Cash flow modeling is the practice of planning and forecasting sources and uses of cash. Its ultimate objective is to provide a framework that enables the most effective and efficient use of pension and investment income and the maximisation of free cash flow.
It is the process of assessing your current and forecasted wealth, along with inflows (income) and outflows (expenditure), to enable a picture to be created of your finances both now and in the future.
Whereas budgets are based on your active plans for the future, a cash flow forecast is an estimate of future projected income and expenditures.
What does cash flow modeling do?
Cash flow modeling allows you to reflect on your current financial position relative to your preferred position and your personal aspirations. This is then projected forward, year by year, using certain assumptions for growth, income/withdrawals, inflation, and interest rates.
What are the variables?
There are of course many variables. And it isn’t just income and expenditure, interest and inflation that needs to be considered. Other assumptions that can change over time include your attitude to risk and capacity for loss, taxes due, the requirement for lump sums such as to pay off a mortgage, fees and market movements.
Spending patterns will also likely change, reflecting both your new lifestyle in retirement and shifting financial responsibilities over time.
Cash flow models can also be stress tested. What would happen if there were a market crash? What would happen to your savings over time if you did not achieve the growth you expected? If inflation increased and eroded capital, or if you needed longer- term care in retirement. All of these possibilities can be factored in to a cash-flow forecast. Enabling you to get a glimpse into the future best case and worse case scenarios.
Determining your income in retirement
Ultimately every new retiree needs to answer the same critical question: What is the maximum retirement income I can withdraw from savings in retirement, without running out of money before I die?
A typical cash-flow forecast will start at a chosen retirement date such as age 60 and end at age 99, or on the second death (death of spouse) age 99. Over time this age assumption is likely to increase with increases in longevity.
The main objective therefore is to determine the maximum safe amount you can withdraw from your savings, investments and pensions each year, safe in the knowledge it will last your lifetime.
Safe withdrawal rates - The 4% rule
The 4 percent rule is a rule of thumb used by many advisers that is suitable to be able to provide a steady income stream to the retiree while also maintaining an account balance that keeps income flowing through retirement. Of course individual safe withdrawal rates will vary dependent on needs and capital requirements. Many experts consider the 4 percent withdrawal rate to be a safe withdrawal rate, as the withdrawals will consist primarily of interest and dividens and so will not simply be eating into capital.
Why cash flow modeling is so important
Cash flow modeling is as close to a crystal ball as you can get. It makes it possible for you to get a glimpse of your financial future before it happens and promptly react to any possible dangers. It gives you advance warning on potential money problems, so you can efficiently use the available time to work out solutions to overcome anticipated financial issues. Allowing you to be safe in the knowledge that despite potential market fluctuations or unexpected need for capital or lower interest rates that you will still have enough money throughout your retirement to last you to the end.