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Danby Bloch: Money versus time

Simply assessing how well a portfolio is faring could be misleading if applied to a pension fund in drawdown

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Too many advisers still think investing for pension drawdown – decumulation – is pretty much the same as building up a pension fund. It is not and advisers need to start reappraising their investment strategies in preparation for the new world of pension freedom that will open up from April. If they have clients in drawdown now, the need to reappraise is even more urgent.

Even the way you measure investment returns is likely to be different. Most advisers normally assess how well or badly a simple growing portfolio is faring, which could turn out to be extremely misleading if applied to a pension fund in drawdown.

If you want to understand the detail, get hold of a copy of the excellent paper from Cazalet Consulting “When I’m 64”. The eponymous Ned Cazalet says it is vital advisers start using client-focused money-weighted techniques for measuring performance, rather than fund-focused time-weighted approaches. This is especially important, in Cazalet’s view, where there are ongoing cash flows in and/or out of a client’s portfolio.

Confused and put off by the jargon? Don’t be. You owe it to your clients to start using these more sophisticated approaches. If you have Excel on your computer you are not far off being able to master these techniques without tears anyway.

Using money-weighted measures will allow you to make comparisons such as buying an annuity and taking withdrawals from a bond.

So what is the difference? In simple terms, the time-weighted approach just looks at the performance of the portfolio over time and ignores any additions or withdrawals. In contrast, the money-weighted version takes into account how much was added or taken away from the portfolio, when these events took place and the price of the investments at the time. The money-weighted returns are often called the “internal rate of return” or “IRR”.

If this all sounds a bit familiar, it should do. It was all covered in the level four syllabus for the investment exam you passed to qualify as a post-RDR adviser. If you were of an older era of examinee, it would have been covered in your top-up CPD. But of course that was all nearly two years ago or more.

In a really simple situation where a portfolio increases at a linear 10 per cent a year and there are regular inputs of the same sum, the two measures will provide the same answer: 10 per cent a year. However, where the portfolio rises and falls and the investor buys at different prices, the two measures can diverge markedly and the simple time-weighted approach will be seriously misleading.

If you want to do it yourself, take a simple single fund portfolio where the client invests £10,000 at a unit price of 100p a unit. Then, 12 months later, the fund price doubles to 200p. The client invests another £10,000 and the portfolio is worth £20,000. After another 12 months, the unit price halves back down to 100p and total value of the fund is worth £15,000.

If you use the simple fund value on day one and then at the end of year two, the time-weighted performance is zero or an annual 0 per cent. But that is clearly misleading. If you take into account the amounts invested, the IRR is an annual minus 17.7 per cent. Obvious in such a simple situation.

Using the IIR tool in Excel, you can plot more complicated scenarios, such as would be encountered in drawdown.

Cazalet gives the following example, although I have changed the sex of the individual in the example to make him seem more politically correct.

Example

The client invests £10,000 on day one at a unit price of 100p. A year later, she invests another £6,000 at a slightly lower unit price of 95p. Another year passes and she invests a further £5,000 at just 90p.

Then, after a further year, the client starts to take withdrawals. The unit price is now 115p and she takes out £8,000. The next year, the unit price has moved up to 120p and she withdraws £5,000. A year later, on the fifth anniversary of the whole scheme, the unit price stands at 128p and the client takes no withdrawals.

The facts were that the fund price had risen from 100p to 128p. So the time-weighted and fund-centred performance was 28 per cent: i.e. 5.1 per cent a year compound over the five-year period. 

But the more realistic IRR approach takes into account that the client had invested £21,000, withdrawn £13,000 and that the portfolio was worth £13,758 at the end of the five years. In fact, the IRR showed the return was an annual 7.3 per cent.

Where contributions and withdrawals are regular, use the IRR Excel programme, but where they are irregular use the related Excel tool XIRR. You can use the net present value to show the cash value now of future projected cash flows.

This reflects just one simple but very useful section of the Cazalet Consulting paper. There are juicier parts. For example, if you ever wondered what really goes on under the bonnet of an annuity, using IRR, this is a great place to start.

Danby Bloch is editorial director of Taxbriefs Financial Publishing 

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