Lawrence Cook: Beware decumulation’s ‘double whammy’

Recent market volatility must be a reminder to advisers to protect clients in the decumulation phase of their life against the combination of volatility and pound cost ravaging, writes Lawrence Cook

Concerns may have been creeping into the market for a little while but October will have left investors and their advisers in little doubt that market volatility must now play a prominent part in their thinking.

In the three months to the end of October, the UK equity market – as measured by the FTSE All-Share index – shed 10%, while short-dated bonds and cash remained static.

This may well have triggered many MiFID II requirements for advisers and discretionary fund managers to write to clients to inform them of this drop – particularly those with a higher risk profile.

This recent bout of market volatility should also remind advisers to ensure they have a modern and appropriate decumulation strategy in place for clients to help absorb the sort of falls in equities we have just witnessed.

Traditional approaches to decumulation would have struggled during this period, as the effects of volatility and subsequently pound cost ravaging took effect. Say a client took a 5% withdrawal at the end of October from a portfolio that had just fallen 10%, how much growth would they now need to see to return to par?

To illustrate the point, let’s keep things simple and consider a £100 investment. If it falls by 10%, it will be worth £90. With a 5% withdrawal of the original sum, the investment will then be worth £85. As a result, it will subsequently need to rise by 18% to return to the original £100 figure.

This, then, is the ‘double whammy’ of volatility and pound cost ravaging operating in partnership. Advisers can be fooled by unintentional blindness to this phenomenon – and this is incredibly damaging for the long-term prospects of their clients in the decumulation phase of their life.

So how should advisers be positioning clients in decumulation in order to meet their income requirements?

There needs to be a change of thinking when it comes to asset allocation decisions for the early years of decumulation. Taking the above example, if the client had only sold out of bonds or cash, leaving equities undisturbed, it would give the growth assets time to recover.

Furthermore, by rebalancing out of bonds and cash to top up on equities after they have fallen, as in the above scenario, the client will experience the benefits of pound cost averaging, and mitigate the potentially devastating side-effects of pound cost ravaging.

While most client portfolios will not have all of their exposure to equities, this example helps to illustrate the dangers of using a more traditional approach when it comes to decumulation. By selling across all assets for income – particularly in the early years – you risk ruining the portfolio before it has had a chance to build up a buffer.

Embrace innovation

Innovation is beginning to come to the decumulation market. It has taken some time but advisers need to know there are options out there and they do not have to manage these risks alone. Instead, they must embrace the innovation that is springing up and acknowledge things can – and need to – improve.

There is a distinct problem within the industry, however, where many see multi-asset funds or portfolios as a diverse and appropriate allocation for decumulation clients. Advisers would never recommend an equity investment for a period of less than three years yet those who have chosen a multi-asset product may well have done
just that.

It comes back to selling equities for income. As multi-asset funds will sell across all of its holdings, including the natural yield from equities, problems will occur in the early years and clients will risk running out of money during retirement.

At the very least, they will need to reconsider their lifestyle in order to make their portfolio last for the long term.

There is a better way – and it is not an individual fund. Using a service that employs best practice by selling down the lower volatility assets in the early years of decumulation, allowing equities to build up a buffer, can provide a sustainable income over the long term.

We always acknowledge that markets can fall as well as rise so let’s make sure client strategies are aligned to this principle so that pound cost ravaging does not end up harming their retirement.

Lawrence Cook is a director at Thesis Asset Management

This article first appeared in the new issue of Retirement Planner’s sister title Multi-Asset Review, which is now out. To make sure you receive your own copy of the next issue, please do register your interest here