Although the many components of drawdown make it complex, through skilful management by advisers, they can prolong the life of clients’ retirement savings. Once the initial plan is set up, advisers can manage drawdown in a number of ways. They will respond to the changing needs and investment situation, especially with an aim of improving sustainability. Options can include not making planned inflation increases, reducing withdrawals, selecting guaranteed solutions, and managing the investments or asset allocation.
A higher value pension pot can better support the time and charges generated from more regular and individual attention, especially when using a number of different strategies. But what about lower value pension pots, that simply cannot support these more frequent and involved interventions?
One important aspect advisers are increasingly concerned about, irrespective of fund value, is how sequence of returns risk impacts sustainability. Increased volatility and the associated investment losses is the engine that drives sequence risk. So how do advisers manage volatility, whilst still delivering a cost effective service?
Cash reserve
A frequently used method is to hold a cash reserve with the objective of improving tolerance and flexibility. The aim is to hold a reserve of cash and the withdrawals are taken from this, providing a buffer from market volatility. The longer term investment part of this portfolio is then held in assets that aim to provide the opportunity for real growth.
This plan is often referred to as ‘Bucketing’ or a three pot strategy. If the markets fall, then withdrawals are not taken from a weakened investment, requiring more units per withdrawal. The cash reserve is topped up when markets are more stable, usually at the next client review. Advisers are known to use 1, 2, 3 and more years of holding cash in reserve.
Cash drag
The problem with holding a large amount of cash creates a phenomenon known as ‘cash drag’. The low interest return on cash creates a performance ‘drag’ on the overall portfolio. The more cash held the greater the drag.
A cash reserve case study
Holding a cash reserve is a good idea and is often used as an effective mitigation to avoid investment volatility. However, the advantages can also mask the impact of cash drag. The issue can be demonstrated using a simplified example, comparing two theoretical adviser firms:
• Adviser A holds 1 year’s cash reserve – £6,000
• Adviser B holds 3 years as a cash reserve – £18,000
To make the comparison simpler, we’ll assume that – apart from the cash reserves – the advisers use the same approach, and that the withdrawals are annual (in practice, they’re more likely to be monthly). We’ll also assume that the first year’s income for each firm’s client comes from tax-free cash and Year 1 starts with a drawdown fund of £150,000, with a £6,000 annual withdrawal of 4% (not adjusted for inflation).
To make the concept easier to explain, we are using simple returns:
• The investment fund provides an average annual return of 5% (net of charges and fees)
• The cash reserve provides an average annual return of 0.5% (net of charges and fees)
After each annual withdrawal, the cash reserve is topped up from the longer term investments to the 1 or 3 year reserve.
