By Iain McGowan, Head of Fund Proposition
The big increase in the number of people choosing income drawdown has brought several issues for advisers to address. While some have been attracted by the ability to take cash withdrawals, many have chosen drawdown because of a dislike of annuities and are looking for a regular income. These clients need to remain invested to avoid inflation eroding their pension fund. However, the most important factor for many of these investors is to avoid having their investments fall in value. Drawdown investors do not have the luxury of time to allow their investments to recover from any market falls. This is compounded by sequence of returns risk, where a drop in value in the early years of drawdown can significantly reduce how long a fund will last.
The rise of volatility management
These changes have not been lost on the investment industry. There are already more than 125 funds in the Investment Association’s new ‘Volatility Managed’ sector. Some funds use diversification, others invest in stocks with historically low levels of volatility and other funds sell assets, hold the cash and then re-invest when markets stabilise. In addition, advisers themselves can help manage volatility by advising clients with a cash reserve to stop withdrawing income and ride out any short-term volatility.
An innovative approach to volatility management
The Scottish Widows Retirement Portfolio Funds employ a different and innovative approach to dealing with volatility. The four funds invest in a mix of equities and corporate bonds, each with a different strategic asset allocation according to its risk rating. In times of high volatility, the equity component of the funds is reduced to limit the impact of any market falls. To achieve this, the funds use a semi-automated process called Dynamic Volatility Management (DVM). DVM uses an algorithm to respond to equity market volatility. When volatility is within defined levels, the funds are invested according to their stated asset allocation. However, when volatility exceeds that level the funds reduce their allocation to equities. The DVM threshold is dynamic and moves depending on equity performance over the previous 12 months. If equity markets have been rising then the DVM threshold will be moved up (as customers can tolerate more volatility after a period of growth). In falling markets, the threshold will be revised downwards so the funds will de-risk earlier.
Once the DVM has been triggered the funds will then remain in a de-risked position until volatility falls below the threshold.
How might DVM operate in different market conditions?
As part of the funds’ development, we tested how a fund with DVM would have performed in a variety of different market conditions and used stochastic modelling to test around 5,000 potential future scenarios to see when they would be most and least effective. It is important to note there is no guarantee that these funds will prevent or reduce equity losses, nor is there any guarantee that they will ensure a pension pot lasts for a specific length of time.