ‘early death’ scenario, for example, cashflow comparison may be used to show the client what their family would have to live on if they died without taking any further action, versus the situation if a life assurance policy is in place. This puts the cost of premiums squarely within the context of the value that could be delivered.

 Similar modelling may then be used to show the value of critical illness, permanent health and redundancy insurance, helping clients to the trade-off between using current income to fund the necessary premiums, and the size of the risk they are taking if they don’t.

 Capacity for Loss
 Cashflow is of course based on assumptions and even the most sophisticated stochastic models cannot predict what will happen in reality, in fact the one thing we can be sure of is that the position will change over time.

 Recent economic conditions mean that many of our clients are looking at a less rosy position than they did last year, and in particular a significant reduction in their Capacity for Loss (CfL). Normally this situation would lead us to recommend taking less risk with their investments, however it is likely that for at least some of these clients the position is likely to improve over time.

 Where this is the case ‘what if’ scenarios are once again useful as they allow us to explore more solutions such as equity release or downsizing, which are thought of more as ‘plan C’ than ‘plan B’. In essence we do not believe the client is likely to have to resort to these options, but we are able to increase the theoretical CfL and support the existing investment strategy.

 In summary, cashflow is not just about producing the desired financial solution, it is also about identifying what can go wrong and planning accordingly.

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