The Financial Conduct Authority raised concerns in their thematic review about retirement income advice (TR24/1) using standard withdrawal rates and cashflow modelling (CFM) when demonstrating income sustainability.

In its data survey, the FCA found that some firms had a standard rate that they used for income withdrawal advice, while others used CFM.

Some 276 out of 962 firms said they had a standard rate, with most using 4%.

The data does not show how the rates were determined nor used in practice, however the FCA did say that the use of an appropriate guide rate to support income withdrawal recommendations was likely to be helpful for clients, especially where CFM tools are not used.

The review states there needs to be a reasonable basis for choosing the withdrawal guide rate used for each client. And where a standard rate is used, this will not be helpful if it does not consider the clients’ individual circumstances.

There are too many variables to use a single standard sustainable withdrawal rate. The age of the client, the term, charges and investment portfolio can all impact the sustainable withdrawal rate.

This is where CFM can help. It can illustrate how much income could be drawn sustainably for a lifetime by taking into account individual circumstances.

The review found 810 firms used some form of CFM while worryingly, 111 firms said they did not use CFM or a standard rate. But the two types of CFM approaches, deterministic or stochastic, have their pros and cons.

Deterministic models are relatively simple and easier to explain to clients. They use assumptions which do not vary, like a future growth projection, but do not allow for the fact markets fluctuate so do not take account of sequencing risk.

Stochastic models take account of the fact that growth is not linear or constant. They assume many scenarios where the client’s fund value is compounded by a range of growth rates which move up and down over the period. This means we can attach a degree of probability to each outcome because some are more likely to happen than others.

There are benefits to both the client and the adviser. The client gets a better understanding of what their future benefits might look like, the range of outcomes and how likely they are to occur. The adviser can offer more robust Financial Planning which helps to better manage client expectations. The downside is they are more difficult to explain to a client.

In an example of good practice included in the thematic review, the FCA stated about one adviser firm, ‘A robust approach was taken on sustainable income, whereby both stochastic and deterministic cashflow planning was used to help to provide sustainable income recommendations.’

Whichever tool you use to illustrate possible outcomes, the FCA has said you should set out why the actual outcomes will vary in practice. To do this, the underlying assumptions used should be reasonable and reviewed regularly to ensure they remain appropriate with factors such as potential investment volatility and sequencing risk built in. This would seem easier to do using CFM. Using standard rates can be trickier as variation cannot be demonstrated quite so easily.

A case of picking the right tool for the job. 

Craig Muir is Senior Pensions Technical Manager at Royal London

Technical Central for Pensions - Royal London for advisers