Portfolio design for income in retirement is very different from most other scenarios and it is time to start setting new advice standards, procedures and rules. The starting point should be to think about clients’ objectives and the risks they face.
Defining clients’ objectives is difficult and needs a lot of talking through. Partly this is because many people have only the vaguest idea about how much they aim to spend at different points in their retirement. In any case, spending and income are closely aligned: most people tend to adjust their expenditure to their available income. Meanwhile, there are lots of unknowns about the future, such as health, availability of work, inflation and family needs.
It is hard to understand how advisers can help clients plan their retirement income and expenditure without some kind of cashflow projections. Precision should not be mistaken for accuracy in making cashflow forecasts. It is usually good enough to make estimates of very broad categories of expenditure based on current and planned patterns. However, it is crucial to look at several different scenarios to understand the consequences of major changes in income/withdrawal levels that could occur.
Drawdown involves more risks than accumulation or steady state. The normal investment risks are amplified by the process of taking withdrawals above the level of a portfolio’s natural income.
Sequencing risk means an early loss has a greater impact than a much later equivalent loss on a client’s capacity to take withdrawals. Try modelling a 20 per cent loss in the first couple of years of a portfolio taking withdrawals of 7 per cent a year and a natural annual income of just 2 per cent. Run the same figures but assume the loss happens after 10 or 15 years. The difference is enormous.
Then there is reverse pound cost averaging or “pound cost ravaging”. In drawdown, the investor sells more units when their value is low and fewer when their value is high, adversely exaggerating the effects of volatility.
Advisers also need to consider how long the client will need to have income. Some long-term cashflow projections take the target lifespan as life expectancy at the starting age. That might be 20 years for a 65-year-old man, according to the Pru.
But this is just the average. Roughly half of all 65-year-old men will live longer and quite a few will be centenarians. Perhaps advisers should plan more conservatively for a healthy client? If the client has dependants who are younger, the timescale might be even longer.
As time goes on, some kind of longevity insurance in the form of an annuity looks more and more inviting, especially if the rate of income withdrawals is expected to exceed the natural income of the portfolio by a significant proportion.
This brings us back to how much a client could afford to lose. One conclusion might be that a client’s spendable income needs to be reasonably predictable – at least in the immediate future. A client might be able to adjust to a much lower standard of living, with enough warning if the capital value of their investments fell drastically.
A related conclusion might be that portfolios of equities and similar investments tend to recover eventually but this might take several years.
All of which drives one to conclude that retirement portfolios, where the client needs to draw capital, should consist of broadly two pools of assets. A safe pool would consist of cash and/or short-dated bonds, which would provide the certainty of resources for the immediate future. The second pool would generate growth (with risk) and consist of equities, perhaps some property and longer-term bonds.
The bigger the safe pool, the longer the client could survive a downturn but this would be at the expense of overall potential growth and inflation protection.
For example, a client expecting £30,000 a year from their portfolio might decide to retain about three years of income in their safe pool. The remainder might be in a longer-term portfolio of equities and longer-term bonds. A client with a high tolerance and capacity for risk would consider the reverse.
In some respects, this approach is just a mental accounting exercise, compartmentalising a conventional mixed portfolio. It will not suit everyone but it has the advantage of translating the realities of risk into a structure and language most clients can understand.
Danby Bloch is editorial director of Taxbriefs Financial Publishing
Pensions flexibility: the new rules – keep your clients up-to-date
Keep your clients up to date with a personalised guide to the new rules and proposals first announced in the Budget affecting retirement income. The latest edition to our Key Guides series covers:
- Revisions that took effect from 27 March.
- Total drawdown flexibility that should be available from April 2015.
- The Chancellor’s announcement on the flat tax rate on death benefits
- New Class 3A NICs.
- Likely increases to the minimum pension age.
- Reductions on death benefits for some individuals.
To find out more call Dave Posnett on 020 7970 4142