In advance of our event on November 14th where we will DISCUSs managing income, we met with Harry Taylor who provides consultancy for a range of financial services businesses to get his take on this subject. Harry’s view is that there are four key topics of interest in the retirement income market, so we spent some time exploring these.
DISCUS. Harry, you have highlighted four key topics of interest, what are these?
Harry Taylor (HT). In my view key topics are:
- Innovation has stalled but there is plenty of opportunity looking end-to-end
- Now is a good time to review income propositions and solutions in use
- The investment dynamics of income drawdown are different from accumulation phase
- Advisers and DFMs can develop investment strategies for this growing market area
Innovation is an important topic and the lack of it following Pension Freedoms has recently been picked up by the FCA. Unlike the legendary Norwegian Blue in the old Monty Python sketch I think innovation is only ‘resting’ rather than a ‘dead parrot’.
I believe that now is a good time for advisory businesses, DFMs and end-to-end service suppliers should review the range of retirement income propositions and investment solutions they have available. A useful starting point to identify potential innovations which I have produced is a high level overview of a generic ‘Retirement Income Management System’.
This whole market area should be of interest to both Advisers and DFMs as it grows rapidly. Good investment strategy is a core part of retirement planning and making the most of pension contributions long term. But there are reasons why a successful investment strategy for accumulation may not be best for income drawdown.
However, retirement income provision has complexity, constraints and the opportunity to meet client needs for long term cash flow. There are often no easy or definitive answers. So when advising clients it is important to understand as much as possible about the risk dynamics.
DISCUS. Firstly, why in particular is now a good time to review the market for retirement income solutions using drawdown?
HT. Since the introduction of the Pension Freedoms, the retirement income market has changed substantially. There are 2+ years of practical experience so everyone is building up a picture of client behaviour.
In the recent FCA Retirement Outcomes Review Interim Report MS16/1.2 (Slide 2) they seem mainly concerned about the non-advised mass market, But regulatory interventions in one market segment can have consequences for others. The FCA have specifically stated:
» We have identified areas where early intervention may be needed
» We will gather evidence on whether consumers pay high charges and have ended up with unsuitable investment strategies
» Product innovation has been limited to date, particularly for the mass market.
In addition, the key points are also relevant:
» Annuities continue to look poor value in the low interest rate environment unless a client needs guaranteed income but not flexibility, qualifies for an enhanced annuity due to ill health or is age 75+ at purchase where the mortality pooling effect starts to outweigh the low interest rate impact
» DC pension pot sizes to support retirement income drawdown could grow very rapidly with pre/at retirement pot consolidation including advised transfers from DB schemes. The Pensions Dashboard will accelerate this process when it comes to market
» Before Pension Freedoms the Government Actuaries Department limits on maximum drawdown amounts acted as a safeguard against running out of money – even where the client had a professional adviser
» Early provider innovations were around investment based annuities with guarantees. That has remained a small niche and the high economic cost of providing guarantees means they do not generally look good value for money
DISCUS. We are looking at investment strategies at our next event, why do you think Financial Advisers and DFMs should continue to develop investment strategies for retirement income?
HT. The investment strategy is a fundamental component to deliver the target cash flow and good client outcomes. But this has to fit in an optimal way with the constraints of client situation, risk factors, risk attitude and capacity for loss, which may change significantly over time.
The investment strategy should cover the four portfolio sources of retirement income: interest, dividends, capital gain and principal. It is the interaction of these with volatility and disinvestment timing/amounts for income that drives sustainability of income.
As the environment is dynamic not static, future projections should look stochastically at the likelihood of a range of outcomes rather than deterministically at one central long term assumption. This requires sophisticated modeling tools and expert portfolio construction.
When drawing down regular income a client is also exposed to sequencing risk. Cashing in assets when prices are down means more are required to generate the required income. Consequently there is no opportunity to participate in any later asset price recovery. This is the converse of ‘pound cost averaging’ in accumulation where regular contributions benefit from buying assets cheaply in market dips. The most damaging impact is from a significant and sustained drop in asset values early in drawdown.
Lastly, risk exposure and price volatility of the portfolio should probably be lower than in accumulation. The dilemma is that enough risk needs to be retained in drawdown to generate the long term returns supporting target income for target duration.
DISCUS. Where could we see innovation emerging over the next few years?
HT. If we consider each of the components of the generic ‘Retirement Income Management System’ there is scope for client centric innovation such as:
» Ways to capture, measure and monitor client risk factors, risk attitude and loss capacity
» Estimating and building the cash flow target and variability levels
» How to deal with longevity risk and portfolio lifetime targets
» Investment strategy optimization and portfolio construction given the practical constraints
» Overall approach to Governance and Administration, payment systems and flexibility offered by platforms and product wrappers
» Proposition development such as ‘Default’ solutions for the mass market, hybrid solutions, use of annuities at advanced ages and Target Date Funds
» Next generation of Tools and Communication methods to support quality client communication and engagement
» Stochastic projection approaches with visual presentation of results and real time scenario planning driven by cash flow targets and risk
» Reducing the cost of providing sophisticated advice through technology
Innovation is ‘resting’ but I am sure there is plenty of opportunity to activate it. You have certainly not seen the last of the Norwegian Blue!
Thanks Harry, and we look forward to your next article on this topic. We still have places at our income event with Gregg McClymott and Abraham Okunsaya so please sign up here to join us.