- What is the potential range of outcomes for a given asset allocation strategy (dispersion of returns)?
- What is the time horizon that the funds are required to last (durability)?
- What level of confidence does my client need that their retirement fund will last the course (confidence)?
The range of potential outcomes will differ for each asset allocation. Rather than using a mean-variance approach, a vigorous scenario analysis provides a more realistic range of potential outcomes.
In broad terms, the range of potential outcomes will be widest for high variance strategies (e.g. global equities), and lowest for low variance strategies (e.g. cash). But this measure alone is not enough as we need to know whether the investments will last.
With the information above, it’s possible to solve for a withdrawal rate – the statistical maximum withdrawal that a portfolio can support such that the expected portfolio terminal value after withdrawals is positive but near zero at the end of the investment term (to a certain level of confidence).
Where a client’s capacity for loss is higher, they can afford to use a withdrawal rate to a lower level of confidence (e.g. 50 per cent). This means that they can take out more, and can reasonably expect their funds to last the course.
Where a client’s capacity for loss is lower, they can only afford to use a withdrawal rate to a higher level of confidence (e.g. 95 per cent). This means that they can only take out less, in order to have high confidence that their funds will last the course.
In summary, we define withdrawal rate as the amount of income required, relative to portfolio value, for a given level of confidence over a given time horizon.
Keeping it fresh
Innovation in retirement investing has been slow. So advisers should keep updating their retirement CIP to evaluate emerging solutions in the decumulation market.
As regards reviewing clients' withdrawal profiles: while withdrawal rates could in theory be used as a “set and forget” strategy, clients are likely to get a better outcome if their retirement strategy remains under review.
This is because each year, the three key variables – pot size, withdrawal rate and time horizon – have changed. By helping clients navigate decumulation, advisers can add most value when clients need it most: to help ensure their clients have the comfortable retirement they expected.
Creating a robust retirement CIP is key to ensuring clients get good outcomes in decumulation.
This means taking a fresh look at existing CIPs and thinking how to modify it them to ensure that 1) investments are suitable for decumulation; 2) that a retirement CIP is formally documented and controlled; and 3) that the necessary processes and tools are in place to create and review clients’ withdrawal profiles and how that withdrawal profile changes over time.