PensionsJun 3 2021

Advisers need better tools to calculate retirement income

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by
Advisers need better tools to calculate retirement income
Pexels/Luis Gomes

However, in the five years since the introduction of pension freedom regulations, there is currently no comprehensive, easy-to-use tool for advisers to suitably recommend post-retirement, income drawdown investments to their clients.

Modelling investments for the post-retirement phase is complicated, and client risk tolerance more sensitive

So, what are the key considerations and steps that advisers need to take to ensure suitable advice for income in retirement? And how can technology better support this process?

Post-retirement options

The Financial Conduct Authority has published Retirement Pathways that guide advisers with clients entering post-retirement. There are four options:

  1. I have no plans to touch my pension pot within the next five years.
  2. I plan to set up a guaranteed income, by buying an annuity, within the next five years.
  3. I plan to start taking a long-term income within the next five years.
  4. I plan to withdraw all my money within the next five years.

While these pathways are aimed at direct-to-consumer investments, advisers do need to take these into account. In practice, for advised clients, they will likely need a mix of the above, depending on their level of discretionary spending, sources of income, bequest/estate planning, and risk tolerance.

However, it is currently very difficult (that is, impossible) to assess risk suitability of the above pathways for clients.

How is post-retirement different?

Modelling investments for the post-retirement phase is complicated, and client risk tolerance more sensitive, especially when compared with the pre-retirement, accumulation phase.

Unlike in pre-retirement, where an adviser only had to consider the client’s goals, risk tolerance and time horizon in post-retirement, there are additional factors such as drawdown frequency and amount, spending flexibility, and investment costs.

Post-retirement is inherently riskier. While a pre-retirement client may have a time horizon of multiple decades, a post-retirement investor’s time horizon is much shorter, as withdrawals need to be made reliably as little as one year ahead and annually thereafter.

Pound-cost averaging becomes pound-cost ravaging

In accumulation, a client can use ‘pound cost averaging’ to ride out short-term market falls and invest in units at a lower price. However, in post-retirement the situation is reversed. As an income drawdown client is selling investment units to generate a regular income, they could lock in losses during market falls.

It is the journey that matters in decumulation, unlike in accumulation, where it is the destination that is important. Investors will need to lower volatility in their portfolio so as not to permanently impair their capital.

Consider the example returns shown in Table 1. There are three different possible scenarios of returns from an investment, each having the same average growth rate over 10 years of 4 per cent.

First, a ‘positive start’, where there are better returns in the first half of the 10-year period. Second, an idealised ‘linear’ return, where the investment generates 4 per cent each year. Lastly, a ‘negative start’, where the investment experiences negative returns in the first half of the period.

Table 1: Sequencing risk example

Sequence of returnValue Growth rates each yearSimple Average
12345678910
Positive start+30%+25%+20%+15%+10%-5%-7.5%-10%-15%-22.5%4%
Linear+4%+4%+4%+4%+4%+4%+4%+4%+4%+4%4%
Negative start-22.55%-15%-10%-7.5%-5%+10%+15%+20%+25%+30%4%

Now consider a pension pot of £100,000 value and its future value while taking a post-retirement withdrawal of £4,000 each year. As can be seen by the final portfolio values below, the impact can be massive depending on how the returns are ordered in each scenario – this is sequencing risk at work.

Final Portfolio Value

Positive start£115,563Linear£100,000Negative start£65,615

How do annuities compare?

While sequencing risk can be addressed by avoiding drawdowns and volatility in a client’s investment, sequencing risk can also be addressed by a client having some flexibility with their income requirements.

However, for clients with little flexibility in their income needs due to a higher proportion of required spending on living essentials, an annuity should be considered as at least part of the post-retirement solution. For advisers, more advanced end-to-end financial planning software should enable comparisons between income drawdown solutions and annuity rates.

Costs

Finally, given how sensitive the client’s investment portfolio is to sequencing risk and their income requirements, the impact of costs can also be massive. For example, considering a withdrawal rate of 4 per cent for a client, once typical fees are added in for the underlying investment fund, platform costs, and adviser fees, this can effectively increase the withdrawal to almost 6 per cent each year.

The significant effect of higher fees is that a client’s pension pot will be more sensitive to sequencing risk and have a higher probability of not lasting to the client’s required time horizon.

Given this, it is important that all of these costs can be adjusted to accurately assess their impact on the client’s income drawdown goals.

A new way of working

All the above must be taken into account for advisers to be able to make suitable post-retirement recommendations. It is complex and there are a number of key considerations to take to ensure suitable advice is given.

Decumulation requires not only a different way of thinking, it requires the support of a financial planning software that powers and automates the heavy lifting. Modelling for Income drawdown not only models the situation but also allows suitable fund selection. Advisers need financial planning software and workflows that enable them to easily assess post-retirement client suitability and compare post-retirement solutions from multiple investment providers.

Traditionally, advisers have relied on disparate systems to research and create reports ensuring suitable advice for clients in decumulation. It is time that financial planning software responded to traditional challenges and provides new solutions. Disruption creates an opportunity for advisers to use technology to ease complexity and make use of a consistent methodology.

Within a single workflow, advisers should be able to assess their clients' risk tolerance, their post-retirement goals, compare across income drawdown funds and annuities to assess which can meet their clients’ needs, adjust for costs, and have each step of this process documented as part of making a suitable recommendation.

Jason Baran is Insight Consultant (investments) at Defaqto