Centralised investment proposition is one of the most reused phrases that the Financial Conduct Authority (FCA) has ever created.
I first came across it in the finalised guidance Assessing suitability: Replacement business and centralised investment propositions July 2012. The guidance wasn’t about whether you should have a CIP, but more about the circumstances when it may be suitable to replace an existing pension or investment with one.
I guess the key statement was ‘clients can benefit from more structured and better researched investments, and firms can benefit from efficiencies in the management of risks associated with investment selection’.
Nobody was going to argue with that and the CIP label and ‘outsourcing’ became a sales opportunity that ensured the phrase’s longevity.
A firm can achieve this and have a CIP with a broad spectrum of approaches. Dynamic Planner has seen and supports them all. You could use the Dynamic Planner system to research the whole of market for each client; you could build and review a panel or model portfolio; or you could negotiate a commercial or client advantage and become restricted. All work and all have the same regulatory responsibilities and challenges.
Within FG12-16 s4.7, the FCA identified ‘firms conducting detailed research on the typical needs and objectives of their target clients’ as good practice and ‘consider objectively their clients’ needs and objectives’ as a key issue the firm should consider.
A theme that has since become codified in PROD rules.
When it comes to retirement planning, there is one moment when the client’s needs and objectives change and you are most likely to recommend a pension switch or transfer.
‘At retirement’, everything changes. You are no longer planning for retirement, you are planning your retirement. You are no longer putting money in, you are taking it out. Your day changes and so does your expenditure. And I don’t have to tell you about all the pension regulation changes.
You could view PROD and imagine your target market is reasonably narrow and defined and you don’t need too many segments of different solutions, but it is utterly implausible that you could use the same CIP before and after retirement and so the ‘centralised retirement proposition’ was born.
So what are the different factors that I need to consider?
The pattern and frequency of withdrawals – We all know the impact on annuities for monthly or annually in arrears of in advance. The same applies to regular withdrawals of capital. Does the target client want a fixed monthly income like his salary? Would they withdraw a lump sum each year and spend it sensibly? Can they afford to delay the start? Could they tolerate a variable income?
Sequence of returns risk – If you take a fixed withdrawal of capital each month, then you introduce additional risk. You may well have effectively managed the risks of your centralised investment proposition, but this is an extra one. Until retirement, the value mattered at annual review. Now it matters every month when the units are sold. This means that the volatility of unit price needs to be managed on a monthly not an annual basis. It isn’t as simple as reducing the overall annual risk.
Early loss risk – When we look for manifestations of retirement risks in the past, the examples of people’s retirement income halving between retiring in 2007 and 2008 is a pretty powerful one. However, that was a combination of a sudden fall in capital value and a fall in annuity rates. There is some important context. Firstly, the fall hurt people in the run-up to retirement as much as those who had retired using pension fund withdrawal, so is an issue for both CIP and centralised retirement proposition.
Secondly, the compulsion or tendency to buy an annuity back then forced the pensioner to lock in the loss. People often confuse this one early loss with sequence of returns risk, but it is different, more visible yet has less impact for clients who remain invested, particularly if they react by adjusting the level of withdrawals. The important factor to consider is whether the pensioner will buy an annuity in the future when the time is right or whether they will continue to withdraw capital until it is gone, or they die.
As with a CIP, as well as the needs of a target market, there is also a consideration as to the level of work that the adviser has to do to maintain it and how the costs of that can be reasonably passed on to the client. With the centralised retirement proposition needing to manage monthly withdrawals and risk you can expect a greater level of work.
There are three approaches to managing out sequence of returns risk:
- Don’t take fixed regular withdrawals. From a non-individual centralised perspective, this means only distributing the interest, rent or dividends to the investor, also known as natural income and leaving the units untouched. This can work for clients who can afford to live on a very small percentage of their capital that varies. Important considerations when selecting a centralised retirement proposition solution for this target client group are: level of ‘income’, its consistency, risk to remaining capital and the total return. This approach works by not spending capital but does nothing to manage out sequence of returns risk.
- Take withdrawals from the stable part of a portfolio, typically cash. This works if you have effective and efficient portfolio construction software that helps you provide both initial and ongoing suitability assessments and disclosure. The approach becomes very individual and hands-on, so there are challenges with scale and also greater inflation risk due to the amount held in non-real assets.
- Invest in a solution that manages risk on a monthly rather than annual basis. This could be through an asset allocation that is negatively correlated in shorter time frames; it could be through highly active management; or the provider uses its own capital to smooth the unit price. In any case, due to the mathematic nature of sequence of returns risk it is a matter of analysing and risk profiling with a monthly rather than annual perspective to identify solutions risk profile even when fixed regular withdrawals are taken. At Dynamic Planner, we define these as Risk Managed Decumulation solutions.
While these approaches can deal with any target market in retirement, there is one final difference to the pre-retirement accumulation market.
Most accumulating clients simply require as much capital as possible, while retiring decumulation clients have very personal and varied income requirements, time frames and patterns.
Therefore, a good central retirement proposition is aligned to and supported by a powerful cash flow planning tool that is easy to use from somebody you trust.
Chris Jones is proposition director at Dynamic Planner