The financial services industry was built on wealth accumulation as developed economies encouraged individuals to take responsibility for their own retirement. As life expectancy increased, governments, employers and individuals faced increased complexity and risk.
Providing a stable source of income for savers and retirees is one the most important functions in financial services. Consistent income generation requires a steady hand at the tiller as the consequences of missteps can be permanent for those in decumulation.
Before delving into asset selection and portfolio construction for income generation, it is worth understanding the regulatory backdrop and the unique risks income investors face.
Deregulation and personal freedom
Most of us in the private sector are too young to have joined a defined benefit pension scheme. Government employees, however, still receive pensions based on years of service.
Everyone else is forced to consider annual retirement contributions, investment returns, inflation rates and longevity risk when trying to gauge the required size of their pension pot. The introduction of pension freedoms in April 2015 removed the need to buy an annuity with your pension, which opened drawdown and income investing to most retirees.
With these new freedoms came a multitude of choices for individuals and their financial advisers. While there are a variety of off-the-shelf income solutions available, it is important to recognise that income generation in retirement is a hands-on process, which requires constant review and adjustment.
While there are various rules of thumb around withdrawal rates, the best course of action is one tailored to personal circumstances.
This brings us to unique risks income investors face, particularly those in drawdown.
Sequence risk refers to the risk that someone experiences a large fall in the value of their investments early in their retirement journey. Sequence risk is highest at the start of retirement as the investor is furthest away from death at this stage. While retirees cannot eliminate sequence risk entirely, a glide path of risk reduction as individuals approach retirement can help mitigate extreme outcomes.
While market downturns are something all investors are exposed to, market declines during the asset accumulation can help improve returns through pound cost averaging. Unfortunately, income and drawdown investors face the opposite effect (pound cost ravaging) as they crystallise losses by selling during periods of lower markets.
Keep a cash buffer
Investors are advised to keep a cash buffer that can be used during difficult market environments. There is no guarantee, however, that this buffer will last during a prolonged downturn in markets.
Inflation risk is something all investors are exposed to. Drawdown investors are more exposed yet again, as they are unable to take advantage of higher wages that tend to follow periods of higher inflation.
A sudden increase in inflation can have a negative impact on asset prices. Bond markets experienced their largest decline in 30 years in 2022. While equity markets also fell, the limited upside in fixed income securities may hamper a portfolios’ ability to regain lost performance. This in turn can increase the impact of pound cost ravaging for clients in low-risk portfolios.