The recent vote for Brexit may not have brought about the apocalypse as some feared, but it has certainly brought lots of market volatility. A little over a year from pension freedoms being introduced, what does this mean for clients’ reviews post the leave vote?
Pound cost ravaging (as the industry seems to term it) is a big factor for clients taking an income from their drawdown pot. It will also affect those who wanted to take their pension commencement lump sum (PCLS).
The long-term impact of the vote cannot be known; I am neither a financial nor political analyst so I have no view on this. But, over the short term, actions will need to be taken for reviews, or dealing with the no doubt numerous ad-hoc contacts from clients.
The figures in the table and below show what can happen with crystallising losses and how negative pound cost averaging can become ravaging. These are tried and tested figures that we use, but they emphasise the problem. The example depicts three funds that have a starting value of £100,000 with performance as shown in the table.
| Fund | |||
| Year | A (%) | B (%) | C (%) |
| 1 | 25 | -5 | 25 |
| 2 | 5 | -20 | -5 |
| 3 | 20 | 15 | 5 |
| 4 | -15 | 20 | -20 |
| 5 | -20 | 5 | 20 |
| 6 | -5 | 25 | -1 |
Overall these have the same performance if there is no income taken and all the funds end up with a value of £101,745.
Over the five-year period, these funds have, arguably, been equally volatile. However, if 4 per cent of the initial investment is taken (which does not seem too unreasonable), then the effects can be very different. If the client takes this income, the values for funds A, B & C become £81,964, £71,556 and £80,318 respectively. It is not just the volatility that can be the issue, but the discrete year-on-year performance of a fund that can affect this. Fund B was the clear loser as the initial performance was far poorer and crystallising early losses means this poor start is very difficult to recover from.
So this year’s discrete performance could be poor, but is there scope for another fall? What would happen if there are further losses? Retaining a certain number of years’ income in cash may be the answer, but would the client then miss out on any potential recovery or investment opportunities the fund(s) are successful from?
Reviews of suitability
Regular reviews are key in maintaining the suitability of the plan that was previously advised for the client. Knowing changes in their situation is a must, although the review may not just be focused on pension plans. Without factoring in the client’s whole situation and fine tuning any plans that are being reviewed, can you truly map out how their retirement situation is looking?
When looking at this post the leave vote, the basic principle of financial planning still applies. If a client does not need to take an income, then turning this off would protect against crystallising gains. Look at whether another income tap be turned on, perhaps from a less volatile fund to reduce the impact of losses. Only a thorough review will uncover this.
Capacity for loss/sustainability of income
Pre-freedoms, capacity for loss (CFL) was a major influence in whether or not a client was suitable for drawdown.
The key message that has been coming from the regulator now is sustainability of income being a major determining factor for clients. Basically, how long will this income last and what will a client do if it does run out? The latter may well be a lot shorter if losses have been realised.
It is important that CFL remains the domain of the adviser, and is an assessment of the client’s current and future positions. While many clients may feel they could cope with losing their drawdown pot or simply tightening their belts, can they actually do that?
Post the leave vote, this capacity will be tested; if a client only had limited capacity is this now the time to look for either an alternative strategy for their retirement income? This would crystallise any potential losses. Or, can they try to ride out this storm?
If they have suffered losses, can they suffer more, or is it time for a change of strategy?
Risk appetite/attitude to risk
How the client feels emotionally about potential losses is key. Find out if the client is emotionally prepared to continue with the ups and downs in the investment journey with their pension funds. This is not to be confused with CFL, which we have just covered.
Check if a client can continue to manage with their funds being invested. If markets were rumbling could a client cope with seeing fund values go down and would they remain invested and tough this out? Or, if they are very cautious by nature, will they crystallise the loss? Clients may be tempted to cut their losses now, when previously they were more optimistic about leaving their pension pot invested. This is the time for some tough conversations about their overall view of drawdown as a strategy. If it was right for them a year ago, they need reminding of the reasoning for this.
At a review, it is essential to check whether their attitude to risk (ATR) remains unchanged.
•Maybe this would lead to a change of investment strategy.
•Maybe this will lead to securing an income with no further investment risks.
•Maybe the client is comfortable with things as they are and no change is required.
Does the fund or portfolio of funds match the ATR?
Clients may have a different view on ATR before and after retiring. But does the makeup of the selected fund meet the decumulation phase? Clients may be willing to retain a medium ATR, but should there be a different medium portfolio for decumulation clients?
In the accumulation phase the effect of volatility may make a client uncomfortable at times, but ultimately all that matters is overall performance of the fund and what the client has in their pot. But the effects of pound cost ravaging on the same fund in a decumulation phase could be catastrophic to the client’s sustainability of income.
In Thematic Review 15/12 last year, the FCA reviewed the suitability of investment portfolios for wealth management firms and private banks. From 150 customer file reviews it determined that 37 per cent were unclear, and that 23 per cent displayed a high potential for unsuitability. In light of this, it could be time to have differing portfolios for clients’ accumulation and decumulation phases.
While the outcome of the vote may have been a surprise to many, from an advice point of view nothing is surprising. Advice is still advice, clients will need reassurance and reviewing in times of crisis. Nothing has changed from that point of view; clients taking an income from any tax wrapper will go through this, they need handholding, reassurance from any ongoing service that they have been promised and paid for.
Mark Devlin is technical manager (pensions) at Prudential Assurance
| Key Points |
Pound cost ravaging (as the industry calls it), is a major factor for clients taking an income from their drawdown pot. Regular reviews are key in maintaining the suitability of plans that was previously advised for the clients. In the accumulation phase the effects of volatility may make clients uncomfortable at times. |