Defending capital to support future retirement prosperity

Pensions are one of those investments no-one really ever worries about until something goes wrong. Like a lot of things, we tend to take them for granted until they break, potentially often at great expense.  

While the introduction of pension freedoms in 2015 alerted people to a world of new possibilities, it did nothing to educate them about the risks. Amid rising equity prices, retirees have seen their assets grow at the same time as enjoying new flexibility.

But after a decade of increasing asset prices, in the 'new normal' environment, as quantitative easing is being tightened or removed, we are entering a lower growth environment where significantly higher volatility should be expected. 

Unfortunately, pension pots do not act in the same way in decumulation as they do in the accumulation phase. After building up a pension pot over decades of hard work, the wrong decision at the wrong time can undo all that patience and investment growth.

Tax free cash

The temptation, as many newspapers suggested at the time but which never really manifested, is to cash in savings to pay for a car, or a holiday, or pay off the mortgage. A recent FCA review found most consumers go into drawdown to access their tax-free cash and tend to overlook the fact that a pot of cash in a savings account is not providing the same growth as in a diversified investment strategy held in equities, bonds and alternatives. In fact, it is likely losing money in real terms as a result of inflation.

 Of course, some clients may have other forms of income, yet while they may feel re-assured their cash is safely in the bank, over time the value is slowly eroded. Over the decade to 2017 the Bank of England estimates an annual average inflation rate of 2.8%, which over a 20 year period could reduce the purchasing power of £250,000 to around £142,000. Clients that access their tax free cash and don’t take a decision to invest the rest may find themselves unstuck when they come to access regular income.

Non-advised

This is not a theoretical problem. Between October 2017 and March 2018 the FCA’s latest data bulletin revealed 272,752 pension pots had been accessed for the first time, of which more than 50% (137,777) were wholly withdrawn in cash, with 75% of these customers unadvised.

The FCA specifically highlights that by investing their pension pots into a mix of assets rather than just cash over a 20 year period – i.e. their retirement – the expected annual income of these unadvised consumers could increase by 37%.

This provides a significant opportunity for advisers to add value, as why would an investor choose to ignore that huge uplift, especially at a time when costs for care might suddenly increase? The FCA’s findings show the main reason is they’re concerned about losing money. But having worked so hard to build up a pension, clients need to understand the importance of not only keeping up with inflation to maintain purchasing power, but also to protect their capital against unexpected events, whether that is an acceleration of the trade wars that halt the equities bull run and sees markets plunge, a hard Brexit that pushes up inflation, raises the price of goods and cuts interest rates, or the need to withdraw more income than expected to fix a boiler or pay for a funeral.

Defending capital

How can clients balance investment risk alongside the need to preserve capital?

In accumulation, volatility can present opportunities to buy favoured assets at a discount. In decumulation, the reverse effect occurs, with investors at risk of being forced sellers at a time when prices are depressed.

One of the key structural challenges to manage for clients to receive a sustainable income over time is sequence of returns risk.

For example, during accumulation, if two £100,000 portfolios experience identical returns over five years but in a different order, with one experiencing the losses in the first two years, while the other suffers them towards the end of the period, both pots will end up at the same destination. In decumulation, however, the journey is much more important. If 5% income is being withdrawn each year from these portfolios, then the one that suffered losses earlier on could end up being worth roughly 22% less than its peer, purely due to pound cost ravaging and the fact there is no time to recoup these losses before more income is taken.

Therefore the destructive power of sequence of return risk could lead to quite an awkward discussion with clients if they are running out of capital and may need to consider an income holiday at the time when they need income the most. Furthermore the volatility in markets, similar to what we witnessed in the first quarter of 2018, can exacerbate sequence of return risk, which is why it is so important to manage it.

Defensive assets, including equities that have a degree of resilience to market downturns, can play a role. Likewise, derivative strategies can allow portfolio managers to capture a risk premium without owning the underlying asset, subsequently protecting in the event the asset falls in value.

Diversification provides vital insulation from the natural fluctuations of the equity market cycles, but clients also need to understand the importance of having an investment portfolio that is focused on defending capital first and foremost in order to provide them with a more sustainable and defensive source of income for their retirement.

While shareholders have enjoyed bumper returns in recent years, especially in the US, equity prices are sensitive to the global political situation and a significant share of stock market growth in recent years has come from a narrow range of stocks, potentially leaving retired investors exposed if sentiment were to change.

Conclusion

Pension freedoms allow clients the flexibility to be able to take a holiday, or fix the roof, while maintaining a reasonable standard of living and knowing their retirement income is secure and keeping pace with inflation. Whether this is taking their tax free lump sum as cash and then drawing down the rest, investing their pension in a diversified portfolio, or even buying an annuity to provide a certain level of guaranteed income. The options to create the right solution for a client’s bespoke retirement are available at their fingertips, providing they first understand the importance of advice and the need to manage investment risk in retirement. By articulating these challenges and helping clients balance the need for income, flexibility and capital preservation, advisers can guard clients against making decisions that could undo all their hard work in saving for a prosperous retirement.   

'This is a Quilter Paid Post. The news and editorial staff of the Financial Times had no role in its preparation'

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QIL-84-18