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Chris Gilchrist: The challenge posed by living off capital

Rich Wilmot - Newton

By now we have got used to the demographic slide presentation showing the number of elderly people in the UK rising inexorably until only one spotty teenager is left pretending to work in order to support us all. For the gloomier sort of economist, this is terrible news: high dependency ratios are bad for GDP growth, etc.

As is often the case, reality will probably diverge quite radically from this. In particular, because people are living longer, they are handing over more wealth in their lifetimes to their children. 

A lot of elderly people today say something along these lines to their advisers: “The children have had a good lump of capital, they’ve got their homes and good incomes. They know there won’t be much more. We’re planning on spending pretty much all of it apart from the house.” 

This is good news. First, the money they give away gets spent by their children, often on home improvements, stuff for their kids, starting a business or paying off debt. 

Second, these older folk do have money to burn. Often they have substantial capital, both in pension funds and other forms of savings. They need advice. Third, living off capital – I mean using capital as well as income to support your standard of living – is quite scary, so skilled advice and careful ongoing management are needed.

I believe a majority of moderately wealthy elderly people will end up using at least some of their capital in this way because they will need more income than the natural yield from a typical, sensibly balanced portfolio of bonds, property and equities.

The key issue is ‘drawdown’ rates of capital erosion in market downturns. During the accumulation phase, you ride out such dips and even benefit from them if you invest regularly. But sudden market falls can easily ruin people who are taking regular withdrawals of capital from a portfolio.

I reckon a new form of capital withdrawal scheme has come along once in each of my four decades in the industry. It has only been a matter of time before the wheels came off.

What looked like the oldest and safest one, the with-profits bond, worked for almost two decades before it was ruined by the greed and incompetence of the life assurance companies. Other withdrawal schemes, such as fixed percentage withdrawals from unitised portfolios, were far more stupid. No such scheme has lasted long. But it is almost time for the next one.

Anyone thinking about this subject should start with Standard Life Wealth’s presentation on drawdown and path-dependency. Simply put, the same repeating three-year pattern of returns over a 20-year period can result in ruin or wealth, based only on the sequential order of returns. Start with a positive return and it is all roses; start with a nasty downturn and it is a case of ‘we’re  doomed’.

Coming up with ways of managing drawdown is the key issue facing investment advisers. So far, my view is that automated lifestyling will not work as clients’ circumstances and needs are likely to change too often and too sharply.

Bespoke solutions that cannot be pre-programmed? This has to be a meal ticket for professional investment advisers. 

I reckon solutions will all come down to rule sets for asset allocation decisions.

Chris Gilchrist is the author of the Taxbriefs adviser guide ‘The Process of Financial Planning’ and edits the investment newsletter The IRS Report

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