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How sensitive is cash flow modelling to rising living costs?

This article is part of
Guide to rising living costs

“If you are looking at building out a model that runs over several years, it’s important to make sure the assumption you’ve got in there for rising living costs is likely to be accurate over the time period.

“Because if you expand something out over a 35-year time horizon, being out by 2 per cent can double or halve the impact you’re going to have over that timeline.”

Smith agrees: “At the crux of cash flow modelling, it’s a forecast, so like any forecast it’s based on some underlying assumptions.

“Two of the key assumptions that we use when we model outcomes for clients is an assumption around inflation and around how their savings and investments might grow on an annual basis.

“The difference between the two is the real return, and that’s one of the key assumptions for any cash flow model.

“What we will do with our clients to help them understand the risks that inflation might pose to their financial planning longer term, is we may reduce that real return to help them understand how sensitive their plan might be to longer-term, persistent inflation.”

Some cash flow software can extrapolate real historical data from the past, adds Smith, replicating periods of high inflation and projecting it forward to show a client how their finances might look if there were to be another prolonged period of inflation, and how that might impact their savings, investments and lifestyle.

Steph Willcox, head of actuarial implementation at Dynamic Planner, acknowledges that short-term disruptions to expected living costs will cause fluctuations in clients’ disposable income and could temporarily change their focus away from saving.

“But cash flow planning is a long-term act and these short-term fluctuations shouldn’t be impacting long-term goals for clients,” says Willcox.

“Clearly this will differ by client though. Those living close to their limits will feel the pinch more than those with lots of disposable income, and will take longer to recover and catch up to the levels of savings or investments they might have had without these disruptions to their expenses.”

Chloe Cheung is a features writer at FTAdviser