James Johnsen: Speculate to decumulate – the dangers of pound cost ravaging

A decumulation portfolio must be able to deliver appropriately risk-adjusted returns through a variety of economic environments and so, argues James Johnsen, cannot be overexposed to a few key risks.

Earlier this year, a report from retirement specialist Aegon challenged the old ‘rule of thumb’ calculation that people can take a 4% annual income from their pension drawdown pot without running out of money.

The report argued that a 65-year-old retiring this year and taking a 4% income has a 20% chance of running out of cash if they live to the age of 95. It also suggested that retirees should take no more than 2.8% if they want a 99% chance of not running out of cash.

This should give retirees pause for thought. The original 4% rule was developed by US adviser William Bengen in 1994 – a time, Aegon pointed out, when interest rates were much higher, and incorporating a period when stockmarkets were extremely buoyant.

Equally, retirees need to recognise that none of the new ‘decumulation solutions’ will do the job of an annuity. No solution incorporating risk assets can claim to offer the nirvana of a guaranteed income for life.

Nevertheless, with careful investment across asset classes, it should be possible to target a 3% to 4% annual drawdown with capital remaining largely intact over the longer term and with the income growing in line with inflation.

Reliable income is the key for most people in retirement. Some may be able to take small fluctuations in their income, but few will be able to tolerate significant falls. The current environment presents real difficulties in this respect.

Income-generative assets have been bid higher. There is a danger that, if interest rates rise, all these assets prove highly correlated and sell off in unison. In this – relatively commonplace – scenario, decumulation portfolios that rely solely on higher-income assets would seem to be at relative high risk of significant drawdowns.

But what is the solution? After all, taking income from capital has its limitations as well. Standard Life coined the phrase ‘pound cost ravaging’ to explain what happens when investors draw down on portfolios in falling markets, leaving their capital depleted and their income permanently lower.

To our mind, there is an argument for targeting some growth assets, and using returns from those to supplement income, rather than the solution constraining asset allocation to an increasingly narrow range of income-generative assets, which may grow narrower still. This, however, means a portfolio needs to be managed on a properly ‘absolute return’ basis to avoid the ‘pound cost ravaging’ issue mentioned above.

Capital preservation mind-set

A broadly diversified approach that invests across all the major asset classes, combined with a capital preservation mind-set is most likely to provide the sort of consistent, low volatility, returns required for decumulation portfolios.

This ensures lower drawdowns and volatility, while still retaining some investment in higher-growth assets. Managing volatility in this way is also important for long-term returns as well – although decumulation portfolios are for the long term and investors theoretically have a long period over which to ride out stockmarket volatility, short-term drawdowns can have a significant impact on long-term returns.

While a 5% loss in any one year would require a 5.3% gain to break even, a 30% loss requires a rise of 43% to get back to par. In other words, even relatively short-term losses can have a lasting impact.

It is also worth reflecting on what investors need to happen to their capital. For the most part, investors do not need significant capital growth – they simply need their capital to be sufficiently stable to support their income; for it to grow in line with inflation; and to leave a pot at the end for their family to inherit. To achieve that, it is not worth taking the potential risk to income of higher growth.

This is why we are naturally suspicious of portfolios that leave large amounts in equities. Using just a few assets for growth is risky in the same way that using just a few assets for income is risky. Most investors in this position do not need to be taking this risk.

The larger houses will continue to market individual funds as the right option for pensions decumulation. But we believe the debate needs to become a bit broader in scope and incorporate a multi-asset class approach.

Above all, a decumulation portfolio must be able to deliver appropriately risk-adjusted returns through a variety of economic environments and, as such, cannot be overexposed to one or two key risks. Many of the solutions proposed to date are in danger of this.

James Johnsen is head of business development at Church House Investment Management