A new approach to cash reserve strategies

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.

 At the end of 10 years:

        •  Adviser A’s client pension pot has £165,471    

        •  Adviser B’s client pension pot has £158,679

It is good news that both adviser portfolios show a positive return. However, Adviser B, using a 3 year cash reserve, has £6,792 less compared to Adviser A’s client pension pot.

Adviser B may have the comfort they have a larger ‘buffer’ in the event of increased volatility, but at what cost on performance potential? Adviser A has less cash reserve, but this potentially means less comfort in the event of investment volatility. However, combined with the cash reserve they are employing a volatility management strategy within the longer term investment.

Spreading volatility management across the portfolio

The challenge to reducing the drag of the cash reserve is to find a solution that is effective for all client levels, at a cost that doesn’t drag on the portfolio in other ways, such as additional fees. In this case Adviser A is using the Scottish Widows Retirement Portfolio Funds as part of their longer term investment strategy for income drawdown clients. 

Using a combination of a reduced allocation of cash fund and the low cost Scottish Widows Retirement Portfolio Fund they effectively spread the volatility management over a greater proportion of the whole pension pot. The funds include a dynamic volatility management process which is designed to manage significant volatility to help a pension pot last longer. When volatility is more stable and within acceptable limits the volatility management process effectively remains dormant allowing equity market participation and growth potential.

We believe that advisers, like Adviser B, could consider reducing their cash reserve (maybe from 3 to 2 years) by employing an alternative investment strategy such as the Retirement Portfolio Funds. 

For more information on Retirement Portfolio Funds visit: scottishwidows.co.uk/RPF

This information is for UK Financial Adviser u se only and should not be distributed to or replied upon by any other person.

‘This is a Scottish Widows Paid Post. The news and editorial staff of the Financial Times had no role in its preparation’