Traditionally, approaches to the post-retirement investment problem have either been tied to a single investment company or have relied on the complicated, adviser-built ‘investment risk buckets’ or ‘waterfalls’ corresponding to a client’s spending needs over short, medium and long-term time horizons.
However, in the five years since the introduction of pension freedom regulations, there is currently no comprehensive, easy-to-use tool for advisers to suitably recommend post-retirement, income drawdown investments to their clients.
So, what are the key considerations and steps that advisers need to take to ensure suitable advice for income in retirement? And how can technology better support this process?
Post-retirement options
The Financial Conduct Authority has published Retirement Pathways that guide advisers with clients entering post-retirement. There are four options:
- I have no plans to touch my pension pot within the next five years.
- I plan to set up a guaranteed income, by buying an annuity, within the next five years.
- I plan to start taking a long-term income within the next five years.
- I plan to withdraw all my money within the next five years.
While these pathways are aimed at direct-to-consumer investments, advisers do need to take these into account. In practice, for advised clients, they will likely need a mix of the above, depending on their level of discretionary spending, sources of income, bequest/estate planning, and risk tolerance.
However, it is currently very difficult (that is, impossible) to assess risk suitability of the above pathways for clients.
How is post-retirement different?
Modelling investments for the post-retirement phase is complicated, and client risk tolerance more sensitive, especially when compared with the pre-retirement, accumulation phase.
Unlike in pre-retirement, where an adviser only had to consider the client’s goals, risk tolerance and time horizon in post-retirement, there are additional factors such as drawdown frequency and amount, spending flexibility, and investment costs.
Post-retirement is inherently riskier. While a pre-retirement client may have a time horizon of multiple decades, a post-retirement investor’s time horizon is much shorter, as withdrawals need to be made reliably as little as one year ahead and annually thereafter.
Pound-cost averaging becomes pound-cost ravaging
In accumulation, a client can use ‘pound cost averaging’ to ride out short-term market falls and invest in units at a lower price. However, in post-retirement the situation is reversed. As an income drawdown client is selling investment units to generate a regular income, they could lock in losses during market falls.
It is the journey that matters in decumulation, unlike in accumulation, where it is the destination that is important. Investors will need to lower volatility in their portfolio so as not to permanently impair their capital.
Consider the example returns shown in Table 1. There are three different possible scenarios of returns from an investment, each having the same average growth rate over 10 years of 4 per cent.
First, a ‘positive start’, where there are better returns in the first half of the 10-year period. Second, an idealised ‘linear’ return, where the investment generates 4 per cent each year. Lastly, a ‘negative start’, where the investment experiences negative returns in the first half of the period.
Table 1: Sequencing risk example
| Sequence of return | Value Growth rates each year | Simple Average | |||||||||
| 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | ||
| Positive start | +30% | +25% | +20% | +15% | +10% | -5% | -7.5% | -10% | -15% | -22.5% | 4% |
| Linear | +4% | +4% | +4% | +4% | +4% | +4% | +4% | +4% | +4% | +4% | 4% |
| Negative start | -22.55% | -15% | -10% | -7.5% | -5% | +10% | +15% | +20% | +25% | +30% | 4% |
Now consider a pension pot of £100,000 value and its future value while taking a post-retirement withdrawal of £4,000 each year. As can be seen by the final portfolio values below, the impact can be massive depending on how the returns are ordered in each scenario – this is sequencing risk at work.
