Absolute returns funds in an age of pension freedom
In a previous article we gave an overview of the Targeted Absolute Return sector, its performance and characteristics associated with the use of funds.
Since the article, pension freedoms were implemented in April 2015 and not surprisingly the sector recorded its highest ever net retail fund inflows of £529m during the same month, according to Investment Association figures.
Accumulation vs decumulation
The vast majority of funds available to the UK market are aimed at saving in the run up to retirement, that is the ‘accumulation’ phase. While diversification is a consideration, the primary aim is maximising returns over the long-term and to increase the size of the eventual pension pot. Most of the current products available and associated marketing is focused on this approach.
This situation has come about as previously funds were little used during retirement, that is the ‘decumulation’ phase, and instead products held within an insurance wrapper, annuities, were commonly used. With limited choice for retail clients, there was little incentive for product providers to innovate.
Now, however, with pension freedoms more investors can use funds as part of a decumulating portfolio. It is expected that there will be some innovation in this area with potentially new products being released in the coming months as insurance and asset manager companies figure out what is both feasible and affordable. Expect to see ‘blended’ products becoming available that will combine elements of annuities and funds in order to address investment risks and longevity risks.
Within the funds available that fit in with these solutions, absolute return funds provide a well-fitting solution. The primary reason is the increased risk of ‘drawdown’, the default option to withdraw funds from an invested fund, during decumulation.
Whereas in the accumulation phase any market drop can be used as an opportunity to invest cheaply and recover over time, during the decumulation phase market falls can permanently impair capital via compounded negative returns and therefore reduce all future income from the portfolio, with little chance for recovery.
An individual investor can manage this risk partly by being flexible in their decumulation withdrawals. However, this can be difficult depending on the investor’s situation and how critical their spending needs are during retirement, for example for medical expenses.
during the decumulation phase market falls can permanently impair capital via compounded negative returnsThe other strategy is to structure a portfolio so that near-term income requirements are met by lower-risk investments, while those further in the future can be met with higher-risk, equity-like investments. This approach is known as ‘risk bucketing’ or ‘waterfall approach’, as future income flows through the portfolio based on the income need in the short, medium and long-term.
