Investment risk is a topic that never fails to dominate conversation among advisers and fund managers.
But clients are less likely to have a grasp of what it means and might assume risk involves being reckless with money rather than taking a prudent view of where opportunities lie.
Closing the gap in the understanding of risk between client and adviser is even more important in the complex world of drawdown, where a slight misstep can lead to clients running out of income in retirement.
Here advisers have the difficult task of identifying, explaining and managing the risks clients face in drawdown such as inflation, longevity and the right asset allocation. Pound cost ravaging and sequencing risk can also be problematic.
This gap between advisers and clients in the understanding of risk was a prominent theme in a seminar last week hosted by fintech provider EValue in London. It shared research about a survey of a UK-representative sample of 1,000 adults aged over 50 that exposes the extent of consumer vulnerability when it comes to retirement planning and provision.
When clients were asked what turned them off about income drawdown, 51 per cent said they were unlikely to consider the option either due to perceived complexity or a lack of trust in investment markets. Meanwhile, 12 per cent said they would consider drawdown but would not have confidence in the plan.
At the seminar Zurich UK Life head of retail platform strategy Alistair Wilson articulated the core of the drawdown dilemma when he said: “There needs to be different asset allocation for decumulation and yet if you speak to the professional advisers out there, they will say ‘we are in the wrong ballpark’. And I would like to understand why we are in the wrong ballpark. The issue is how do you explain risk and take consumers on the journey? At the moment there is this move from accumulation to decumulation and there is no change to asset allocation from an adviser point of view.”
Scottish Widows launched four retirement funds in February 2018 with the aim of helping advisers build flexible solutions. It then launched a new drawdown tool this April to make clients’ pots last longer and cut administration overheads for advisers.
The provider’s head of fund proposition, Iain McGowan, says: “Whatever word is used in discussions with a client, whether it is ‘risk’ or ‘uncertainty’, the adviser will have to gauge what is the best way to explain the issues of inflation, investment performance and longevity. The design of a drawdown solution is about meeting client objectives.
“The right asset mix for a client in drawdown and saying whether they are taking too much or too little risk varies and is hard to generalise about. A client’s attitude to risk depends on where they are in the journey and personal circumstances. Centralised retirement propositions have to be nimble and serve the needs of clients in drawdown otherwise they are not doing their job.”
Clearly, advisers have to help clients understand drawdown but how do you describe risk in a way that resonates? The identification, explanation and management of risk for drawdown clients is a considerable challenge the profession now faces.
Money Honey managing director Jane Hodges
I usually try and explain that when you are building up wealth it is good to buy at a low price and sell high. Then explain this is the same in decumulation but the other way round. If you are selling assets regularly to drive an income, then it can actually be really bad to have to sell when the markets are low.
Good cashflow modelling can help you show the impact visually and that helps enormously. We should use pictures as the words are often meaningless.
Drawdown planning tips
Everyone agrees financial planning at the end of the client’s journey is far harder than the start.
Plutus Wealth Management chartered financial planner Ruban Sanmuganathan says: “Managing any sum of money from which income is being drawn from is far more difficult than a sum of money that is staying static or being paid into. The decumulation phase of an investment needs far more care and attention both at the beginning and, more importantly, on an ongoing basis.
“This message must be made clearer. I know advisers will already be doing this but I suspect that, since pension
freedoms, many people have gone into drawdown who are not receiving professional ongoing advice for the investment management of the money.”
Sanmuganathan shares some useful planning tips for maintaining income for clients in drawdown against inflation.
“Over a 20-year period inflation will significantly erode the spending power of any given sum. In a perfect world the level of income required from an amount of capital will be very small and allow the client to take less investment risk to achieve an income that increases with inflation while preserving their capital.
“But this is rare so, in reality, a compromise must be made between allowing capital to erode and the level of investment risk being taken. Clients have to make a choice about how much risk they take and that is the first thing that needs to be explained.”
When it comes to working out a sustainable withdrawal rate, Sanmuganathan adds: “Identifying a sustainable level of income is very hard. Historically, a figure of 4 per cent was used but this figure is from the 1990s and since then, long-term growth and interest rates have fallen significantly so, as a broad estimate, I prefer to use a figure of 2 to 2.5 per cent for a balanced risk investor.
“No investment can mitigate low-frequency but high-impact market crashes while at the same time providing long-term good annualised growth – this is a fallacy that people hunt for. But using good structural planning, like dividing money into short-, medium- and long-term needs and then taking differing risk levels for each is a solid approach.”
Although there are many technical challenges of drawdown, handling the emotional and psychological hurdles that make clients not accept good advice can be the hardest.
Helm Godfrey chairman Danby Bloch says: “Clients’ natural instincts are to go with investments with which they are familiar – cash and property for the most part – and be reluctant buyers of investments that hold out reasonable prospects of long-term growth – like equities.
“Mostly they can’t afford to invest so much in cash or near cash. They expect higher returns and will need them if there’s any inflation.
“Part of the problem is that subjective worries – risk tolerance as measured in psychological profiles – tend to take precedence over more objective measures like the timescale over which the investment will be needed. The questionnaires are quick and easy to answer and carry a good deal more weight than they should.
“A lot of problems arise from the difficulty of explaining what possible investment losses could mean in practical terms. Asking someone whether they can cope with losing say 20 per cent of the value of their portfolio is pretty meaningless.”
These subjective perceptions of the clients are compounded by the fact that drawdown is complex. High withdrawal rates and drops in stock markets at the same time can be likened to riding two horses headed in opposite directions.
Bloch adds: “The risks in decumulation – where you are drawing both capital and income from a portfolio on a regular basis – are a good deal greater than in the accumulation stage or even in steady-state retirement. The risks – uncertainties, if you prefer – arise on both sides of the account. You have to worry about ups and downs to income/assets on one side and expenditure on the other.
“Reverse pound-cost averaging and sequencing risk can massacre the return on a portfolio in relation to expectations for covering costs.”
Bloch argues advisers have to become a lot better at helping clients follow their spending in drawdown.
He says: “The impact of a potential investment loss only comes to life when it is translated into the implications for the client’s expenditure. And that can only be done with cashflow planning. Mind you, most cashflow planning tools are pretty unidimensional tools that provide a very rough and ready, unnuanced answer.
“Expenditure can be much higher than projected because of inflation, illness, accidents or lack of control. Most people will probably live longer than they expect – or at least longer than their parents.
“I think advisers need to get much better at helping clients monitor their expenditure – reducing outgoings for some in some circumstances but encouraging other people to spend more or even give more away.”
Explain the risk of drawdown to clients using visual tools
When it comes to retirement, advisers have to find ways to make risk visual for clients: for instance, using a traffic-light system to demonstrate chances of running out of money, and different facial expressions to illustrate the likelihood of meeting their income need. Using numbers is one thing, being able to see it is quite another.
When it comes to using the word “risk” I don’t know that this makes a difference. It is not the word risk per se that is the problem – most clients understand that word; it is the definition of risk that is the problem. The industry defines risk as volatility yet the real retirement risk is outliving your money.
The conventional idea that, when people reach retirement, they need to dial down on equities and pile in on bonds does not hold up to empirical evidence in the context of three or four decades of retirement.
I think the centralised retirement proposition is jargon thrown around by providers and consultants who have little idea what it means.
Abraham Okusanya is director at Finalytiq