Equity IncomeSep 28 2016

The truth about pension funds

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The truth about pension funds

Securing retirement income in a low-interest rate environment is becoming increasingly challenging for financial advisers. Falling gilt yields post-Brexit saw 10-year UK government bonds drop to a historic low of 0.50 per cent in August. And the prospect of rates rising sharply anytime soon appear remote. 

So as annuity rates plunge, drawdown is likely to continue to emerge as the more popular option. 

For those planning for retirement income, where we need to focus is not just on attitude to risk but on a customer's capacity for loss – two very distinct but interrelated concepts that need to be understood fully on a client-by-client basis before any decision is made around the best option for delivering that retirement income. 

The FCA has described capacity for loss as “the customer’s ability to absorb falls in the value of their investment. If any loss of capital would have a materially detrimental effect on their standard of living, this should be taken into account in assessing the risk that they are able to take.”

It is really only when the customer’s capacity for loss is established that we move to understanding their attitude to risk. And by that we mean understanding the level of risk that a customer is comfortable with in pursuing their income objective.

I think that this definition needs to be extended (where applicable) to include a customer’s ability to absorb falls in their retirement income.

Capacity for income loss and attitude to risk are more relevant in the current economic climate where falling interest rates and prolonged market volatility may lead to a recalibration of client expectations in relation to their retirement income. So advisers are not changing the way they plan but changing the conversation with their clients around their longer-term income prospects in retirement.

Moving into the more risk-laden assets has ramifications for retirement income.  

Recent research conducted with eValue  shows the implications for pensioners of investing in various risk-rated portfolios and what a sustainable level of retirement income is that has a “reasonable” chance of success. 

The full research is set to be published in October but we have a preview of some of the early findings.

For the analysis below, the researchers have taken 95 per cent as a typical level of chance of success (a 1-in 20-failure rate). They have used quite conservative failure rates here, given advisers may have a pool of customers who are affected by an economic event such as a market fall – what we loosely refer to as concentration risk.  

If we take eValue’s investment profile with a risk rating of 4 (see chart for composition), their economic stochastic model projects that a pensioner can take an income of 3.3 per cent for 30 years with a reasonable chance of not running out of money. Invest in a risk profile of 7 and this number goes to just over 2.8 per cent.

 Here’s an example to illustrate this:

Joan retires at age 65. She opts to invest in drawdown in a portfolio that corresponds to eValue’s risk profile 4. 

At 65, Joan is in good health and her life expectancy is 90. Joan takes an income of 4 per cent income a year. Taking this level of income gives her a 1-in- 20 chance of exhausting her funds by age 88. That is two years without any income until her expected death at age 90 – or  even be longer given increasing live expectancy.

And that’s just the law of averages, but what would happen had she been unlucky and experienced a 10 per cent market drop in her first year of retirement? This risk — commonly referred to as sequence of return risk — would shave years from Joan’s income so that she would run out of income much earlier into retirement. It is this type of scenario where a pensioner suffers a significant drop in their retirement fund value and then experiences a slow recovery that impacts most. The retiree must now face the decision on whether to risk running out of money early or taking a haircut to their current income levels. Not an easy conversation for an adviser or client.

Where a retiree’s capacity for loss is minimal or non-existent, we need to seek solutions that offer the benefit or upside potential but with the comfort that a market dip or heightened levels of volatility will not decimate income levels over the entire retirement span, or force a retiree to take a haircut on the amount of income that they can afford to take. Since pension freedoms were introduced, drawdown with guarantees is emerging as a more popular option – providing the opportunity to participate in market performance, and a guaranteed income for life that will not ever go down irrespective of what happens in the market. At a very basic level, these solutions offer the ability to invest through funds and avail of any market performance. The upswing in a pensioner's fund value is locked in and this increases subsequent income levels. A bit like a watermark: once the mark is reached, the income level is set from this high level watermark and won’t ever decrease. 

Getting the very best outcomes for retirement income is a complex mix – understanding each clients’ capacity for income loss and their appetite for risk over what may be a 30 or 35-year retirement span is a large part of the challenge. Combining these factors with what a customer can reasonably take in retirement in such a volatile market without running out of money makes the conversation on retirement goals a sobering one for both adviser and customer. It is worth considering some of the newer solutions like drawdown with guarantees that give the pensioner the option to participate in the markets, get the benefit of any increased performance with the peace of mind that their income is protected no matter what happens in the markets.

We as an industry need to manage expectations in what is the new retirement reality of increasing longevity, low medium to long-term interest rates, market volatility and all against the backdrop of the pension freedom generation’s ability to self-determine.

Barry Cudmore is managing director of Aegon Ireland

 

Key points

Securing retirement income in a low interest rate environment is becoming increasingly challenging for financial advisers.

Moving into the more risk-laden assets has ramifications for retirement income.

Where a pensioner's capacity for loss is minimal or non-existent, we need to seek out solutions that are available.