We explore cashflow modelling in part two of our retirement planning series (click here for part 1).
This is a crucial tool in any financial planner’s toolkit. It helps identify whether your financial trajectory aligns with your vision of the future. Or put another way, are you on track to have ‘enough’ income and liquid capital to meet ongoing spending needs and ‘live your best life’ for the rest of your days?
In terms of methodology, the starting point is your current financial position. This is then combined with various assumptions for inflation, income, spending, investment returns, retirement dates, etc., to project that position forward.
Cashflow modelling is essential for those considering when they can afford to retire, either partially or fully, or what that retirement might look like in terms of spending power.
To demonstrate its effectiveness, I’ve used a recent ‘real life’ case study in this week's blog, changing the names of course and rounding some of the figures to nice whole numbers.
Cashflow case study
Background & objectives
Ethan and Claire have been clients for several years.
Their objectives are relatively straightforward – they wish to retire as early as possible, whilst they’re “still active enough to do the things they enjoy”, mostly outdoor activities such as biking, hiking, kayaking, etc.
When discussing the prospect of full retirement vs partial (i.e. some form of second career, potentially with reduced hours and more flexibility), we agreed to model on a full retirement basis. Ethan and Claire may continue to work in some capacity, but they want this to be a lifestyle choice rather than financial one.
They’re also open to the idea of downsizing their main residence to supplement spending needs if required, eyeing up a potential move to the south coast.
Current position
- Ethan and Claire are both 45 years old,
- They’re currently employed, each earning £100k a year,
- Their home is worth £1.2m with an outstanding mortgage of £350k (repayment basis; 4.5% interest; 15 years remaining). They’re currently overpaying this by £500 a month,
- They each have pensions worth £250k, into which they’re contributing 15% salary each year (split 50/50 between employee and employer contributions),
- They also have stocks & shares ISAs worth £50k each and are contributing £1,000 pm to these from surplus income,
- Their cash savings are currently £40,000 which we agreed was a reasonable emergency reserve,
- In terms of spending, Ethan and Claire anticipate they need around £5,000 a month / £60,000 a year (excludes mortgage payments) to ‘live their best life’ in retirement. Incidentally, this matches the PLSA’s estimate of what a ‘comfortable retirement’ costs, under their Retirement Living Standards – link here.
- When discussing timescales, Ethan and Claire said they “expect to work until around age 60” but as noted above, they ideally want to bring this forward.
Assumptions
Having established the client’s current position and objectives, the next step is to apply some assumptions to project that position forward:
- Inflation: Averages 3% a year
- Income: Rises with inflation
- Property: House prices rise with inflation; in the baseline ‘do nothing’ scenario, I do not model any future downsizing
- Mortgage: Ethan and Claire continue with the current overpayments (£500 pm); the interest rate remains at 4.5%
- Spending: Averages £5k a month / £60k a year (excluding mortgage costs), rising with inflation, between now and age 75. Thereafter, I model a -2% inflation-adjusted annual decline (i.e. spending only increases 1% pa vs inflation 3%), reflective of a shift to a more ‘passive retirement’, as is typical.
- Cash: Returns an average 2% a year (1% below inflation)
- Investment returns: Average 5% a year, net of all costs; this applies to their pensions and ISAs
- Retirement: In the baseline scenario, Ethan and Claire both retire fully at age 60 – I later consider scope to bring this forward
- ISA & pension contributions: Continue at current levels (£1k a month to ISAs, 15% salary to pensions)
- State Pensions: They’re both entitled to full State Pensions from age 68
- Life expectancy: We model to age 100 by default
Disclaimer: When investing, your capital is at risk. The value of your investment (and any income from them) can go down as well as up, and you may get back less than you invested, particularly where investing for a short timeframe (we normally recommend a horizon of at least 5 years). Neither simulated nor actual past performance is a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
Financial projections
Now for the charts, which provide a projection of Ethan and Claire’s future financial position.
Note, that all charts are expressed in today’s price terms, i.e. adjusted for inflation.
1. Liquid capital
The most important projection is that of liquid capital. This includes cash, investments and pensions, i.e. those assets that can be drawn upon to meet ongoing spending needs, but excludes property which cannot (not immediately anyway).
Maintaining positive liquid capital throughout implies that Ethan and Claire won’t run out of money and can therefore sustain their spending target of £5k a month for life (with a modest and gradual decline from age 75).
As you can see:
- Ethan and Claire currently have liquid assets worth approx. £640k,
- These are set to increase substantially between now and retirement (assumed age 60), driven by surplus income and the ongoing pension and ISA contributions,
- Post-retirement, there is a period of modest decline, as investments are drawn upon to fund ongoing spending needs,
- However, the pace of decline gradually moderates and then subsequently reverses upon the commencement of State Pensions (currently worth £11,500 a year and payable from age 68), and reduction in spending in later years (this is better illustrated in chart 3).
- More broadly, on the assumptions stated, Ethan and Claire are clearly on course to have ‘enough’ income and liquid capital to sustain their spending needs for life.
2. Total net worth
Here, we bring their property asset back in to project total net worth:
Ethan and Claire currently have total net worth of approx. £1.49m.
This is set to increase to around £3m (today’s prices) at the point of retirement, before plateauing around this level thereafter.
3. Income vs spending
This final chart shows total expenditure (orange line), sources of income (earnings, State Pension) and required withdrawals from investments and pension savings:
This is a busy chart but the key points are:
- On current overpayments, Ethan and Claire’s mortgage will be cleared around 3 years early – see the sharp drop in total expenditure at age 56-57,
- I assume Ethan and Claire take some money from their pensions for the bridging period between retirement and commencement of State Pensions – to utilise their tax-free Personal Allowances,
- State Pensions are due to commence at age 68 and shall provide approx. £23k of guaranteed and inflation-protected income each year (turquoise bars above),
- Ethan and Claire are due to deplete their investments (surplus cash and ISAs) around age 86 – green bars above. Thereafter, they’ll start tapping their pensions again – blue bars,
- The chart shows the gradual decline in spending, in today’s price terms, from age 75 onwards. Between ages 75 and 100, their spending needs are assumed to decline from £5k per month to around £3k in today’s money.
Conclusion
In this baseline ‘do nothing’ scenario, we’ve demonstrated that, on the (conservative) assumptions stated, Ethan and Claire are comfortably on track to have enough income and liquid capital to sustain spending needs for the rest of their days.
It follows that they can afford to:
a) Retire earlier,
b) Spend more,
c) Or a mix of the two.
Focussing on the first point, given this is their primary objective, and using the cashflow software, we calculate that Ethan and Claire can afford to bring forward the date of retirement by 4 years.
That is, they can afford to bring forward the date of full retirement to age 56 (vs 60 previously).
Here’s the revised liquid capital projection in this scenario:
On the assumptions stated, this is the earliest they could retire and still not deplete liquid assets before age 100.
Albeit note here, even if they were to deplete liquid capital, they could always release funds from property (valued at £1.2m in today’s prices) either via a future downsizing or borrowing in later years.
What if scenario: Downsize
That segways nicely into the final section of this blog.
Another key benefit of cashflow analysis is the ability to model alternative ‘what if’ scenarios, reflecting certain actions and/or changes in assumptions.
In this instance, we consider the impact of a future house downsize on Ethan and Claire’s ability to bring forward the date of retirement, via the following overriding assumption:
- Three years from now, Ethan and Claire decide to move to the south coast and downsize to a new home worth £750k in today’s price terms. They clear all outstanding debt in the process.
With an injection of liquid capital, the result is that they can now afford to bring forward the date of retirement even further to age 52 ½ - see chart below:
Notice the jump in three years’ time on the assumed property downsize. This will enable Ethan and Claire to bring forward their retirement to age 52 ½.
That’s equivalent to an extra 7 ½ years’ of ‘active retirement’ vs their original baseline assumption of working to age 60, which is potentially life changing!
And this prompts a wider debate around the value of financial planning. Investment selection and tax planning are key ingredients, but the wider piece of ‘am I going to be ok’ (aka. am I going to have ‘enough’) is the true value add in our opinion.
Summary
Cashflow modelling provides an insight into the health of your future finances.
Step one is to identify your goals, step two is to quantify these into a tangible spending target, and step three is to use cashflow modelling to gauge whether that target is affordable.
In the real world example above, we were able to use cashflow modelling to demonstrate that our clients are comfortably on track to have ‘enough’ in retirement, and that there is scope to bring forward that date of retirement, even more so in the event of a future house downsize.
Of course, one must caveat that this is ‘only a projection’ – the future is unknowable. But therein lies another key benefit of financial planning, whereby your plan shall be reviewed and refined on a regular basis to reflect changes in circumstances and objectives, but also wider economic conditions and regulations.
Disclaimer: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require in order to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles.
