What is the question, I hear you ask?
“Do I have enough money to live on, and maintain the lifestyle I want in retirement?”
Every day financial advisers across the country – indeed right across the world – devote time to answering this question for their clients. And despite it being the most asked question, it is probably the least thought about question of our age – that is, until retirement is at our doorstep and we need to understand our options.
The Pension Freedoms introduced in 2015 have bolstered the need for financial advice at retirement, given that those reaching retirement need to consider the alternatives to purchasing an annuity. This freedom of choice for managing their retirement pot – the decumulation phase – brings with it both complexity and risk. We recently covered the risks an article: tackling the four biggest risks to your clients’ income and have summarised these (and more) below.
Six risks to clients in decumulation
Clients in decumulation face the following risks, or pain points, that need to be managed:
1. Significant market falls. Also known as ‘drawdown’ market falls have the potential to decimate a client’s retirement savings and significantly knock their confidence.
2. Volatility. Fluctuations in price create volatility, which then has a drag effect on portfolio growth.
3. Sequencing risk. The sequence of returns can have a significant impact on the income available during retirement. For example, two clients with identical wealth can have entirely different financial outcomes, depending on the state of the economy when they start their retirement.
4. Pound cost ravaging. The opposite of pound cost averaging, pound cost ravaging occurs when markets fall and more units need to be sold to match the income required to meet the client’s income needs in retirement.
5. Inflation risk. Or purchasing power risk, can damage a client’s wealth over the long term by eroding the value of their money.
6. Longevity risk. The risk that the client will live longer than than their retirement pot can sustain.
Addressing the risks: the ‘pots’ approach
Thesis Asset Management recently published a white paper looking at how financial advisers and product providers manage these risks (you can download a copy here). After considering the different approaches used, such as annuities, other products, cashflow planning, and drawing ‘natural income’, Thesis undertook more detailed analysis on the ‘pots’ approach for managing retirement income.
The ‘pots’ approach involves managing retirement investments in separate pots, a service we have seen many advisers adopt (usually running the strategy themselves) for their clients.
Simplistically, this would include a:
» Long-term pot – with a high level of risky assets to deliver growth (i.e. dealing with risks 5 and 6)
» Short-term pot – with income generating and highly liquid assets to meet regular withdrawals (i.e. dealing with risks 1,2,3 and 4)
Note that some advisers will have more pots than others, but the principle remains the same.
The pots approach is attractive for clients and research indicates that 79%* are happy to see their retirement strategy in multiple pots. However, it can be time consuming to administer and introduces implementation risks, which can be quite significant. For example:
» How much and for how long do you leave money in short-term pots? Is there an optimum time and amount?
» How much is needed in equities for the long run to manage inflation and longevity risk?
» How can you ensure consistency across all clients?
» If you are consistent across all clients, are there implementation risks? For example, if working on an advisory basis how do you make changes for clients needing the same thing at the same time and manage the process of getting permission each time.
» Are you comfortable making big asset allocation decisions, like moving from equities to lower risk assets, and how do you implement these changes quickly, consistently, and fairly for all clients?
The Thesis research, which considered two pots over an investor’s decumulation journey, revealed that investment in the decumulation phase is different from the more familiar accumulation phase. No surprises there. However, what they found is that to sustain a portfolio over the course of a long retirement and defend against longevity and inflation risk, sufficient exposure to growth assets and real-returning assets is required. The drag of holding too much in defensive assets over the long-term tends to reduce the portfolio’s ability to generate the returns it needs to sustain itself for the long run.
What is required is a solution that recognises that in the long run clients need to hold a suitable weighting to growth assets, but also helps to address the very real threat of sequencing risk in the early years of decumulation.
What’s the answer?
Thesis offer their preferred solution, which they call the Managed Income Service. It follows a predetermined asset allocation glide path, with some of the defensive assets being sold each quarter to pay income and any excess reinvested into the growth assets. This means that the growth assets can fall without the need to sell them to generate income. The defensive assets are used to pay income, leaving the growth assets to recover.
This approach also helps to address sequencing risk, as a fall in the growth assets will see a larger amount rebalanced out of defensive assets, turning pound cost ravaging on its head and reintroducing the benefits of pound cost averaging.
In essence, the pots approach is a method of providing fire insurance in case the worst happens in the short term and leaving enough in riskier assets to ensure clients do not outlive their wealth. To find out more, download a copy of the Thesis white paper here.
*Cicero Research report ‘Retirement income: the price of freedom‘.