The retirement outcome reviews policy statement (PS19/21) made it clear that a lot of time and effort has gone into ensuring that there are some clear investment pathways laid out for those moving their funds into drawdown.
But what about in the run up to retirement – how should a prospective forthcoming retiree prepare for this?
Well, first of all, it is important to acknowledge that many people ‘ease’ their way into retirement these days.
Many individuals will gradually reduce their working hours and transition their way into retirement, possibly supplementing the gap in income from their pension funds. There are also many who, although technically regarded as being in drawdown, have simply taken their tax-free cash but may not be retiring for several years or longer.
But the change from accumulation to decumulation shouldn’t be underestimated.
One of the reasons I agree with the principles of introducing investment pathways for non-advised customers is that, hopefully, it will at least make people aware that their strategy fundamentally needs to change, which will often necessitate a change in underlying funds or portfolios.
‘Crystallising the loss’
Why is this? Quite simply the impact of ‘sequencing of returns’ risk needs to be addressed. Much is written about this elsewhere but in simple terms taking an income from a fund when the value is depressed has the effect of ‘crystallising the loss’ and thus can cause significant harm to the long term performance of the portfolio, and could even result in the fund becoming exhausted earlier than expected.
It is commonplace for advisers to stress test this scenario these days, which can be done using a cashflow modeller by, for example, assuming a significant fall in the value of an investment early in the life of a drawdown, and then looking at the long term impact. For example, a fall of say 10% in the first year could easily result in a fund ‘running out’ several years earlier than was otherwise predicted.
So what are the strategies to help alleviate the effects of sequencing of return risk? These aren’t mutually exclusive and nor is this an exhaustive list but some of the most commonly used mechanisms are as follows
- Use the ‘buckets’ approach – invest in a range of different funds and/or asset classes and take income from whatever fund or asset class has performed the best
- Hold an amount in cash to pay income in the short term, therefore guaranteeing no loss due to falling markets
- Invest in a smoothed fund which helps iron out day-to-day fluctuations in underlying values
- Use the ‘natural’ income of funds or assets, so for example taking dividends, interest payments and rental income, leaving the capital untouched
None of these methods is perfect, with all having their advantages and disadvantages.
However, whichever one an adviser uses, or even if they use a combination of strategies, it seems entirely sensible to start gradually preparing the portfolio for decumulation rather than waiting till the day arrives when income needs to be drawn.
When annuities were the retirement vehicle of choice it was quite common to use a ‘lifestyle’ type approach where the risk of the investment portfolio was decreased over a period of years with, for example, a large part of the holdings moving from equities to bonds, to mirror more closely an annuity-style return.
For many, that’s not so relevant now as income drawdown is more commonly used than annuities. However, it shouldn’t stop an adviser from thinking about how a modern ‘lifestyle’ type approach could still be used in the run-up to income drawdown.
Here’s an idea of how this could work based upon our drawdown strategies discussed above.
|The ‘bucket’ approach||Align the portfolio into different fund types containing assets that are as non-correlated as possible. This could for example, be by asset types but also geographically, large cap small cap etc. Any existing holdings can remain part of the existing strategy if appropriate|
|Hold an amount in cash||This is self-explanatory but is often used in conjunction with one or more of the other strategies. Care is needed to get this right as money held in cash or cash funds is unlikely to provide anything approaching a real rate of return|
|Invest in a smoothed fund||Funds could gradually be moved over to a multi asset smoothed fund during say a five year window. This has the added advantage that the portfolio is likely to become more diverse as the time to draw benefits approaches. Ongoing contributions can continue to be paid into a more volatile fund to benefit from ‘pound cost averaging’|
|Use natural income||In order for this to work it is possible/likely that funds with a higher income will need to be accessed. This being the case over again say a five year period the portfolio could be tweaked to use funds paying a higher level of natural income than may previously have been the case. This additional transition time helps to guard against buying funds at the wrong time – for example if UK Equity Income funds were being considered but UK markets were at high levels|
One of the many advantages of using an adviser is the ability to plan over time rather than just at a point in time.
With volatility back in the markets of late, it feels that planning a glide path to retirement with the use of a modern lifestyle strategy should be part of a client’s plans as they prepare for retirement.
From an adviser’s perspective think about it as a transition from a centralised investment proposition to a centralised retirement proposition.
Kirsty Anderson is business development manager at Prudential UK