Pension Freedom 

Drilling down into decumulation risks

  • Understand the risks of managing a pension pot in retirement.
  • Learn what the risks can do to a portfolio in decumulation.
  • Grasp what advisers can do to help clients manage decumulation in retirement.
CPD
Approx.30min
Drilling down into decumulation risks

Probably the most commonly asked, or at least thought about, financial question of our age is: "Have I got enough money to live on in the lifestyle that I want?"

Perhaps this isn’t surprising since so many of us now rely on building up a pot of money to live off when we stop or reduce our time spent working.

In the past those working for large employers might have relied on the work’s pension scheme which would promise an income for life after retirement.

That provision has diminished at the same time the demographic bulge of the Baby Boomers has reached retirement age. If that wasn’t enough, this market has been given a turbo boost following the introduction of pension freedoms in 2015.

Not surprisingly we have seen an increasing focus on the needs of clients in this situation. Much of the debate and discussion has focused on understanding the risks in managing a pot in retirement – the decumulation phase.

These are primarily:

  • Drawdown i.e. a significant fall in markets. This risk is not habitual in its movements and therefore unpredictable. When drawdown does strike it can be significant and is able to cause a lot of damage to financial plans and to client confidence.
  • Volatility drag. The second risk is a cousin of drawdown and its work is somewhat more subtle. We know volatility is at large from statistical analysis but is rarely glimpsed. However, its effects are insidious and persistent.
  • Sequencing risk. The notoriety of sequencing risk has increased considerably over recent years. Commentators and the Financial Conduct Authority (FCA) have observed the ill effects of its work. Efforts to contain it has improved but they have so far been patchy in their success rate.
  • Pound cost ravaging. The bad half of the family. The pound cost averager has been a friend to many advisers and clients over the year. Not so the pound cost ravager who works in opposition and works just at the worst time and its effects have been highlighted and commented on by many. As markets fall, more units are sold to match the income required.
  • Inflation risk. Perhaps the most infamous of the risks, inflation has a long track record of damaging clients’ wealth in the long run. Despite our better understanding we need to maintain our vigilance to avoid the pain it can cause.
  • Longevity risk. The last risk is perhaps the only one that is welcome. The result of longevity is that, on average, we will live longer than our forebears. The benefits of this on our lives comes with a price for investors.

But while we may know what these words mean, there is a lack of comprehension about what these risks, when combined, can do to a portfolio in decumulation, and what the options for advisers are.

Drawdown risk is our prime suspect, because it is investors’ greatest fear and the risk with the most dramatic effect on their lifestyle.

It is easy to use volatility as a shorthand for market risk, but in fact it is long-term loss of value which presents the real danger to a financial plan. Too much emphasis on volatility is leading to sub optimal asset allocation to deliver the long-term returns that clients need.

Holding your nerve

The UK equity market has seen a major fall every eight years on average since 1935. The times between falls vary considerably, as do their causes, but for an investor who needs to use some of their capital, a market fall at that time can have a major effect on their ability to achieve their objectives.

We cannot reliably predict exactly when drawdown will strike, but we know that sooner or later it will.

For investors who do not need to take money out of their portfolio after a market fall, the impact of drawdown risk is lower. The portfolio can be left to recover in value.

Advisers need to be careful that the fall is not too much for the investor’s risk appetite, however, otherwise they may panic and sell at the wrong time.

Even if we hold our nerve, recovery is not as straightforward as we might think. A 10 per cent fall in price, followed by a 10 per cent rise in price does not return a portfolio to its starting value, but only to 99 per cent. The effect is even larger for greater drawdowns.

A portfolio that has experienced drawdowns will therefore lag where we might expect it to be based on simple addition of percentage returns. This apparent con artist is volatility drag.

CPD
Approx.30min
  1. There are six main risks when it comes to the decumulation phase. Which one of these is not listed and is therefore not a risk?

  2. The UK equity market has seen a major fall every how many years, on average, since 1935?

  3. A 10 per cent fall in portfolio value requires an 11 per cent rise to return a portfolio to its starting point. If a withdrawal of 5 per cent of the portfolio’s starting value is taken after the fall, then clients need how much of a rise to get back to the starting point?

  4. Which of the risks does the author describe as making "a moderate drawdown into a serious threat to an investor’s long-term objectives"?

  5. Sequencing risk is at its most dangerous when what?

  6. If inflation is in line with the BoE's 2 per cent target this accumulates over time to leave how much of the starting value after 20 years?

Nearly There…

You have successfully answered all the questions correctly, well done!

You should now know…

  • Understand the risks of managing a pension pot in retirement.
  • Learn what the risks can do to a portfolio in decumulation.
  • Grasp what advisers can do to help clients manage decumulation in retirement.

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