Drawing down from capital is inevitable for nearly all of us once we are in retirement. According to the industry regulator, the FCA, the average UK pension pot entering drawdown is £123,000, underlining that belief.
More and more of us will face this conundrum in future, with estimates forecasting that there will be more than 20 million of us over the age of 60 in the UK by 2030.
The challenge for firms here is clear, but it has been exacerbated by too few products attempting to address this issue. In January 2019, the FCA Sector Views commented: “There has been little in the way of product innovation in retirement income products since pension freedoms came into force.”
What is the answer then, for your clients to drawdown on capital most efficiently?
Key #1: Know your client’s risk profile
The first key is accurately understanding a client’s risk profile, in the context of a risk-based cashflow plan. Do this well and you create a solid foundation for all subsequent decisions made. Do it badly and the risks for the client and indeed for the advice firm are higher in decumulation than accumulation for obvious reasons.
The risk profiling exercise, encompassing capacity for risk, investor experience and, of course, attitude, really must form part of a risk-based cashflow plan.
Ensuring that helps clients understand what their ‘must-haves’ are and which cannot be put at risk – e.g. ‘heat and eat’ – as well as what more discretionary items like travel might take to fund.
A drawdown client’s financial plan needs to address longevity risk and the possible – and potentially high – impact of long-term care costs. This all needs to be completed on a real not nominal basis.
Key #2: The trade-off with a selected investment
A second key is to consider carefully the trade-offs with any investment solution. These chiefly include:
- The absolute level and consistency of income paid out
- The risk of capital erosion, i.e. whether income is being paid at the expense of capital
- The value at risk, i.e. exposure to higher absolute losses
- The total return over time in terms of income and capital appreciation
Key #3: Sequence of returns risk
A third and final key is managing sequence of returns risk. But what exactly is that?
In essence, sequence of returns risk is the difference in capital value that a client receives if they take a fixed withdrawal and begin their investment journey in rising markets – compared to the same returns but in a different order and in falling markets.
At Dynamic Planner, we completed some research into sequence of returns risk, looking at the example of a popular multi-asset fund – a Risk Profile 4 on our 1-10 risk scale – and how it performed in drawdown over a period of seven years.
In the example, of a £100k portfolio and withdrawing £420 a month (5%), we discovered a final figure at the end of the timeframe ranging between £90k and £140k, depending upon the sequencing of returns. In brief, a big difference.
What are the key takeaways from this?
Monitor that investments target the level of risk agreed with the client – to ensure that the risk to capital remains the same – on a monthly basis. Doing this on an annual basis is too infrequent. By risk targeting diligently each month, a solution’s ability to deviate from its risk profile is reduced and so too are potential losses for the client if performance dips.
When a client in drawdown introduces unavoidable additional risk to their portfolio, by encashing units monthly to pay for a fixed capital withdrawal, this is effectively managed more closely. As a result, a client’s capital is likely to last longer – and we could all use a few extra pounds in our pocket at the end of the month, whatever our stage of life.