DrawdownJul 4 2019

How to ensure clients have enough cash in drawdown

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How to ensure clients have enough cash in drawdown

The risk of outliving their pension pot looms over many pensioners, their families and their financial planners, thanks to pension freedoms and ever-extending live expectancies, according to Heather Owen, financial planner at Quilter Private Client Advisers.

According to Ms Owen, three key factors come into play when it comes to drawdown:

  1. How much money the client has in their pension.
  2. How much income they need.
  3. Where their money is invested.

She says: “As financial planners, we can help clients to grow their pension during accumulation, and we can help temper any unrealistic spending expectations to a degree. 

“But perhaps one of the key influencers is how drawdown funds are invested.”

According to Ms Owen, clients have a number of options for their pension fund.

She explains: “Buying an annuity will guarantee a set income, whereas holding funds in cash can make the longevity mathematics a lot simpler. 

Decumulation is a complex field, and there is no one-size-fits-all solution.Heather Owen

“However, neither offer the chance for growth, and unless your client knows they are sitting on enough capital at the start of retirement to simply work their way through bit by bit – not forgetting the added effect of exposure to inflationary pressures – it is likely they will need to look for investment returns to help sustain their pot.”

She continues: “With an entire universe of things to invest in at our fingertips, where to begin? 

“It’s not as simple as saying 'anything that grows will do' – clients in drawdown may want to limit their exposure to particularly volatile and unpredictable assets, although some exposure would help to bolster and increase the size of the pot.”

She suggests some clients may seek income-paying assets such as gilts, corporate bonds, and commercial property, where they can draw the income generated in the portfolio.

“But again, if the client’s income needs exceed the income their fund can generate, the client may see capital depletion quicker than they would like,” she adds.

“Decumulation is a complex field, and there is no one-size-fits-all solution. The final investment decision will always come down to the client’s individual needs and circumstances.”

Sustainable income

According to Colin Simmons, retirement income expert at Prudential UK, one of the biggest challenges that advisers face when advising on income drawdown is determining if the client’s income is sustainable throughout their retirement, however long that might be. 

So when planning a retirement income strategy, it is important to establish a secure core level of income for clients through products such as a defined benefit pension, state pension, annuity or guaranteed drawdown, or by investing in lower risk, more stable investments. 

Then, on top of this, is aspirational income – or what the client wants to retire on – which is based around their own aims and objectives. 

He explains: “This is the income that has the flexibility (if required) to be adjusted and possibly reduced in the future. 

“And above this, again, is the top tier, [the] 'nice to have'. Income which can be used for things like leaving a legacy or a special holiday.”

Mr Simmons continues: “To establish a sustainable level of income, cash flow modelling can be used to paint a picture to clients of the potential outcomes, and stress testing is an excellent way of helping clients to understand their capacity for loss.

“Importantly, it also helps advisers document the client’s understanding as part of an evidence-based income strategy.”

But he warns any assumptions used in the cash flow modelling process need to be both reasoned and reasonable, with the underlying process itself stress tested. 

He adds: “Simple methods of stress testing include assuming negative returns losses at different stages throughout retirement, and looking at the impact of a lower long-term growth assumption.

“Advisers need to consider the expected returns from the assets they are investing for their clients, perhaps by using stochastic models or anticipated growth rates provided by the investment manager.”

Another way to safeguard against sequencing of return risk is to keep some money in a cash account for short-term withdrawals.Colin Simmons

If they are in good health, then a client's drawdown pension could remain invested for two or three decades, or even more, notes Patrick Connolly, chartered financial planner at Chase De Vere.

He says: "To achieve real returns over this timeframe they need to hold at least some of their money in equities. 

"However, as they are likely to be relying on their pension money to provide an income for the rest of their life, they should also hold safer assets, such as fixed interest, to provide diversification and also some protection if stock markets perform badly."

What is the sequence of returns risk?

Most investors accept some short-term volatility as the price worth paying for the opportunity to realise gains over the long-term.

However, in decumulation, volatility losses can be compounded when assets are sold during a downturn. 

This is known as the ‘sequence of return risk’, or ‘pound cost ravaging’ and it is the risk of an investment experiencing volatility when in drawdown. 

“When in accumulation, investors have the capacity to absorb volatility to varying degrees, depending on their circumstances,” explains Ms Owen.

“However, when withdrawing monies from a pot, volatility becomes a much greater concern because of the impact this has on fund value.”

But this risk can be managed in several ways.

Most advisers will use a combination of strategies, suggests Mr Simmons.

He explains: “These include using smoothed funds that help reduce volatility, taking withdrawals out of ‘natural income’, regularly monitoring different ‘pots’ and withdrawing from those that have performed best, and calculating and regularly reviewing a sustainable withdrawal rate. 

“Another way, of course, to safeguard against sequencing of return risk is to keep some money in a cash account for short-term withdrawals.”

Managing other decumulation risks

While the sequence of returns is perhaps the biggest risk, there are others to be aware of. 

Ms Owen suggests that those in decumulation are inevitably exposed to a range of investment risks, although some can be moderated by blending asset classes. 

She says: “A number of things need to be taken into consideration – alongside the emotional attitude towards risk – which is the need to take the risk, and the capacity for loss. 

“Both of these are important considerations during accumulation years but become, perhaps, more acute when decumulation years are upon us.”

But there are also some risks that cannot be controlled, such as longevity risk for those who could outlive their pension provision.

She continues: "While outgoings typically reduce in the later years of retirement, the fear that one may outlive their pension provision is a pertinent one for many. 

“With more and more people walking the tightrope between generating an income and sustaining capital, outsourcing investment and planning decisions to a professional adviser has never been more crucial.”

Keeping worries at bay

Running out of money is probably the biggest worry for most people in drawdown and this can be managed through regular reviews, suggests Mr Simmons.

He adds: “There is also a risk that a client could make an unplanned dip into their fund or that their personal circumstances may change in retirement – for example, as a result of the death of a partner or a divorce. Or they may decide that they want to help a child or grandchild financially for a deposit for a house or university fees.”

He notes it is also important to consider the impact of an increase in inflation, which could potentially erode a client’s income. 

Mr Simmons continues: “Being able to identify clients who are or who may become vulnerable and having the appropriate procedures in place should be at the heart of any responsible advice firm.”

He adds: “The benefits of setting up a power of attorney in good time can save clients and their families a lot of time, cost and heartache later in life.”

victoria.ticha@ft.com