Cash flow modelling with rising living costs in retirement

“People who are retired haven’t got the luxury of turning on the taps of salary,” says Rosie Hooper, chartered financial planner at Quilter Private Client Advisers.

“When you get to retirement you start to think, ‘This is it, this is my whole wealth, this is all I’ve accumulated’.

“And then all of a sudden, inflation and rising living costs feel really scary, because it’s not like you can work an extra shift or decide to get a promotion.”

Different sources of retirement income

As well as distinguishing between working and retired clients, further differences can be drawn among retirees.

“For those who are on a low income and perhaps that income is secure – so perhaps they’re mostly dependent on a state pension, or they have a defined benefit pension – and they don’t have a lot of wiggle room, they will be much more sensitive to increases in the cost of living,” says Jamie Smith, partner at Foster Denovo.

Inflation-linked increases in state and DB pensions can somewhat provide a cushion against rising living costs.

But Claire Trott, director of Technical Connection, highlights how the timing of increases is delayed from the point when they are calculated, with September’s CPI figure usually determining an increase that takes place in April.

And a final salary scheme will usually increase up to a maximum of 2.5 per cent, says Louise Higham, financial planning director at Tilney.

“If you’ve got any inflationary increases above that figure, you may find that your net income is affected by the rising costs of living.”

Meanwhile, clients who are taking money from an income drawdown may have to increase the amount they are taking, which could affect the longevity of the fund, warns Higham.

“If they’re taking out 10 per cent a year but are in a low-risk portfolio that might only produce 3 per cent a year net return, then they’re using quite a lot of the capital.”

For clients without fixed income sources and who maybe rely on cashing in any liquid investments, William Stevens, head of financial planning at Killik & Co, says: “With them it’s about looking at the level of income they’re drawing from those accounts, and potentially thinking about the feasibility of that long term.

"If you do have increasing costs [you] perhaps need to be a little bit more cautious around the income strategy over the medium and long term.

“Where clients are drawing from defined contribution schemes, this is where it’s important to stress test any models that are built in for clients.

“The thing I would always say to clients is, we want a financial plan to be a worst-case scenario, because anything above that is a benefit. There’s no point in planning for the best-case scenario.”

Capacity for loss

Hooper at Quilter likewise highlights the role of a loss capacity report: “We need to know how much the client can lose, before the lifestyle changes.

“During the pandemic, when the markets were going down – and nobody feels comfortable with the market going down – clients weren’t stressed because they knew they had the loss capacity.

“It’s nicer to tell a client about what might happen as a scenario that you can do in cash flow, before it happens.”

Steph Willcox, head of actuarial implementation at Dynamic Planner, warns that retired clients in the decumulation phase of their cash flow planning will have less ability to withstand volatility within their income or expenditure.

“It will be important to ensure that their long-term cash flow plan is suitable for the client’s capacity for loss, and that any short-term changes to their plan – which may include drawing down more money to meet increasing expenses – is not at the detriment of their longer-term plans.”

Hooper also refers to the balance between immediate rising costs and future goals.

“The thing for me about cash flow planning is that I’m not planning for next year or the five years. I am actually planning to the end of a client’s life. 

“We don’t want to turn to a spreadsheet and say maybe inflation’s going to be 5 or 6 per cent every year, but equally we don’t want to plan our living based on 2 per cent.

“Clients want to be told, if inflation was to stay at 5 per cent over the next five years, 'How much money do I need to save now to work my way through that period?'

“Or if they’ve already retired and they can’t save, ‘How much should I be pulling my purse strings in? Because what I don’t want is to be living my best life today at the [cost] of tomorrow’.”

Chloe Cheung is a features writer at FTAdviser