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Risk Disclaimer
The information, opinions, estimates or forecasts contained in this article were obtained from ATEB Compliance, are reasonably believed to be reliable and are subject to change at any time. It has been produced for information only.
Views and opinions are those of the author and do not necessarily reflect those of BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned. No action must be taken or refrained from being taken based on this content alone.
Key takeaways:
Cash flow models – compliant of not?
When reviewing advice on DB transfers, it is not uncommon for us to come across cases where different projections result in the client receiving a mixed message. For example:
Factor | Indicating |
Critical yield (or TVC) is very high | Transfer is unlikely to be advisable |
Drawdown run out age is high | … but your fund will never run out |
Cash flow model is ‘optimistic’ | … and your income will be higher too! |
The first two factors appear in the Pension Transfer Report (previously the TVAS), so it is understandable that advisers might assume that these are comparable – but they are not. They measure entirely different things and are based on entirely different assumptions. These differences need to be understood and explained to clients.
Cash flow models are increasingly being used by firms when advising on pension transfers, and the assumptions that firms make are widely variable, in particular, the growth rate. This often results in cash flow models that give an impression of the client’s future financial situation that is not only more optimistic than realistic, but also confusingly different to the indications from the key elements of the Pension Transfer Report, namely the TVC and critical yield figures.
The FCA considered the use of cash flow models when finalising the new transfer advice rules that took effect in 2018 and decided against requiring their use. In fact, the FCA has concerns about the use of cash flow models of which more later.
However, the rules do not preclude the use of cash flow models, or other projections, provided certain conditions are met. Identifying those conditions is not easy as they are contained in several different places within the FCA Handbook. The key requirements are:
Meeting the requirements
So, the rules do not preclude the use of cash flow models, but they must be used in accordance with a pretty demanding set of rules as summarised above and must also satisfy the clear, fair and not misleading rule. Firms must use growth assumptions that are no less conservative than the mandated assumptions and, where other assumptions are used in addition, these must be realistic and supported by objective data. Charges must be accounted for and all relevant projections should be explained clearly to the client.
The objective of the rules is to ensure that clients are given a fair and accurate indication of how their finances might look in future so that they can make an informed decision as to whether to transfer or not. Facing the client with different outcomes from different projections, especially without adequate explanation, hinders an informed decision and could result in a future complaint. Ideally, firms should ensure that they use consistent assumptions. The FCA has stated:
“It is our preference that the role played by the proposed receiving scheme is communicated to the client in the advice as consistently as possible with the KFI which will be provided to the client if a transfer was to proceed.”
The KFI must use mandated growth assumptions. For pension products, the MAXIMUM intermediate rate is currently 5% (ignoring inflation reduction) … but, as required by the rules, a lower rate must be used if more appropriate to the funds in question. The higher and lower rates are then simply 3% points above and below the relevant intermediate rate. The provider of the KFI should do all the ‘objective data’ work to assess the appropriate intermediate rate.
So, the simplest way to ensure the cash flow growth assumption meets all the rules is to look at the key features illustration (KFI). The intermediate growth rate used there (before inflation) can be taken as an appropriate gross growth assumption for any cash flow model that is to be prepared.
To meet the requirement to take account of charges, a deduction must be made to reflect the overall charges that will apply. The net result is an appropriate growth assumption to use within the cash flow model. At its simplest, it would look like this:
Intermediate rate from the key features illustration | X% |
Less reduction in yield (RIY) figure from the KFI | Y% |
Appropriate rate of return to use in the cash flow model | (X-Y)% |
However, the RIY figure does not usually reflect the initial adviser charge accurately – it will be amortised over a number of years rather than accounted for up front. This means the RIY on the KFI is understated, although probably not enough to be significantly misleading. How can this be allowed for in the cash flow model?
It could be argued that using the straight RIY figure from the KFI will still result in a growth assumption that is closer to the requirements of the rules than the assumptions currently used in cash flow models by many firms.
However, a more accurate way to incorporate the initial charge would be to deduct it in cash up front from the starting capital and then deduct the annual adviser, platform, plan and fund charges from the KFI intermediate growth rate and use the net result as the cash flow growth assumption. It would be good practice to ensure that the client is aware of the basis of the model, including the assumptions used.
So, now the basis of the cash flow model is sorted out, consideration should be given to how the model is used and the following question.
Does the client understand the output from the Cash Flow Model?
Probably not in many cases, any more than the average client will understand all the implications and nuances of the Pension Transfer Report (or previously the TVAS) without clear, balanced and consistent explanation. That explanation should be presented in discussions with the client but should ALSO be documented in the Suitability Report. The output from some Cash Flow Models can be 30 or more pages long!
Risk Disclaimer
The information, opinions, estimates or forecasts contained in this article were obtained from ATEB Compliance, are reasonably believed to be reliable and are subject to change at any time. It has been produced for information only.
Views and opinions are those of the author and do not necessarily reflect those of BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned. No action must be taken or refrained from being taken based on this content alone.
Our view
There are two areas of concern around cash flow models:
These concerns are not just our opinion. It is public knowledge that the FCA has concerns about the use of cash flow models, specifically around assumptions and how well the client understands the output.
This view is easy to understand when a client can be faced with 5, 10, 15 or more different charts, based on optimistic and unrealistic assumptions, which are not viewer friendly or easy to understand and when there is no clear explanation from the adviser.
The first concern can be easily resolved by using the growth and charges figures from the KFI as indicated above.
Resolving the second concern is less straightforward. In many cases, it will be best to simply use the cash flow models in the background to the advice as support for the recommendation made but not presented in detail, or at all, with the client. If the output is to be presented to the client, advisers should ensure that the cash flow model output is explained clearly to the client and that the client is not faced with more charts than is really going to help the client to make an informed decision. Less is usually more!
Finally, we would mention that the KFI rate should also be mirrored in the Pension Transfer Report (PTR). The PTR providers will use the 5% maximum intermediate rate unless a lower rate is entered when creating the report. If the KFI indicates a lower rate is appropriate, that is what should be used in the PTR
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