The new pensions freedoms that came into force this April allow much more flexibility on how to invest for and in retirement.
This flexibility is welcome and overdue. It also means that advisers have a more important role than ever in helping their customers navigate the multi-dimensional world of retirement investing – both from a financial planning perspective and from an investment perspective.
From a financial planning perspective, on the one hand, not much has changed.
The objective remains to ensure customers have the means to enjoy the retirement they expected.
On the other hand, responsibility has shifted – it is now in the adviser’s court to help customers make the most of their newfound flexibility.
This means advising on drawdown rates and designing solutions for the various different retirement ‘buckets’ (for example, cash, investments, guarantees, and planned legacies) with a clear understanding of the tax position.
As this wasn’t enough, from an investment perspective, creating and managing an investment strategy for decumulation requires consideration of a fundamentally different set of objectives and risks.
Whereas traditionally, accumulation focused on growing a pot, the focus for decumulation is about making it last.
In technical terms, the main risk for retirement investing is “shortfall risk” – the risk of running out of money to have the retirement your client expected.
Key retirement risks
Managing shortfall risk is a bit like running a defined benefit pension scheme.
The value of the pension pot assets have to at least match the present value of the drawdown payments it will have to make over the customer’s life. The reason shortfall risk is so important is there are no future contributions from salary to top up the pot.
The key drivers of shortfall risk are not only the familiar ones like the market risk (volatility) associated with managing assets and inflows, but also less familiar ones associated with managing payments and outflows.
This means ensuring the pot can stretch to cover drawdown payments and their sensitivity to interest rates (duration risk), ensuring the client does not outlive savings (longevity risk), ensuring portfolio increasingly matches the currency of the drawdown payment (currency risk) and ensuring the pot can match or outpace inflation (inflation risk).
It’s not surprising that with these different types of risk a different approach to asset allocation is required for professional retirement investing.
For decumulation, investing to support a retirement income does not necessarily mean investing in high-income yield products.
It’s important to look beyond the headline income yield to consider the underlying asset allocation to understand the level of risk involved and consider how that squares up to the key retirement risks.
So using equity income funds alone for drawdown is probably not appropriate. For clients seeking income yield, multi-asset income provides greater diversification.
Providing the right kind of retirement income means your pot is being managed to ensure it lasts over time.
As time goes on the level of risk should necessarily decline, so to provide a purpose-built drawdown strategy, we believe target date funds, therefore, have a key role to play.
Many advisers simply assume target date funds are the same as lifestyling. This is not the case.
They are much more flexible with managers able to introduce a tactical overlay to ensure the asset allocation can adapt to changing market and legislative conditions.
Target date funds offer a ready-made strategy both for the accumulation stage (before target date) and the decumulation stage (after the target date).
The target date in the name of the fund is simply the date that you expect drawdown commence: so for drawdown it is a start date, not an end date.
These funds do not distribute income (so may not have a “yield”), as it is more tax efficient to roll up the income within accumulation units.
Furthermore, when units are sold to make drawdown payments, the underlying mix of assets is not affected, so your investment strategy remains in place.
With retirement planning now infinitely more complex, the need for purpose-built drawdown portfolios has not been greater.
Henry Cobbe is head of research at BirthStar® Target Date Funds