How to help clients choose the right income fund for retirement

Most people are familiar with the risk rating of funds for the accumulation phase, where an independent firm will consider the overall volatility of a fund and/or similar measures, before placing the fund somewhere on its risk scale, typically one to 10, where one is the least risky and 10 is the most risky.

Defaqto has done the same for decumulation. As is the case with the accumulation investor, there is a questionnaire based on client requirements and attitude to risk for decumulation.

The results of this questionnaire put each client into one of four different suitability categories. Similar to Defaqto's accumulation ‘workflow’, there will be lists of funds ‘mapped’ to these different profiles that the adviser can then choose from for their client (see below).

The types of investor in each of these categories are likely to be as follows:

Low Income Volatility - The client has a greater need for a consistent level of income from their investment and a need to safeguard their initial investment against market downfalls. The client will have a low capacity for loss and may require investment income for non-discretionary spending.

Medium Income Volatility - The client will be able to accept a short-term fall in their investment, with the expectation that this risk would be rewarded with greater income and capital gains in the long-term. The client has a need for level or growing income over the long-term but will accept short-term fluctuations.

High Income Volatility - The client will be able to tolerate falls in investment with the expectation that this risk is rewarded with level or rising incomes in the long-term. The client will have higher capacity for loss and is likely to require investment income for non-discretionary spending.

Capital Preservation - The client has a need to safeguard their initial investment and has a low capacity for loss. They have a high income risk tolerance and would be willing to tolerate fluctuating dividend payments. They are likely to use income for discretionary spending purposes only.

As with all investments there will be a trade-off between return and risk.

Defaqto's process for deciding which of the above four categories an income fund should fall into relies on the principle alluded to above that the total return for any fund can be broken down into the income part of the return and the capital gain or loss, and that these income and capital gain/loss components, as well as the total return, will each have an associated volatility or risk.

Therefore, there is a trade-off between income and capital as well as return and risk. 

Defaqto's methodology for deciding which of the four income risk ratings an income fund should receive is based on: