The pension freedoms which are being introduced on 6 April 2015 will give those over the age of 55 much more flexibility about how they manage their investments throughout their retirement.
While pensioners no longer have to purchase an income for life in the form of an annuity, they do still face the issue of having to provide themselves with an income that will last them throughout their retirement, however long that may be.
Without taking a level of investment risk, these investors are in danger of eroding their capital more quickly and potentially running out of money or having to make changes to their lifestyle. For many people being able to leave an inheritance behind for their loved ones is also an important consideration.
Put simply, these investors are now faced with drawing an income for life from a savings pot which often has no guarantees built in and they are reliant on the investment return to provide all or some of the income that they need.
And this is all set against a backdrop of persistently low interest rates and investors who, having been marked by the experience of the last five or so years of investment volatility are increasingly looking for a cautious, balanced approach to portfolio investment construction.
When an investor is thinking about taking an income from an investment portfolio, there are essentially two choices; whether it is the underlying assets within the portfolio that should deliver the income or whether the product wrapper should deliver the income.
Depending on which route is chosen, the assets you would invest in could be quite different.
Taking the first route and relying solely on the regular payments from the underlying investments would mean you would need to invest into assets which deliver steady income, for example bonds and property, or a growing income, such as blue chip equities with a good dividend paying track record.
The other option would open up an enormous range of assets that would otherwise be excluded, particularly if you were prepared to co-invest with other investors in a large multi-asset fund. This way individual retail investors are afforded a greater degree of protection. What this means in practice is that they now have access to assets that are perhaps more complex to understand, may require a substantial minimum investment or may be deemed as being too illiquid.
Using the services of a professional fund manager, who is expected to understand, means the portfolio can contain assets that may produce longer-term income streams and less volatile valuations. These assets include infrastructure such as hospitals, schools, bridges and ports as well as private equity where the investor could be investing into the talent of the next generation of engineers, designers and captains of industry. These are potentially risky but co-investing could reduce the risk substantially.
The benefits of a well-diversified fund are, of course, well known, and I would question why anyone would want to reduce the universe of investable assets simply to receive the dividend or interest payments from the underlying stocks.
With capital volatility being a major risk to investors’ income, diversification is the one tool we have at our disposal, that we know is proven to reduce volatility within an investment portfolio.
For investors, ensuring they can invest into a range of traditional assets such as equities and bonds is simply not enough; they also need to make sure you have access to less correlated assets including property and alternative assets such as private equity and infrastructure.
Now that investors need to consider providing themselves with a longer-term income stream, with the new rules suggesting a term of more than 20 years, this should mean they are well-placed to take advantage of the illiquidity premium that is offered by such alternative assets. These assets tend to deliver higher income streams with less capital volatility.
It is important to consider their illiquid nature, but holding these for the longer-term does bring considerable benefits, in particular the benefit of a stable income stream. Another interesting concept to be factored in is pound cost averaging. When someone is saving towards their retirement, pound cost averaging is a very useful technique. It allows savers to take advantage of buying into the market once it has fallen and effectively means they get more for their money.
Conversely, in the income phase of their investment life, following the same route is disingenuous. The requirement here is for steady and growing capital, not volatile capital. Taking income once the market has fallen effectively means the need to sell more of your portfolio to generate the required amount. This can quickly erode the capital value of the fund and would also put pressure on the income that portfolio could produce.
Well-diversified portfolios containing assets which are less correlated should produce less capital volatility and, therefore, build in some protection against the downs of investment markets.
The changes to the way people will manage their money in retirement means income generation and portfolio or fund performance is effectively becoming more personal, and investors’ requirements essentially becomes the benchmark for their advisers and fund managers.
As an industry, when we talk about “alpha” we mean “investment alpha”, but clients increasingly want “investor alpha”. Put simply, they are interested in what the fund does for them and how it helps them meet their own investment goals.
Clients’ goals are regular income or capital growth, protection against market falls, protection against the impact of inflation on their spending power and importantly to have a noiseless investment journey.
While this does not necessarily mean that fund managers need to build personal funds for investors, it does mean there is a need for greater clarity about what the investor should expect from their investment. This should help advisers to retain their clients’ interest and involvement in the portfolio. An engaged client is, of course, a valuable commodity.
With this in mind, how we describe investment funds as an industry will become key, and setting benchmarks such as beating the FTSE will become meaningless.
The shift from an investment to an investor benchmark has the potential to fundamentally change the retail investment world by the end of the decade.
Andy Brown is investment director at Prudential Portfolio Management Group
Key Points
A product wrapper could open up an enormous range of assets that would otherwise be excluded.
With capital volatility being a major risk to investors’ income, diversification is the one tool we have at our disposal.
Investors need to make sure they have access to less correlated assets including property and alternative assets such as private equity and infrastructure.
