Two riveting holiday must-reads both happen to have been published in the last few weeks. The first is Damaged Goods, the story of Philip Green, Dominic Chappell et al on the plight of the BHS pensioners following the funding problems in their defined benefit (DB) pension scheme.
The second is the Retirement Outcome Review published by the FCA, which is concerned with making sure customers are obtaining value from the pensions industry in the wake of the pensions freedom legislation introduced by George Osborne. I will leave you to decide which is the more exciting of the two.
Still, there is one common theme running through both and that is the growing plight of the public who are almost exclusively going to have to rely on defined contribution (DC) pensions in future and ‘go it alone’.
(As an aside, underlying this is a growing scandal that those in the private sector who create the country’s wealth cannot afford DB pensions even though the public sector still can, courtesy of the private sector taxpayer. This is despite many public sector workers retiring and taking on second jobs to boot. Surely this unjust state of affairs cannot continue forever.)
The biggest contributor to the demise of DB schemes has undoubtedly been increasing longevity, although there have been other contributory factors, including the government’s tax raid on dividends held in private sector pensions under Gordon Brown (no impact on the pay-as-you-go public sector pensions, of course) and the tightening up on early leaver benefits that we saw in the 1990s.
The impact of all of this is the public are being forced to provide for themselves and save up for their retirements now employers have scrapped their DB schemes, which had become unaffordable. We have also witnessed the demise of annuities in recent times and the associated rapid increase in drawdown products.
The main problem with annuities is the very low income rates that are generated as the money is effectively invested in low-yielding fixed income assets. The main problem with drawdown, meanwhile, is the need to make sure your savings last throughout your lifetime while your savings ‘decumulate’.
The savings industry has for many years been solely concerned with accumulation and trying to build as big a savings pot as possible within a given risk tolerance. There is now a real need to develop thinking on how to tackle the decumulation issue too.
So what are the main differences in investment approach when investing for accumulation as opposed to decumulation? With accumulation, you are generally trying to build up a pot of cash for some time in the future, optimised according to the level of risk you wish to take. Volatility is generally your friend in that, the more risk you are prepared to take, the higher the return you can expect.
With decumulation, you need to optimise the portfolio according to the risk you are prepared to take and the withdrawal you will need to make over time. Volatility becomes your enemy, with sequencing risk a major concern.
Financial outcomes can be dramatically different, depending on when and how you start to take your income, and for how long. Taking too much, too early, when markets are low can have a devastating impact on your likelihood of achieving your desired level of income throughout your lifetime with the chances being improved if you take less risk.
It is not possible to give absolute levels of guarantee without investing in assets with an absolute guarantee although what can be done is to model the potential outcomes and give expected chances of success for a given level of risk – known as ‘confidence’ – together with the level of income desired and the time horizon over which it is required.
With the enormous amounts of money that are going to be required for drawdown, advisers must be aware that to avoid the chances of claims against them they need to adopt a business model that properly considers decumulation. The FCA has stated in the Retirement Outcomes Review it expects to see extensive product innovation to solve the decumulation conundrum in the non-advised sector – but for advisers this is a real problem now.
The public are totally confused by, and lack trust in, pensions – a situation not helped by, as the FCA states, “frequent changes to pension rules and tax changes”. There is a massive need for advice in an ageing population and, as the regulator also points out, 33% of non-advised drawdown clients are invested wholly in cash – a wholly inappropriate solution.
Advisers who are looking to create a robust retirement proposition need to consider: how best to assess suitability in retirement; how to select the right withdrawal rate for a given investment allocation and time horizon; and what products or combination of ‘retirement-ready’ products and solutions to recommend to match a client’s retirement needs.
Pension freedom knocked the question of how to manage decumulation firmly into the advice sector’s court. As well as creating a tremendous opportunity, firms that want to de-risk their retirement advice process will need to get this right.
Henry Cobbe is head of Copia Capital Management