Eric Morecambe on Cashflow Planning

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!



4 thoughts on “Eric Morecambe on Cashflow Planning

  • I whole-heartedly agree with you Abraham. (Mr Preview!)

  • Dear Abraham,

    Thank you for the opportunity to discuss this point.

    Volatility drag and sequencing risk are not new phenomena, but clients of deterministic planners have succeeded in mitigating these risks through careful planning.

    You are absolutely correct that Financial Planning variables are unpredictable; however we can make sensible short-term assumptions about these variables. A good planner establishes the variables to be used alongside their client, and reviews them regularly. The success or failure of a financial plan is down to the quality of the assumptions and the knowledge of the planner, rather than the quality or basis of the model used. A stochastic model using poor assumptions is just as dangerous as a poorly created deterministic plan.

    In order for a stochastic model to succeed, certain deterministic assumptions are required – where do you draw the line? You recommend modelling investment return, life expectancy, and inflation stochastically. But what about house prices, the devaluation of the client’s car, school fees, long-term care costs, insurance premiums? Even with a low standard deviation on each, this would create an unmanageable and meaningless range of possible outcomes that would be no value to the client.

    A well-constructed deterministic plan created by a well-informed planner, in collaboration with their client, doesn’t tell the client “you will never run out of money”. What it does is tell the client is that, based on today’s assumptions, everything SHOULD be fine. Our well-informed planner encourages the client to review this plan on a regular basis, and that the past performance of their investments is no guarantee of future returns.

    If a stochastic planner tells their client “there is a 90% chance that you will never run out of money”, without similar caveats and disclaimers, this “illusion of certainty” could be even more dangerous than that of the deterministic planner.

    If I may reference the illustration in your white paper: you look at the case of Molly, who suffers from the effects of the “evil twin”, and her portfolio is decimated within 22 years.

    Let’s examine the assumptions behind this:

    Over the past twenty years, the standard deviation of the RPI is 1.178, and its average is 2.9%. A sensible short term assumption would be that RPI for the next twenty years will follow a similar pattern. Is it realistic, therefore, to project using an average of 3.8% inflation, and to suggest that next year’s inflation might be 17.8%?

    Molly’s portfolio fluctuates wildly – for a divorcee in her 60s, she seems to invest very aggressively! At age 89, when most would be de-risking their portfolio, she experiences 24.9% growth. It would seem that Molly’s adviser has fallen into the trap of adopting the same investment approach during the accumulation and decumulation stages, which you rightly advise against in the same paper.

    As George Canning once said, “I can prove anything by statistics…”

    • As you brought it up, Molly’s portfolio in the paper is actually based on a 50% MSCI World Index + 50% Dimensional Short Dated Bond Index, adjusted for 1.25% fees and corresponding annual inflation.

      May be not so aggressive after all…

      How does defining outcomes in terms of probability create an illusion of certainty? The clue is in the word…. probability?

      And isn’t that what doctors do when they tell you the probability that a surgery would be a success or chances of serious side effects? I doubt that suggests to patients that success is assured. Deterministic plans create a mental impression – tell the client what you like, you have given them a mental image.

      As they said ‘ a picture is worth more than a thousand words…

  • How nice it was for our parents’ generation, many of whom were lucky enough to be members of well funded defined benefit schemes!

    Our job is all the more interesting because of all of the uncertainties we face, but stressful, because it is so easy to fall into so many expensive traps out there!

    Tick the wrong box on an offshore bond withdrawal instruction and you could cost your client and then, consequently, your firm, a very big cheque.

    Overfund a pension scheme; same problem…

    Recommend an investment which experiences more of a loss than your client has been “briefed” for, and along come the ambulance chasers.

    It woudn’t surprise me if we read about claims in the future based on the potentially toxic cocktail of unrealistic cash flow assumptions combined with a market crashes.

    Added to this potentially toxic mix is the increasing comfort (I think) in our world in defining levels of risk when in fact who knows whether fixed interest or shares are more or less risky right now. What today might look like a “moderately cautious” portfolio, might with hindsight have looked more risky than an “adverturous” portfolio. The FCA does not, I think understand that asset risk is dynamic and tends to be aligned to economic cycles (which themselves can often only really be properly understood with hindsight).

    Far easier (arguably !) to work with clients who are unlikely to need to spend their capital and can live off “natural” income streams!


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