30 mins CPD
- Considering the implications of key assumptions on cashflow models
- Understanding the interaction between inflation and other assumptions
- Exploring and justifying what is “reasoned and reasonable”
Over the next few weeks, we’ll be posting a series of blogs looking at some of the key assumptions that influence the outcome of your cashflow models. For each of these, we’ll explore what is “reasoned and reasonable”; the wider-reaching implications of changing these assumptions, and we’ll be hearing from some of our most experienced and authoritative customers in terms of what they assume and why.
When we reach the end of the series, we’ll be sharing a Cashflow Best Practice Assumptions guide on our website with links to each of these posts.
We’ll look at the wide-reaching implications of the assumption you make below. For now, here’s what some of our users had to say about inflation:
Why is it important?
Inflation controls lots of things within your cashflow model. Not only those assumptions you’ve explicitly linked to inflation (such as expenditure or earnings), but also:
- Car prices – as cars are a large component of both RPI and CPI, we assume future car replacements will increase in line with your chosen inflation rate
- Motoring expenses – again, a large component of inflationary indices. Any costs you enter in a Motor Vehicle will increase in line with your inflation rate.
- Household expenses – similarly, any costs you enter in a property item will increase in line with your inflation rate.
- Tax allowances – where not frozen by law, we assume future tax allowances will increase in line with your specified inflation figure. This includes Income Tax allowances (Personal Allowance, thresholds, etc.) as well as the Lifetime Allowance for pension saving.
Bear in mind your chosen inflation rate also impacts on real return clients are getting on their investments. We’ll discuss this in more depth in a future post on expected returns, but it’s good practice to think about growth rates in terms of premium over inflation, rather than in absolute terms. For example: if your client is in a portfolio aiming to achieve returns of 4% and you are assuming an inflation figure of 2%, your client will benefit from a 2% real return on their portfolio. Conversely, if you assume an inflation figure of 3%, the same client will only achieve a 1% real return on their portfolio.
Adopting a low inflation rate will result in a model showing slow growth in the cost of living, slow increase in index-linked income, rapid growth in income forecast to exceed inflation, and high real return on investments
Adopting a high inflation rate will result in a model showing faster growth in the cost of living, faster increase in index-linked income, slower growth in income forecast to exceed inflation, and lower real return on investments
In other words: a higher inflation rate will normally result in a more conservative cashflow.
An exception to the rule
There are always exceptions to any rule.
When you are dealing with expenditure that typically increases above inflation (such as the cost of care or private school fees) the opposite is true.
A simple example:
A client pays £20,000 private school fees, increasing by 6% per annum for 10 years (7 years school; 3 years uni).
If inflation is 3%, in 10 years’ time the annual cost of fees will grow to £ 25,897 in today’s money.
With inflation at 2% over the same period, the cost of fees will grow to £28,274 over the same period. This equates to an extra £2,377 per annum.
In the case of expenditure that increases above inflation: the higher the inflation rate, the more conservative the model. This deserves careful consideration when building cashflow models whose primary aim is to plan for e.g. school fees or the costs of care.
What is reasonable?
The 12-month UK RPI inflation rate for May 2021 is 2.2%. This is the latest available data according to ONS.gov.uk at the time of writing. Should you, therefore, use the latest available data and assume an inflation rate of 2.2% for your cashflow model?
The answer is almost certainly “no”. At least if you were justifying this in terms of the current rate being a reasonable predictor of future inflation rates. Remember, your cashflow model could potentially be projecting for 30, 40, even 80 years of your client’s financial future. What might be a reasonable assumption today might not be reasonable for the next 80 years.
The chart below shows RPI inflation from 1989 to 2021, with a rolling average. Even taking into account the heady highs of the early 90’s, the average over this 32-year period is 4.3%:
Would it be reasoned and reasonable to assume that an inflation rate of 4.3% is a fair assumption for a long-term projection? You could argue that it is “reasoned”, in that it is supported by historical evidence over the longest period available. It would, however, be hard to argue that it is “reasonable” to assume that the historic dramatic swings of inflation are going to reoccur in future.
So, what if we ignore the highs of the 80s and 90s, and just look at the last 10 years?
This brings the average down to 3.2%. Would this be a fair assumption for a long-term inflation figure? Many would argue that even 3.2% is too high. Bearing in mind that a large part of the Monetary Policy Committee’s remit is to keep inflation at 2% (and they’re currently doing a pretty good job of this!) a rate even lower than 3.2% could be prudent.
Providing you record both the decision you have made and the logic behind it, you could argue that anything between <2% and >4% is a “reasoned and reasonable” assumption for inflation in a long-term projection.
The following are useful resources when deciding on and documenting your assumptions and the reasoning behind them: