This is helpful because an adviser may have to nurse a client to an uncomfortable conclusion – they may be inclined towards caution, but cannot afford it.
There are several drivers of this caution. The obvious one is that it is not as easy in retirement to go back to work to make up investment losses.
But we must also contend with what you might call ill-informed optimism and misguided pessimism.
Firstly, the optimism. Seven Investment Management's annual survey research consistently shows that investors looking at the size of their pension pot overestimate by about 100 per cent how much income it will generate, or how long it will last.
Battling instinct
As for the pessimism, that is human instinct according to Nobel Prize winners Daniel Kahneman and Amos Tversky, who developed the concept of ‘prospect theory’.
Supported by an array of studies in the fields of psychology and experimental economics, the concept posits that we place more emphasis on avoiding losses than on acquiring gains – losses hurt roughly twice as much as gains feel good.
This leads to another dangerous tendency.
Rather than evaluate the expected range of returns for a lower risk portfolio alongside those of a higher risk portfolio, our natural loss aversion leads us to instinctively contemplate what the likely return from a lower risk portfolio might be and then contrast it to what we could face if something utterly terrible were to happen with a higher risk portfolio.
FCA findings
This perhaps explains why the FCA found so many consumers ending up with investments that were not right for them, including in cash – and why those who struggled most with this were those without the benefit of professional advisers.
Overall, 33 per cent of non-advised drawdown consumers are wholly holding cash, according to the FCA Retirement Outcome Review Final Report, which took the view that “holding funds in cash may be suited to consumers planning to draw down their entire pot over a short period".
The FCA continued: "But it is highly unlikely to be suited for someone planning to draw down their pot over a longer period. We estimate that over half of these consumers are likely to be losing out on income in retirement by holding cash.”
The FCA report draws the conclusion that someone who wants to draw down their pot over a 20-year period could increase their expected annual income by 37 per cent by investing in a mix of assets rather than just cash.
Arguably, this is the clearest signal yet from the FCA that it does not assume investors should necessarily reduce risk at retirement.
