In discussions with a client recently, they questioned the assumptions and accuracy in a retirement cash flow forecast model of their expected income, expenses, capital appreciation and de-cumulation (spending it) that we were assuming inflation at 2.5%pa and a mid-market growth rate on investments at 5% pa gross, 4% pa net after a 1% fund management charge.
They suggested that with inflation currently at 9%pa (April 2022), if they were achieving average growth returns of 4%pa, they would be losing money and then run out.
We highlighted that inflation is an artificial driver of investment growth. In short, if inflation is consistently high, it pushes wages up, pushes business costs and therefore prices up which, in turn pushes profits up. Higher company profits mean higher dividends and higher share values, albeit the businesses have not suddenly become economic miracles, it is the fact that the normal market level trading conditions or ‘level playing field’ has been pushed up to a higher level due to higher prices.
The impact on investment returns in the medium term will therefore be higher growth.
It is the regulator, the Financial Conduct Authority (FCA) that sets investment and inflation assumptions to be used in projections and illustrations based upon current and forecast economic conditions.
Regulator’s Prescribed Low Rate Growth, Mid Rate Growth and High Rate Growth % Per Annum Assumptions Over The Years
When looking at the above historic assumptions, when you look back to the 1980s and 1990s when we had similar inflation levels to today, average investment returns were also much higher. As previously mentioned, higher inflation ultimately means higher investment returns by default. Broadly speaking, the FCA required assumptions for investment return projections and illustrations, at Mid Rate Growth are 2.5% over inflation and high rate growth are 5.5% over inflation. In the 1980/90’s for pensions, at 8.5% and 13% pa. This was because inflation was higher and average investment returns were higher.
In conclusion, despite inflation being higher, it has not yet been for a sustained period, so the FCA has not adjusted upwards any assumed investment growth rates. Therefore, when cash flow forecasting today, inflation assumptions and investment growth assumptions are lower, so broadly speaking all cash flow forecasts will be as accurate as we can forecast.
If the FCA does increase assumptions due to inflationary and investment return increases, your cash flow forecasting will remain broadly in line as margins will be similar.
In summary, if we forecast inflation at 2.5% pa and mid rate investment growth at 5% pa (gross), 4% pa net of charges, then if inflation assumptions are increased to say 5% pa, the assumed investment rate 7.5% pa will mean your forecast model will remain unchanged in terms of real spending power over the years.