It used to be that retirement represented the finish line after years of working and saving.
On reaching that point, most people would simply use their pension savings to buy an annuity that would provide a guaranteed income after retirement or begin drawing on their final salary pension.
That remains the case for some, but they are definitely in the minority. Those reaching retirement now mostly remain invested in retirement and have to navigate the complexities that come with the flexibility of drawdown arrangements.
As we approach a decade since the pension freedoms were first set out, that challenge is one that continues to exercise pension companies, investment managers and financial planners alike. The recent market volatility has underlined the need to get it right in decumulation.
Time versus money
Creating a sustainable retirement income while also preserving your wealth is far from straightforward, as many are discovering. There is one overarching risk among all the complexities and nuances: running out of money.
There are various reasons why this may happen, including the specific investment risks around drawdown.
It can be easy to fall into the trap of drawing down too much too soon due to human error, fraud, over-optimism about investment returns and/or dipping into retirement funds to cover short-term emergencies.
Some people use up their savings too quickly and succumb to longevity risk – that is, underestimating how long they could live for.
This is a common mistake, according to the Institute for Fiscal Studies. Its research found that people in their 50s and 60s typically underestimate the likelihood of living to 75 by some 20 percentage points and to 85 by up to 10 percentage points.
If someone’s actual life span exceeds their life expectancy, the financial implications are potentially severe.
Risks
Drawdown has other features that give rise to dangerous risks, for instance sequence risk, which is when poor returns in early retirement take chunks out of the pension pot and so reduce how much income can be sustainably taken from it.
That can be exacerbated by pound-cost ravaging, where income continues to be taken from a drawdown fund even as its value is being eroded by market volatility. Advisers can add a lot of value in helping through clients these particular risks.
Trying to avoid or minimise sequence risk or pound-cost ravaging can, however, lead to another big risk: the risk of investing over-cautiously, resulting in low investment returns that are insufficient to meet their longer-term needs.
The importance of advice
There is no silver bullet that takes all these risks out of the drawdown equation. They are a natural side-effect of the flexibility that drawdown can offer. But there are effective ways of mitigating them, so that the drawdown phase can be enjoyed without sleepless nights.
Professional financial advice first and foremost is essential, especially when it comes to creating a sustainable income withdrawal level, picking an appropriate investment strategy and taking income in the most tax-efficient way.
A good financial adviser can also help take the emotion out of decisions that have potentially significant consequences.
The costs of not taking financial advice for retirement decisions can be heavy. Research by the Financial Conduct Authority found that savers who did not seek advice were more likely to move their entire pension into cash, for example.
No magical product
The investment-related risks can also be tackled by building and maintaining an appropriate investment strategy. Although there is no magical drawdown investment strategy out there, there are a few key tenets to proper portfolio construction.
Firstly, taking a total return approach that seeks to maximise overall returns through both income and growth, as opposed to focusing on one or the other. Secondly, always being mindful of costs.
This is supported by diversification, which should be at the heart of any well-constructed portfolio.
Diversifying by spreading money across a range of different asset classes plays a big role in mitigating sequence risk and pound-cost ravaging without reducing the total expected return.
Maintaining a properly diversified portfolio reduces the volatility of returns and the impact of falls in one particular asset or market, therefore lowering the impact of poor returns early in retirement.
Rebalancing can be especially valuable for retirement portfolios too, as it helps ensure that income is being taken from assets that have recently done well and not from those that have underperformed and might bounce back in future.
Rebalancing and carrying out regular reviews also ensures the portfolio remains aligned to the investor’s risk profile.
Some investors also seek to mitigate risk by maintaining different pots of cash, such as for the short, medium and long term.
Keeping a small pot of cash available makes sense in the short term, as investors can dip into it in the event of an emergency, rather than raiding their investments.
However, while keeping significant amounts of money in cash rather than growth assets may help reduce sequence risk, it exposes the investor to more inflation risk and lowers expected investment returns, which may ultimately increase the chances of eventually running out of money.
Best of both worlds
Successful drawdown investing invariably means accepting some of the risks that come with remaining invested during retirement. There is no way around that, it is part and parcel of the risk/reward trade-off.
That is where the experts come into play. Financial advisers and planners have a vital role to play in helping investors navigate the decumulation landscape, not least when circumstances or market conditions change.
Advisers also help shape the investment strategy that is key to mitigating decumulation risks and making drawdown work.
Ultimately, good financial planning allied with the correct investment strategy can give clients that all-important peace of mind and help ensure a financially secure retirement.
Nic Spicer is UK head of investments at PortfolioMetrix
