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I have been a big fan of cashflow modelling for some time. I even encouraged many of the adviser firms we work with to adopt it. But why am I becoming increasingly ambivalent about the usefulness of cashflow planning as we know it?
Think about this statement…
‘Never try to walk across a river just because it has an average depth of four feet.” ~ Milton Friedman
Very few financial planners will disagree with the fact that some of the most important financial planning variables – investment returns, inflation, and life expectancy – are unpredictable, if not completely random. They certainly don’t behave in linear patterns.
Yet, when we choose a model to help client visual the potential financial planning outcomes, we choose deterministic models that assumes that average inflation, investment returns and life expectancy. We runs straight line projections that assumes the world of investing is linear. OK, may be we explain to client that things won’t actually work out that way and may be we run 2 or 3 different scenarios, but we create a visual image in the client’s mind that has no grounding in reality. That feels very odd to me, for there specific reason.
The Evil Twin
The first one is what I call the impact of the evil twin of volatility drag and sequencing risk. Fact is, assumptions of long term averages are unhelpful, especially in a retirement portfolio. They are easily thwarted by the powerful combination of volatility drag and sequencing risk, which is amplified by portfolio withdrawals.
So, what the devil is sequencing risk? Ehrrr…, let’s defer to the legendary Eric Morecambe’s to explain this one…
‘ I’m playing all the right notes, but not necessarily in the right order’
Sequencing risk is how the order of returns impacts portfolio longevity, especially when withdrawals are being made from the portfolio. The point is that, poor returns in the early part retirement can cause untold damage to the portfolio, even if these poor returns are then followed by good returns. This means that, average long term positive returns notwithstanding, if the order of returns is unfavourable, there is a negative impact because returns in early years of retirement have a disproportionate effect on the outcome. Once cash outflows are happening, it’s not enough for returns to average out in the long run. The portfolio could be severely decimated before the good returns finally have a positive impact.
That’s more bad news. Sequencing risk not only applies to investment returns, it also applies to inflation. Higher inflation in the early stage of retirement means that clients need to increase withdrawals earlier on in retirement to maintain their lifestyle. This could wreak havoc with their retirement plan, even if inflation becomes restrained in later life.
The point is to highlight the danger of averages and it’s why I strongly believe that deterministic cashflow models like Voyant, Prestwood etc aren’t sufficiently robust in financial planning.
Illusion of Certainty.
The second reason is what I call the illusion of certainty. A deterministic planning tool pretends volatility drag and sequencing risk don’t exists. It assumes that clients portfolios will experience a smooth linear growth over time. These tools are used to help clients visualise likely retirement outcomes, but they give clients an impression that their investments grow in a smooth, linear format over time, when in reality nothing can be further from the truth. Deterministic planning tools convey the illusion of certainty, where there is none.
The reality is, investment outcomes are unknown, so why pretend to clients that they are? Using tools that attempt to simplify potential outcomes, but in the process miss some of the most important factors that could impact the plan’s outcome is clearly an inadequate approach.
Some financial planners argue that ‘whatever the plan is, it would always be wrong’ or that ‘all plans are wrong, regardless of the tool you use’. This argument misses the point, as it is not about being right or wrong. Actually, this argument strengthens the case for NOT using deterministic models. If the plan will always be wrong, shouldn’t we instead focus on the chances of a favourable outcome? Shouldn’t we test a range of hundreds and even thousands of possible scenarios, and define the outcome in probabilistic terms rather than deterministic?
The third reason is that there’s a better model that what we currently use. Don’t get me wrong, I’m not advocating ‘no planning’, I’m advocating ‘better planning’. I think we need to define financial planning outcomes in probabilistic terms. This mean, using Monte Carlo models. It’s not the Holy Grail but its far more robust than deterministic models. It ensures the plan rigorously tested under a range of possible but ultimately unknown outcomes. In the absence of certainty, why run oversimplified straight line projections, when in actual fact you could run thousands of potential outcomes to estimate the probability of success or failure?
Clearly, I believe this goes right to the heart of how we do financial planning, so I put together a new white paper for all you lucky people! It’s titled Pound Cost Ravaging: Volatility Drag, Sequencing Risk & Safe Withdrawal Rates in Retirement Portfolios and it looks at this issue in much greater depth. Oh, and it’s free, so what more could you possibly want? Yes, we both know how lucky you are…. NOW, GO!