One of the biggest conundrums facing an aspiring retiree when approaching pension drawdown and retirement is how to invest your investment pot so that it lasts as long as you do.
Historically, conventional thinking suggested that in the five years prior to retirement, you adjusted the asset allocation gradually away from growth investments, which had been appropriate during the so- called ‘accumulation phase’.
This involved reducing exposure from predominantly equities towards non-equity investments which would provide a secure and growing income stream in retirement, often using annuities. This is known as the ‘decumulation phase’.
This was fine when interest rates were at 5 per cent which was roughly the rate of income from an annuity purchase which provided that income for life, often with inflation proofing. However, when the ten- year benchmark gilt yield is below 1 per cent, as now, this isn’t going to work as inflation is higher than this level and the absolute level of income from say a £1m pot, is insufficient to live on. The risk of running out of money is very real.
This is where alternatives such as infrastructure funds and other non-equity income generating assets such as specialist property vehicles have been making inroads into investment strategies as many yields up to 5 per cent. However, they are not of the same risk as gilts and each carries their own risks which can be susceptible to changes in government tax policy, regulations and even Brexit.
All of these are up in the air at the moment in the UK within this Brexit fuelled political environment. .
An alternative approach increasingly being considered is to retain a higher equity weighting in perpetuity, which can provide up to a 4 per cent income yield without taking added risk relative to standard equity market risk, and refraining from reducing the equity exposure as you retire.
This has looked like a good strategy over the last ten years, but we have enjoyed a ten-year bull market in equities and so clients have enjoyed buoyant capital markets as well as a growing and secure income stream.
This is when the often-ignored disclaimer comes in regarding past performance which should not be relied upon as a guide to the future. It should not be forgotten than in the ten years prior to 2009, the equity markets halved twice following the bursting of the Technology bubble and the Credit Crisis of 2008. Just imagine how it would feel as you retire on this equity income strategy for that £1m pension pot to reduce by 50 per cent whilst you are drawing upon it, meaning there is less to recover when it eventually does.
This is referred to, in technical circles, as sequencing risk or pound-cost ravaging. In simple language, it is the risk of volatility affecting your capital and the income you are withdrawing from it, just at the point when markets are experiencing a prolonged and severe downtown.
Let’s be realistic. If an investor decides to go into drawdown at age 55, he should plan his income stream for 30 years, in which time he could well experience at least two major market setbacks for whatever unforeseeable reason.
This doesn’t really matter as it is the outcome of collapsing equity markets that matters. At its extreme, the banking crisis of 1929 wiped out many a fortune from which there was little recovery for many years. Hopefully we have all learnt lessons from that episode but then again, that was what effectively happened in 2008 although Quantitative Easing saved the day and we avoided a prolonged depression.
So, what to do? As ever, a mix of well-diversified assets is crucial because you never know where the next crisis is going to come from or what effect it will have. A serious analysis of your attitude, appetite and tolerance to risk is vital.
Most important of all is to have a near-cash or cash buffer of at least 18 months’ income so that if you need to turn off withdrawals from your invested pot, you can, without starving. Similarly, you need a buffer replenishment strategy which is dynamically reactive to market levels and your fund valuation.
The key is to know your required future cash flows and what portfolio value is your minimum threshold for long-term income sustainability, both on the upside and downside, with a
corresponding investment strategy that kicks in as thresholds are breached. These thresholds should be determined with reference to the desired level of income, not as much as possible whilst the good times roll, because this can be disastrous when the bad times roll.
Investing during drawdown or the so-called ‘decumulation phase’ is complex and requires a dynamic approach which is often best provided under a discretionary investment management arrangement so that buffer replenishment and withdrawal cessation can occur in a flexible way relative to market conditions and ongoing fund values.