The investment and fund market, in the UK at least, is still geared much more towards accumulation rather than the lead up to retirement and decumulation phases of the investor’s lifecycle.
In these later stages, market volatility can have a devastating effect on a fund from which withdrawals are being taken. When an investor is making regular withdrawals, as he will do in retirement, a portfolio with fewer large losses and gains will more likely preserve capital better than one with more ups and downs in its value. This is due to the fact that when a withdrawal is made after a market decline, the funds are no longer there to benefit from any subsequent market recovery and make up the lost value.
Therefore, with greater volatility (as well as earlier negative returns after one begins to withdraw his income) it is likely that the pension pot will run out more quickly. Similarly, with less volatility the pension fund is likely to last longer.
In the past there have really been two possible investment strategies for clients approaching retirement to follow:
• Staying invested, usually with the majority of their fund in the stockmarket (that is, equities) but probably some diversification into other asset classes too
• De-risking their investments (switching to lower risk assets) or using‘lifestyling’, both similar in approach
The advantage of staying invested is that exposure is maintained to equities, which have historically provided the best returns over the long-term. Equities, though, have also been one of the most volatile asset classes and have seen some big falls in recent years, for example, the ‘dot-com’ crash of the early 2000s and the credit crisis in the late 2000s, therefore the client risks losing a significant portion of his pension savings.
Even if the fund is diversified, however, it may not be protected from a market shock. In the dot-com crash, while equities fell heavily, the other main asset classes generally provided positive returns, with the result that a diversified fund would have fallen a lot less. Following the credit crisis, though, almost all asset classes declined in value, apart from high quality government bonds. In this case, even a well-diversified portfolio would have suffered big losses.
In the case of de-risking/lifestyling, the risk of the fund suffering from any market shocks are reduced as the fund is moved out of equities and into fixed interest. There are, however, the following disadvantages to this approach:
• The fund misses out on the growth potential of equities
• There is the issue of market-timing - due to the fixed nature of lifestyling, the fund could end up selling equities at low points and buying fixed interest investments that are overvalued
• Again, due to this being a fixed process, with the switches and their subsequent asset allocations being based on years to retirement, this strategy may not be suitable if the client retires earlier or later than expected
• Also, with the recent changes relaxing the compulsion on people to purchase an annuity when they retire, lifestyling is likely to become less relevant
As a result, the market has started to see ‘volatility capped funds’. As we have just seen, even a well-diversified portfolio can suffer big losses when all asset classes decline in value. Having the ability to de-risk a portfolio from riskier asset classes during periods of high volatility will help to protect it from the adverse effects discussed above.
Volatility capped funds aim to do exactly this, reducing exposure to risky asset classes when investment markets are more volatile, while attempting to capture their return potential in less volatile times.
A volatility capped fund will typically have a target asset allocation, which is its neutral position. The fund will also have a target volatility, usually consistent with the average volatility that has been observed for the target asset allocation over time.
If the realised volatility of the fund over the short term exceeds its target volatility, the portfolio’s exposure will be increased to ‘safe’ assets, usually government bonds and cash, while exposure to riskier asset classes, for example equities, will be reduced.
The exact amounts of these increases and decreases (and hence new asset allocations) are those that are expected to bring the fund’s volatility back to its target. The opposite process happens when volatility decreases although, normally, exposures to the riskier asset classes will not go above their original/neutral levels.
As illustrated in the following chart, by reducing exposure to riskier assets during periods of higher market risk (also known as dynamic de-risking), the resulting portfolio is expected to have fewer instances of large losses, but also less large gains, thereby smoothing the investor’s ride.
Often these types of fund will exist as a range, with each fund having a specific volatility target to suit varying investor risk profiles.
The retirement market is undergoing significant change at the moment as a result of both demographic and legislative changes.
In particular:
• The retirement years are extending, as much of the population are living longer and thus needing sustainability of both capital and income
• Following changes announced in the 2014 Budget, the use of lifestyling is likely to decline and instead there will be an increasing tendency for clients to remain in drawdown
The dynamic of investing for taking withdrawals from a fund rather than investing purely for long-term growth is different - when investing in the run-up to retirement and decumulation phases rather than accumulation part of the investor’s lifecycle, having a fund with less volatility is even more important.
As a result of the above, the market has seen the arrival of volatility capped funds (as well as other retirement solutions). These are expected to provide smoother performance and more downside protection compared to investing primarily in the stockmarket or even a more diversified portfolio.
Patrick Norwood is Insight Analyst (fund management) of Defaqto
Key points
Market volatility can have a devastating effect on a fund from which withdrawals are being taken
In the case of de-risking/lifestyling, the risk of the fund suffering from any market shocks are reduced
The market has started to see ‘volatility capped funds’
