The issue of safe withdrawal rates, sometimes called sustainable income rates, has come increasingly into the spotlight for advisers serving baby boomers approaching or in-retirement, following the rapid decline of annuity purchasing since the then chancellor George Osborne went public on Pension Freedoms in April 2014.
The FCA’s recent Bulletin (Issue 12) published in March shows that more than twice as many pots have entered into income drawdown policies rather than annuities over the last two years. A total of 345,265 pots have been used to buy income drawdown policies while 152,843 moved into annuities. Scarily, 620,150 pots were cashed out completely since October 2015.
‘Drawdowners’
The growing army of ‘drawdowners’ must be wary of potential traps, including ‘pound-cost ravaging’. This triple whammy happens when markets fall steeply. Retirees then suffer falling capital value of the fund, further depletion due to the income they are taking by selling assets at rock-bottom prices, and a drop in future income as dividends follow asset values downwards.
This poses a problem every time markets take a tumble but is especially dangerous near the start of retirement because investors can rack up big losses and never make them up again if they are not careful.
One recent lurid headline suggested that as a result of this triple whammy some drawdown-based incomes could be cut in half in short order.
So, what tools and techniques are now available to help the majority that are either cashing out in full or purchasing an income drawdown policy in retirement? There is already lots of guidance available in this area. You can read about safe drawdown levels sitting at somewhere between 2 per cent and 5.8 per cent of total value of assets held in the policy.
Some prefer to peg the drawdown level at close to average annuity rates which currently sit around 4.8 per cent. But surely it depends hugely on the performance of the assets the policy is investing in, the size of the overall fund at the start of drawdown, the position on the economic cycle and much else besides?
There are well-trodden strategies for preserving drawdown funds during market downturns by building up three to five years’ worth of cash reserves which can be used for drawdown payments so you are not selling assets into falling markets, thereby crystallising losses in bad times like the recent Great Recession. But holding five years of cash, maybe 20 per cent of the portfolio, at today’s nugatory interest rates feels like standing in the rain waiting for a delayed bus.
Key points
- People using drawdown must beware of traps, such as 'pound-cost ravaging'
- Tools exist to help people calculate withdrawal rates
- Advisers are well placed to help clients write down their at-retirement objectives
Others prefer to choose emerging hybrid products which offer to lock in part of your retirement funds to secure a guaranteed income. Such lock-ins can be judiciously upped over time, perhaps by taking profits from the drawdown portfolio in good times. There is a win-win element to this strategy. Having a bedrock of secure income enables the adviser to increase the equity proportion of the remaining drawdown portfolio, so it is quite likely there will be periods of future gains to harvest.
You might also re-align your portfolio, perhaps selling some funds that are still on an upward curve and draw down the proceeds from these sales only. Alternatively, you might buy more stocks which have a strong and stable track record of dividend pay-outs.
Technology
Advisers can run the slide rule over many of these drawdown fund-preserving techniques for clients. However, they are also increasingly turning to technology to determine safe withdrawal rates for clients.
One such tool that has already gained a healthy following is Finalytiq’s Timeline app. It bases its calculations on historical monthly returns for all global asset classes since 1900 – a very large data set indeed.
Advisers input the customer’s portfolio and current income withdrawal rate and then the app calculates what would have happened to those funds if it had been started in all months since 1900.
All this number crunching tells you what proportion of ‘starter’ customers would have succeeded in not running out of money prior to death. If your chance of successfully not running out of money is over 85 per cent (based on those past numbers) then the client may feel happy to leave withdrawal rates as they are.
Vanguard will shortly publish its own research on the ‘cap and collar’ withdrawal model. This approach, easily understood by clients, increases the drawdown income each year in line with the investment performance of the drawdown portfolio, but subject to a pre-determined cap and collar.
So, with help from their adviser, a client may have decided to cap annual increases at 5 per cent and to limit annual reductions (when investment performance is negative) to 2.5 per cent. The logic behind this approach is that holding back some of the gains in the good years will protect against losses in lean years. Bible students might recognise the same advice given by Joseph to the Egyptian Pharaoh to lay-up profits in good times for lean times to come.
The adviser can choose to use these types of tools to set up automated alerts which could drive interventions if the policy has been pushed off course by extraordinary market events like three years of poor equity returns or overall fund growth falling below 4 per cent for example. If these pre-set thresholds are reached, advisers could seek (or be given in advance) clearance from the customer to adjust portfolios to take more defensive positions and/or reduce amounts being withdrawn.
However, providing a plethora of powerful tools can be dangerous, especially if they are in the hands of the inexperienced. One simple truism is that it is safer not to touch a tool at all until you have a clear sense of purpose as to the objective that you seek to achieve with it.
Objectives
Advisers are well placed to help clients take a step back and write down their at-retirement objectives. A process that can help here is to focus on three goals: building ‘essential income’ for unavoidable monthly bills; ‘lifestyle income’ for the things the retiree would like to do; and finally a ‘legacy target’ to leave funds either to a spouse or the next generation.
It is clear, given the increasing number of baby boomers moving their retirement funds into drawdown, that there is increasing demand for more decumulation planning tools to assist advisers and guide consumers directly. Many of these tools will be finding their way onto platforms.
Others will be integrated into existing adviser planning and illustrations suites in the coming years. Who knows, they may even be deployed on the pension dashboard in a couple of years.
Adrian Boulding is director of retirement strategy at Dunstan Thomas
