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Cash flow planning as inflation hots up

For financial professionals only

Suddenly inflation is back at the top of the agenda, and that makes financial outcomes a lot more difficult to assess and even harder to explain.

That’s where cash flow planning comes into its own. Here are our 3 top tips for creating and interpreting financial plans.

1. When building a cash flow model, first decide if you are going to use constant pounds, nominal pounds or, if your software modelling tool supports it, both.

Here is an outline of the difference between them.

Modelling in Nominal £s Modelling in Constant £s
Definition Future cash flows are recorded in the actual amounts of cash that would be saved or spent. Cash values include the effect of future inflation. For example, identical household costs of £1,000 in 2022 would be recorded as £1,050 in 2023. Future cash flows are recorded in today’s terms, removing the anticipated effects of inflation. Household costs of £1,000 a year would be held constant throughout the modelling.
Advantages Investment returns generally include a measure of compensation for inflation so no estimate of this element of portfolio return is needed. You can compare your future wealth and spending with your current position in terms you and your client understand. It can be easier to determine future rates of spending if you are working in familiar values.
Disadvantages As with some pension illustrations, modelling with inflation included produces future values that can’t be easily compared to today’s monetary values and can seem out of proportion. Inflation deflates the real value of debt, particularly long-term mortgage debt on a fixed rate of interest. Accounting for this effect and explaining it to people can be tricky.

2. Check if your assumptions have change

For nearly ten years inflation didn’t exceed 3% a year. In this context, many financial plans have been run on a 2% inflation expectation.  While CPI is the internationally preferred measure of inflation, CPIH is the measure of consumer inflation that includes owner occupier housing costs. These are measured in the Owner Occupier Housing (OHH) cost data series which accounts for 17% of CPIH and is the main driver of the difference between CPI and CPIH.

Look at the difference between these ONS CPI charts for 2011 – 2021 and  2012 – 2022. Inflation has broadly doubled, and could reach 8% at some stage this year.

The question is, do financial plans that work in nominal £s need to change their assumptions for inflation? And where to find evidence for what inflation may be like in future?

One source is the Bank of England’s yield curve website.

As the Bank issue index linked gilts, this is an area under their scrutiny. Comparing market prices of index linked and conventional gilts allows an assessment of anticipated future inflation.

This chart shows that the market doesn’t expect inflation to fall below 3% a year for 20 years. Index linked gilts use the Retail Price Index (RPI) data series. which some prefer for its inclusion of housing costs, particularly mortgage interest bills. However, CPIH includes housing costs too so may be a data set for planners to follow, especially pre-retirement.

3. What is the cost of being retired?

A final issue to raise around inflation assumptions is the question of the ‘basket’ of goods and services specific to retired people. During the employment years, salaries – broadly – end up matching the increased costs of living. In retirement, the balance of consumption changes, with a greater weight on basics, food and heating and, depending on affluence, travel and entertainment.

These questions are studied carefully in the PLSA Retirement Living Standards project. Their latest report (October 2021) explains retirement baskets in detail.

While this work is focussed on the less affluent, the target incomes are a useful logic check for retirement plans. They assume no cost for accommodation in the higher lifestyle brackets and the heating and lighting costs assumptions are beginning to look out of date.

If you’d like to know more about balancing the needs of your clients in difficult markets, please follow us on Crowdcast where you’ll find our regular webinar schedule.