Cash Flow Modelling and Stress Testing
Cash flow modelling involves assessing a client’s current and forecasted wealth, along with income vs expenditure.
Cash flow modelling may be used to give a forecast of their fund in the future so that they can reasonably decide how much to withdraw each year
Stress testing a pension is good to understand how a level of income will be impacted if the portfolio suffered a major market crash just before the withdrawals started or if continuous poor performance occurred. Other factors to consider
During the accumulation phase a dip in fund prices works to the client’s advantage as they get more units in return for their contribution. This is known as pound cost averaging.
The opposite is true during decumulation, as taking withdrawals during a market downturn means more units need to be sold.
This is known as reverse pound cost averaging and this can lead to a rapid reduction in the value of the fund, i.e. the process adversely exaggerates the effects of volatility.
This is often referred to as sequencing risk or sequencing of returns risk. In other words, it is the risk that the poor returns happen early in retirement, creating a drag on the investment growth achieved
From these tests you can start to create a safe withdrawal rate, which is the highest percentage of the initial portfolio, adjusted for inflation in each subsequent year, which can be taken without running out of money over a 30 year period.
Question - Use Your Note Taker To Jot Down Ideas / Calculations
Four clients all have money purchase pension funds of £200,000 and require an income of £12,000 p.a. Assuming they all have a balanced attitude to investment risk and ignoring any non-financial factors, which of these clients is most likely to have the lowest capacity for loss?
a) William, aged 62, who has a significant portfolio of rental properties
b) Sarah, a widow who is 66 and in receipt of her Basic State Pension, but has no other savings or investments
c) Richard, who is 65 and in receipt of his State Pension and who also receives a generous pension from his previous employer’s defined benefit scheme.
d) Janice, who is 58 and who will be able to reduce withdrawals from her money purchase scheme when she reaches SPA at which time her State Pension and company pension income will be adequate for her needs.
B)
It is most likely that Sarah will have the lowest capacity for loss because she is the most dependent upon the income from the money purchase scheme.
William’s portfolio of properties, will provide rental income and could be sold to provide capital if necessary.
Richard is in receipt of his State Pension and of a generous secure pension income, so he has more secure income than Sarah.
Janice only needs £12,000 a year for a few years so it is far less likely that her pension fund will be depleted, even though she is younger than the other three clients.