Retirement asset allocation: The problem with natural yield

Henry Cobbe explores ‘potentially devastating’ consequences of sequence of return risk to drawdown investors and explains why advisers should become better acquainted with target date funds

Pensions freedom means there are now more ways of taking a retirement income as an alternative to an immediate annuity.

According to the Association of British Insurers, quarterly sales of annuities fell from £3bn in Q1 2013 to £995m in Q2 2015 while use of drawdown has increased from £405m to £1.3bn in the same period (see Fig. 1).

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While drawdown creates flexibility, the key decision for investors and their advisers is to get an appropriate asset allocation for clients using drawdown.

The asset allocation has to be such that it offers potential for growth to sustain drawdown over many years, but not be too volatile to expose a pot to sequencing risk.

Potentially devastating

Sequencing risk is a function of the order and timing of investment returns and their impact on eventual outcome. The charts on this feature assume portfolio growth of 3% p.a. annualised over 20 years using different linear and non-linear sequences.

Financial planning tools sometimes use ‘linear’ assumptions, but in reality the market rarely moves in a straight line.

We also show two non-linear sequence examples: Path A and Path B. The former grows steadily with some setback; the latter reflects a drop and recovery in the markets (see Fig. 2).

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In the accumulation phase of the savings journey, sequencing risk can create some performance disappointment, but regular contributions can ride to the rescue for overall outcome (pot size) (see Fig. 3).

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In decumulation, sequencing risk is potentially devastating because, combined with withdrawals, there is a risk of running out of money (see Fig. 4).

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As sequencing risk is so important in drawdown, it is essential for advisers to consider not only the merits of drawdown relative to annuity but also the asset allocation of the funds used in a drawdown strategy.

Is natural yield durable?

For the reasons above, portfolio objectives are therefore very different in decumulation than in accumulation. Accumulation is about growing the pot; decumulation is about making it last.

Accumulation requires consideration of risk, return and time horizon; decumulation requires consideration of durability.

How can a retirement portfolio achieve durability? Some consider ‘natural yield’ (the dividend income from equities and interest income from bond) to be durable.

By harvesting the income and not touching the capital, the capital is ‘durable’ and the natural yield can provide a retirement income.

While true in theory, in practice this works only for investors with very large pot sizes: an investor with £1m can earn £25,000 to £30,000 p.a. on natural yield.

For anyone with a portfolio of £500,000 or less (which is the majority of the investing public, given that average portfolio size is £30,000 at retirement), retirement income will be provided by a combination of portfolio income and capital withdrawals. This makes how capital is allocated as or more important than the income yield on a portfolio.

Furthermore, there is presently a concern that moving up the risk curve to ‘chase yield’ from property funds, high yield bonds and equities, there is growing risk to capital values from any future increase in interest rates that may not be immediately apparent.

Asset allocation

As investors will draw down capital to provide an income in retirement, the asset allocation of the portfolio is important for ensuring durability.

While portfolio design in accumulation takes an ‘assetoptimised’ approach (the objective of securing the best available risk-adjusted returns for a given risk preference), portfolio design in decumulation takes a ‘liability-relative’ approach (the objective of withstanding regular withdrawals for a given withdrawal rate and time horizon).

This liability relative approach means that, conceptually, the present value of a portfolio and any future contributions (the asset) should match the present value of expected withdrawals and any legacy target (the liability).

If the asset is greater than the liability, there is a ‘surplus’; if lesser, there is a ‘deficit’.

This ‘asset/liability investing’ framework is not new. It is the bedrock of defined benefit schemes and reflects the common sense of ensuring you have enough savings to cover your spending (see Fig. 5).

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A durable portfolio is therefore one where the behaviour of the asset portfolio and the withdrawals liability move in tandem.

This means that portfolio design and risk management have to consider not just risk and return, but time value of money factors such as current and expected inflation, the current and expected interest rate curve, and time.

Target date funds

Target date funds (TDFs) are all-in one multi-asset funds that provide a changing asset allocation strategy over time. They gradually shift from an asset-optimised approach before the target date to a liability relative approach after it.

Unlike lifestyling, the target date is not a particular day, but a ‘window’ of time (typically three to five years). It is not an end point, but the turning point from accumulation to decumulation. It is the time when drawdown is expected to start.

Finally, whereas lifestyling assumed conversion to annuity TDFs typically assume a ‘through retirement’ strategy, and , therefore, shift to a liability-relative approach, unlike multi-asset funds used for accumulation. Stochastic cashflow modelling tools can assist the evaluation of the required holding in a TDF to fund a retirement plan.


By providing an investment strategy that moves seamlessly from an asset-optimised approach to a liability-relative approach, TDFs can form part of a retirement centralised investment proposition, providing a durable income not from natural yield, but from an asset allocation strategy that is designed to grow and then preserve capital value against expected withdrawals, to mitigate the effects of sequencing risk.

For this reason, we expect TDFs to form part of the adviser toolkit, alongside cash, guarantees and later-life annuities, as an all-in-one portfolio strategy designed for retirement investing.

Henry Cobbe is head of research for BIRTHSTAR