When clients ease up on their working hours and approach decumulation, an adviser’s life becomes more challenging. There are many moving parts that advisers intuitively understand. Part of the issue is that, if it’s all intuitive and we don’t explain it, clients may not understand the value they get.
Annual allowance, lifetime allowance, inheritance tax. Investment wrappers withdrawal rate, sustainabiltiy of income. The list goes on.
We’re now a long way from: ‘Why don’t you save £20 per month into this endowment savings plan, Mrs Jones?’ Financial advice has changed and decumulation is much more involved than the accumulation phase. But, unless the client perceives the strategic financial planning, why would they want to pay for it? In other words – be prepared to show your workings to illustrate just how valuable your advice is.
They do not have to know how to calculate a Sharpe ratio or work out their pension input period but they should recognise the expertise you offer. Many of us grapple with how to manage the many considerations around decumluation.
Especially, how to tackle the opposing risks of sequencing of investment returns, longevity and price inflation.
When I was a director at a DFM I spent hours developing our proposition with the chief investment officer. We consulted with several advisers and proudly presented our new shiny service, which did a good job of managing sequencing risk and longevity. However, hardly anyone recommended it to their clients.
Why? Partly, it was a solution to a problem many didn’t know they had.
With the Financial Conduct Authority promising a thematic review into retirement income advice that is changing quite quickly. But ultimately the answer is not to be found in a product from an investment house; this is primarily an advice issue, not a product issue.
For all those financial advisers that already knew this, sorry. We have all the products we need. It is how we use them to manage clients’ risks that really counts.
Let us look at sequencing risk in particular.
As the client builds their retirement pot, the risk of a bad run of investment returns increases: sequencing risk.
If you are unfamiliar with it, the chart below shows that it is not the investment return by itself that matters, but the order in which it happens. It is no good saying to an investor ‘I had all the right notes, I just played them in the wrong order’.
The order certainly matters. This example illustrates the point. 4% investment return in nine out of 10 years with the one exception being -30%. I have just changed the order. I then subtract a client withdrawal of £25,000 per year. Hey presto! The client in scenario one now knows sequencing risk is a big deal with only £198k left after 10 years, whereas clients experiencing scenario 10 have £287,000 left.
The table above is about sequencing returns from day one of regular withdrawals. But the sequencing risk issue starts earlier, in the years running up to that point.
One can argue that derisking portfolios in the last few years means the client misses out on the massive compounding effect of investment returns in those years.
That is true, but what is the investment there for? For most, it is to deliver a desired lifestyle, not to risk that in the hope they can get more. We can say it is a risk trade-off.
If in the last few years of accumulation the portfolio suffers a 30% fall, that can have a material impact on the lifestyle provided during retirement. Or it means deferring retirement, neither of which are optimal.
If the portfolio value is pretty close to achieving the financial planning objective then de-risking the strategy makes sense. You are trading off potential investment return for reducing the risk of failing to achieve the planning objective. That feels like an insurance premium worth paying.
Once we start taking money out and not paying in, things look different.
Not just the hard numbers, but psychologically for the client. A friend of mine who has worked in financial services all his career recently told me he had just started to decumulate. He said it felt ‘weird’. The cosy saving part of accumulation shifted to ‘have I got enough?’ And ‘will it last?’
The positive aspect is that it tends to make clients more cautious, which means their funds are less likely to be depleted through reckless spending.
However, our role is to help clients steer a path that gives them comfort and helps them achieve their desired lifestyle. The question we need to answer is ‘what is the appropriate strategy for decumulators?’
This varies according to the client but there are some guiding principles. To combat longevity and price inflation risk over the long term, most agree that investing in equities is the answer.
The principle remains that only equity investment has a sustained record in beating inflation and is likely to help us avoid outliving our money. If you look at any serious study it would tell you that investing perhaps 100% in equities is the right answer, probably.
The key word is ‘probably’. Saying to a client: ‘It’s OK, your retirement is probably going to be ok’ is not what they want to hear. What I mean by ‘probably’ is that, based on historical data, an equity-based strategy more likely than not will be better than other strategies. A probabilistic basis is a sensible approach.
We can gauge levels of probability using stochastic modelling. It avoids being tempted into giving absolute answers to questions which do not lend themselves to such certainty. We are unlikely to recommend a 100% equity portfolio.
This is because of the potential severe impact of poor investment returns in the early years. A big drop in early years is a risk worth trying to mitigate because of the scale of its potential impact. This suggests having some of the portfolio in lower-risk assets, what is just as important is the order in which you sell down assets to meet income needs.
Selling equities in the short term makes little sense as these tend to be volatile. It makes more sense to rely on assets that exhibit lower volatility.
If you use a multi-asset portfolio then taking, say, a 4% withdrawal across all asset classes is likely to be sub-optimal. In most years, equities tend to be the best performers, so selling these is illogical. It might be better to sell down bonds in the early years and leave equities to grow over time.
Beyond the short term, say, five years, we can start to withdraw money from equities once they have had a chance to grow and overcome any short-term sequencing risk horrors.
The implication of all this for risk profile and asset allocation is that we start with say 50%/50% equity/bond allocation but gradually shift to perhaps 80%/20% over time.
That is an evolution of investment planning from the traditional approach but sensible to manage decumulation risks.
Lawrence Cook is head of UK intermediary distribution at Sanlam