Averting difficulties in decumulation

However, awareness of the need to take an entirely different approach to one’s savings in retirement, in order to draw an income, appears somewhat hazier. 

When accumulating a pot of pension savings, the ultimate destination is paramount: achieving enough money to fund one’s retirement. So long as the total return generated by investments is sufficient for this, any bumps along the way due to market drawdowns fade into insignificance.

When decumulating assets in retirement, though, it is the "journey" that is most important, during which one needs to maintain enough money to provide a sustainable income for as long as one needs it, above the rate of inflation. This can be made hard, if not impossible, by any market drawdowns that trigger a negative sequence of returns.

An understanding of these differences is essential to avert difficulties in decumulating assets, especially given the current state of the annuity market. While an annuity may still be the best option for some people, such products rarely offer individuals freedom to use their savings flexibly. And because the rates on offer are so low, far larger sums are required for annuities to produce the same levels of income as they did only a few years ago.

It can be hard to grasp the impact that inflation has on one’s wealth over the long term, as it eats into savings gradually. But at an inflation rate of 3 per cent, people would lose over a quarter of their purchasing power in just 10 years – and almost half over 20.

In addition, while we know we are living longer than ever, many people underestimate how fast life expectancy is increasing. Over the past 100 years, life expectancy has increased by about three years a decade, figures from the Office for National Statistics show. 

This creates a danger that people spend their retirement savings too quickly, leaving them poorer in later life. As such, it is crucial to help them use their retirement savings to generate sustainable income.

Meanwhile, a negative sequence of market returns early in retirement can shrink savings to the point where what once appeared an achievable level of income can soon become unattainable – even if markets catch up later on.

Withdrawing income from investments in a falling market essentially leads to "pound-cost averaging" in reverse: investors are forced to sell units in their portfolios when prices are declining in order to pay for their desired level of income.

This also means that when markets rise again, clients will hold fewer units and be less well-placed to benefit from the rebound. Doing the utmost to avoid such a negative sequence of returns, therefore, should be at the core of a decumulation strategy.

Multi-asset funds can help skirt these risks, through the creation of stable and robust portfolios for pensioners seeking to draw a sustainable income. In order to do so, fund managers should strive to imbue their portfolios with three characteristics: consistent performance; downside cushioning, where possible; and greater diversification.

Portfolios can be made genuinely diversified through the selection of a mix of assets that exhibit low levels of correlation with each other. Should a geopolitical flare-up or macroeconomic shock trigger losses in one asset class, such as equities, owning other assets that tend to move in a different direction, such as government bonds, would probably help cushion performance on the downside.

A diverse range of investments should also enable portfolios to even out some of the peaks and troughs of the markets. This has a beneficial impact on retirement savings, because relatively smaller but more consistent investment returns tend to result in superior returns over the longer term. By contrast, larger moves up followed by smaller moves down tend to lead to inferior returns.

This underscores the importance taking a "top down" view to diversifying portfolios at the moment of deciding their asset allocation. Yet genuine diversification can only be achieved if this approach is combined with a "bottom up" view as well.

By picking a broad range of fund managers to run parts of portfolios, one can have investments across different fund-management styles, as well as in multiple regions, financial assets and industrial sectors. This is essential because we know the market does not always reward all styles, all of the time.

A further level of diversification is found at the level of security selection – ensuring that there are diversifiers within asset classes.

Finding securities that provide an income is key to building portfolios for retirement; certain stocks that have a long history of paying out much of their earnings to investors are often favoured. Before the financial crisis, shares in UK banks were a favourite to meet this challenge.

But having too great an exposure to these stocks would have wrought havoc on a portfolio during the financial crisis. Bank share prices were battered, while the only payouts a number of the largest went on to make went to the government, which had been forced to bail them out.

It follows that just as diversification is essential in crafting the right portfolio for retirement, it should be achieved in the right way – rather than just diversifying for its own sake.

During a strategic asset allocation process, for example, fund managers can take forward-looking estimates for risk, return and correlation to produce thousands of trial portfolios. This helps avoid "tippy" portfolios – situations whereby small changes to input assumptions lead to wild variations in the outcomes.

If these inputs are tested and changed very slightly thousands of times, an average asset allocation can be taken, enabling more stable and robust portfolios to be forged.

By taking such an overall approach, at the same time as seeking to manage any risks posed by markets over the short term, fund managers should be able to create portfolios capable of generating the capital growth from which a sustainable income can be drawn.

Such portfolios would be built to navigate the needs and circumstances of retirees, which are so very different to those of people seeking to accumulate assets ahead of retirement.

Anthony Gillham is manager of the Old Mutual Generation Portfolios, Old Mutual Global Investors