Cashflow modelling as a tool for advice

Cashflow modelling as a tool for advice

The use of cashflow modelling is subject to much debate and divides opinion among advisers as much the EU referendum did. The question is simple: is it necessary to undertake a cashflow analysis in the provision of advice?

Since pension freedoms and the increased popularity of pension drawdown, it has come more to the fore as a means to demonstrate sustainability of withdrawals and people's ability to meet their income needs in retirement (and/or along the glide path to it).

Before I offer an opinion on this, where do we stand from a compliance perspective?

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Cashflow modelling in isolation is normally generic in nature and is not itself a regulated activity or deemed to be one by the FCA. However, where this is used as an ancillary service alongside regulated advice, it becomes part of the regulated advice process.

So, if you are providing cashflow modelling leading on to regulated advice, then the whole process – including the cashflow modelling – would be regulated. In these cases you would be expected to include the modelling as part of the file and justify the assumptions used.

FCA technical specialist Rory Percival stated in a webinar back in April 2015 that “advisers should not artificially split out these different services”. FCA rules around adviser charging set out in COBS 6A also confirm that these rules apply to any related services.

More often than not, advisers will use a cashflow modelling tool from a third party provider to produce a model and perform any scenario-based testing. This is where further guidance from the FCA can be referenced.

For example, back in 2011 the regulator published Finalised Guidance FG11-05, which has some valuable lessons in the use of tools, albeit the focus in that instance was on risk profiling:

•    Understand how the tool works and what it is designed to do;

•    Understand the limitations of the particular tool (what it is not designed to do) and take steps to mitigate them;

•    Only use a tool you are satisfied provides "outputs that are appropriate and fit for purpose".

While these are helpful, before using cashflow modelling I recommend reading Paul Armson’s publication 7 Deadly Sins of Cashflow Modelling, which captures some of the pitfalls, as well as the benefits, of using it. 

Assumptions are a key aspect of cashflow modelling. Change these and at a stroke the impossible can become achievable, if not probable.

Rory Percival used the phrase “sensible and reasonable” to describe the assumptions to be used, which aligns almost identically with the “reasoned and reasonable” terminology used by the Institute of Financial Planning standards board. Certainly it would be prudent to get the client to participate in agreeing what assumptions are relevant.

If there is no regulatory requirement to use cashflow modelling, why bother?

Some practitioners credit the introduction of cashflow modelling with transforming their businesses and relationships with their clients. Certainly, it has the capability to transform discussions with them and highlight quantifiable risks to any financial plan that could then be appropriately insured.