Avoiding foreseeable harm: how stress testing supports your Consumer Duty approach

A file review asks a simple question: how did you show this client what could go wrong? The answer needs to be on the file, in a form the client could understand at the time.

The Consumer Duty has applied since 31 July 2023, and the consumer understanding outcome expects communications that clients can understand. In March 2024, the FCA published its concerns about how firms prepare and use cashflow modelling. They included clients being shown assumption-based projections without a clear explanation.

The FCA's guidance sets out five findings and what firms can do to improve. One of them, planning for uncertainty, asks firms to stress test outcomes and explain the results clearly. This post covers those findings, how stress testing helps you evidence client understanding and how to build it into your process with Monte Carlo in FE CashCalc.

What does the FCA say about cashflow modelling?

The FCA's article focuses on retirement-related advice, and it says firms should consider the impact on other areas where they use cashflow modelling. It describes cashflow modelling as a key step in providing suitable advice, and it sets out five findings.

• Information accuracy. Firms should consider whether the information clients give them is accurate, complete and consistent with their goals.
• Justifiable rates of return. Returns are one of the most important parts of the model. Firms need a reasonable and justifiable basis for their assumptions, and should include all charges and the effect of tax on withdrawals.
• Planning for uncertainty. Cashflow modelling is based on assumptions, and firms have explained this poorly. Firms should stress test outcomes and plan beyond average life expectancy.
• Consumer understanding. Different communications can show different growth rates. Firms should be aware of the differences and explain them.
• Considering the output. Firms need to review the outputs, including how long funds last in the base scenario, the stress tests and how the model handles tax.

These findings are the FCA's view of good practice and what it has seen go wrong. The article does not name Monte Carlo as a requirement. It does say firms should consider stress testing.

How does stress testing help you evidence understanding?

The FCA gives a clear reason for stress testing. There is a risk that clients see a detailed projection as a certainty. Showing plausible alternative scenarios gives firms some evidence that the risk they propose matches the client's risk tolerance and capacity for loss. It also gives clients an indication of whether they will meet their goals in retirement and what different outcomes could mean for their income.

The FCA lists things firms should consider when stress testing:

• illustrating a rare but feasible fall in asset values at the start of income withdrawals
• reducing net of inflation rates of return to show the effect on how long funds last
• highlighting the lower percentile outcomes in stochastic modelling output

The Monte Carlo simulation in FE CashCalc gives you those directly. It runs 10,000 scenarios and shows the results at the 25th (pessimistic), 50th (average) and 75th (optimistic) percentiles, along with a graph of a random 200 of the scenarios. The lower percentile is the view the FCA suggests highlighting. Built in to the stress testing are scenarios that will show a fall in asset values at the start of withdrawal as well as the reduction of rate of return.

And it's easy to evidence that you've run this. A saved simulation and a printed report show what you ran, with which pots and parameters, and a smart notetaker can record what the client saw. That is a record you can point to when you are asked how you explained the risk.

How do you build stress testing into your process in FE CashCalc?

In practice, this looks like the following steps in the UK FE CashCalc gross cashflow modeller.

1. Build the plan from figures before tax. FE CashCalc's gross modeller calculates all of the tax due, which addresses the FCA's concern about tax being ignored on withdrawals.
2. Open the stress testing section of the plan and choose the pots to include. You can select one pot, any combination or all of them.
3. Set the asset allocation, the age to run the simulation for and a minimum threshold, then run 10,000 simulations.
4. Review the graph of scenarios and the yearly breakdown. Look at the 25th percentile first, then the 50th and 75th, and check the money in, money out and charges.
5. Explain the result to the client in plain language, including that it rests on assumptions.
6. Save the simulation and print the report, which lists the pots, parameters, charges and money in and out.
7. Run it again at the annual review. You can run Monte Carlo on any saved gross cashflow model, so last year's plan can be stress tested without being rebuilt.

When you run a combined simulation, FE CashCalc blends the charges you have entered for each pot into one percentage, and the report lists them. That supports the FCA's expectation that charges are visible and considered.

Make the evidence part of the file

The Consumer Duty puts client understanding at the centre of advice, and the FCA's guidance shows what it expects from cashflow modelling. Stress testing is one of the clearest ways to show clients the range of outcomes, and to keep a record of what you showed them.

With Monte Carlo now in the FE CashCalc gross cashflow modeller, you can do that on a plan that already calculates the tax, with no rekeying into another modeller. It is included in your existing FE CashCalc subscription.

Try it in FE CashCalc, our cashflow planning software, on a live client plan and see what a saved simulation and a printed report add to the file.