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Justifying rates of return in cash flow modelling

Steph Willcox, head actuary at Dynamic Planner, delves into how advisers should tackle ‘justifiable rates of return’

Steph Willcox


The FCA have kept us waiting for their Thematic Review of Retirement Income, but the amount of information they provided certainly made for some interesting reading when it was released last month.

As well as the review itself the industry received a host of documents that weren’t expected, including a “Dear CEO” letter, a retirement income advice assessment tool and an article detailing how firms can improve the way they use cash flow modelling to demonstrate the suitability of their advice.

A key finding in the cash flow report is ensuring that that advisers are using “justifiable rates of return” in their modelling, but of course justifying the rates you are using is likely to be very subjective, so the FCA also helpfully provided some examples of what constitutes quality cash flow planning and what they are expecting to see from advisers who are making use of cash flow planning tools.

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The FCA state quite rightly that the returns used within cash flow modelling are one of the most important parts of the model, especially since a client’s investment objective may rely on their investments achieving a certain rate of return.

Within the financial planning software space there are two main forms of cash flow planning tool when it comes to assumptions. Those that allow advisers or firms to set their own assumptions, and those that set the market assumptions and do not allow them to be overwritten.

Even when the assumptions are set by the software firms, the adviser is still in control of which assumption is used for a client’s investments.

Setting your own assumptions

If you are setting your own assumptions in cash flow tools, it’s going to be important to document the reason for using these assumptions, particularly if you are using different assumptions for different clients.

The FCA is clear that if assets are held in different wrappers or products, but invested in similar ways, the rates of return you use should be the same. This should be consistent against other clients and all similar investments.

Ensuring you have a range of set assumptions to use in different circumstances will be important, as well as ensuring this is documented and kept up to date as required. The FCA says that this documentation needs to take wider economic circumstances into account and be reviewed regularly.

If you are using a deterministic model, where one constant investment return is used throughout the plan, it’s important to use stress testing to show the impact of lower returns than expected. This helps to ensure that your clients are aware of the potential losses they may experience and helps them to understand the volatility present in their investment portfolio.

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If you are using a stochastic model where thousands of investment projections are completed for each time period that are based on an assumption of the expected return and volatility then the need for stress testing disappears.  However you still need to ensure you are highlighting the lower percentile outputs to your clients rather than letting their eyes be drawn to the high returns situations.

Accepting cash flow tool assumptions set by someone else

Whether you are accepting assumptions set by software firms, or at a higher level within your firm’s hierarchy you need to ensure that you have their justification of the assumptions available to you, and that you have reviewed this justification each time it is updated.

Being able to explain the assumptions used to your clients is vital in their financial understanding and ensuring that they stay up-to-date with their own financial plan.

If the assumptions are set for you, you will still have control over which assumption is used in the forecasting of each investment and so it may be appropriate to ensure that the process of assigning the investment the correct funds, or the correct risk level does not vary between clients to ensure consistency with your cash flow planning.

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With the release of this cash flow guidance, it seems reasonable that the FCA will check in with firms in the future to ensure the cash flow modelling they are performing represents quality modelling and the assumptions used for investment returns have been documented and well understood.

Using cash flow modelling to show the value added as an adviser helps to meet your Consumer Duty obligations, so following the guidance on quality cash flow modelling should similarly follow. Documenting the justifications for the rates of return you are using seems like a sensible and important place to start given the emphasis placed on this within the FCAs guidance. 

Steph Willcox is head actuary at Dynamic Planner

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