Reinventing retirement planning: Later life investment strategies

In the second of three articles analysing retirement planning post-pensions freedom Ian Porter outlines a new way of looking at later life investing

Behavioural finance: What would you choose?

[su_note note_color=”#d2d2d2″ radius=”0″]The previous article in this series looked at longevity and the impact that this should have on the design of portfolios for clients adopting the new flexible drawdown regime.

Read: The longevity issue

This, the second of three pieces, considers the assets that clients have at their disposal and their views on how they are prepared to invest in later life.[/su_note]

The articles are based on a white paper written by Birmingham University’s Dr Paul Cox.[/su_note]


The lexicon of retirement planning has been forced to change ever since annual, maximum contributions were reduced and lifetime limits on the amount of pension capital that can be accrued were made more restrictive.

Most affluent and high net worth (HNW) savers will aim to have more than a pension to call on in retirement and this complicates the planning process, perhaps significantly.

It is partly because of this diversity of savings that many are unsure as to whether they have actually saved enough for retirement.

Also, while advisers know that each client is unique in their needs, the “product” industry needs to be able to build solutions that are scalable.

Research commissioned on behalf of consultant Aon Hewitt (2014) suggests that as much as the industry might like to have a ‘one-size fits all’ solution, the search for such is likely to be fruitless.

Research by Ignition House, with people who have defined contribution (DC) wealth found that most respondents had more than one pension arrangement and, in fact, had saved for retirement via a wide range of vehicles.

The diagram below presents participant responses to the questions: “What pension savings do you have?” and “What savings and investments do you have?”

RP pension arrangement chart

Spend, spend, spend?

Before the freedom and choice changes, pension wealth has been spent in retirement. Evidence also points to there being little to no appetite to defer taking income from pensions.

In the 64 to 69 age band, three-quarters of men and half of women with pension savings are drawing an income from them.

Pensions have also been viewed as a way of paying down property related debt at the point of retirement. The knowledge that tax a tax-free lump sum is available means that most do not worry about debt coming up to retirement.

But, will this landscape now change? While pension wealth, historically, gets spent, other liquid and property wealth, generally, does not.

This will be slightly illogical under the new pensions regime as the tax treatment of pension wealth for inheritance tax purposes will be highly favourable.

The smart retirees have caught on to this significant change already with anecdotal evidence that plans to “deplete the pension fund” are being reversed in favour of spending non-pension wealth.

It is perhaps also worth noting that while “down-sizing” of property is often considered as a capital/income generating strategy the Aon Hewitt research referred to earlier found that only 20% of those surveyed actually expect to downsize, but few outside the South East had considered the practicalities of this option.

Those that had already downsized reported that it had not worked out to be as much as they expected – typically releasing just £20,000 to £50,000.

Planning and risk management

Regardless of which “wrappers” a retirement fund is comprised of it needs to be invested in lined with the overriding goals of:
• Generating a dependable and possibly growing income
• Enhancing the fund value to improve longevity of capital
• Doing both of the above in a way which first with appetite for and ability to absorb risk

Given the identified longevity issue advisers will instinctively understand the need to not under risk a portfolio.

However, 80% of people age 55 and over with DC wealth would rather be safe with saving – even if investing in higher risk investments have the potential for better outcomes they are not particularly interested in moderate to high levels of investment risk.

The graphic below refers to research done by PADA and tests the difference between concepts of risk as they are articulated versus how they are understood.

RP loss gain chart


Heading for a fall?

On this basis, is the industry heading for a fall if we continue to use tools that assess risk in the traditional “20 questions” way? Do we now need to be far more cash flow and longevity aware for decumulation scenarios?

Our research, available through Financial Library, identified that it is difficult to reconcile approaches to “accumulation” investing with the far more cash flow dependent scenarios found in drawdown.

Our conclusion is that applying one, risk-rated, total return solution to the whole fund is unlikely to meet retirees needs.

In income drawdown, investing for total return would lead to reinvesting all cash flows from assets back into the same risky assets, while at the same time selling the same risky assets to top-up the allocation to safe assets that’ll be lower once income has been taken by the consumer.

If risky assets weren’t sold, the asset allocation to safe assets would naturally fall and this would make the overall fund’s position increasingly higher risk.

Such an approach could generate wasteful transaction costs and needless rebalancing, introducing additional “timing risk” into the picture.

[su_note note_color=”#d2d2d2″ radius=”0″]A more appropriate solution could be a drawdown portfolio of three moving parts:
1. One part liquidity for short-term cash flows.
2. A second part of investments that can be released when larger, infrequent sums of income are wanted by the consumer.
3. A third part consisting of investments designed to provide good investment returns.[/su_note]

Together, these are going to make-up a portfolio with overall low risk. Our aim is to grow consumers money and make it last longer.

We can think of the three parts we’re talking about as corresponding to three types of investment risk: zero to very low risk, low to medium risk, and medium to high risk.

RP investment chart

Once the first part is depleted, the aim is to use cash flows from capital assets in the second part of the portfolio (such as dividends from equities, and coupon payments and repayment of principal on maturing bonds) to refresh the liquidity account.

The second part values limited downside risk with income and some growth. It might hold a mix of government and corporate bonds with maturities of about five years, possibly held to maturity, as well as some higher dividend paying equities from non-cyclical industrial sectors and possibly appropriate structured products.

Holding bonds with a mix of maturities on a yield to maturity basis will provide cash flows to the first part.

The third part, the growth engine, aims to deliver a relatively high proportion of total return through dividend or coupon payments, effectively removing from the investment picture a significant part of risk to being able to top up part one and two of the portfolio as a result of capital volatility and associated ‘timing of sale’ risk. The total return mindset is foregone as the cash flows are not reinvested.

So where does this multi-layered approach sit with the concept of risk profiling?

I think we have to remember that risk profiling while an empirical test of attitudes is not infallible or definitive in terms of giving guidance on portfolio construction. It is a discussion starter that should lead to investigation and confirmation of what a portfolio should look like.

Talking point

It is a discussion starter that should lead to investigation and confirmation of what a portfolio should look like.

And before we even get to retirement we have to consider whether glide path approaches that have been built on risk profiling (automate or advised) and the assumption that tax free cash and annuities are the end destination for savers are now redundant and can actually work against the interests of savers. Our research suggests that unnecessary life styling could result in a fund 16% smaller than necessary at retirement.

Our research suggests that unnecessary lifestyling could result in a fund 16% smaller than necessary at retirement.

The third and final article in this series will look at the modelling that underpinned this research and how portfolio construction was tested in search of the optimal at retirement portfolio.

Ian Porter, head of business development and marketing, Sanlam Private Wealth