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Danby Bloch: Why running down retirement funds is riskier than building them

Decumulation portfolios should be more cautious than accumulution portfolios

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Decumulation investment portfolios should generally be more cautiously invested than their equivalent accumulation portfolios. Many advisers do not make the distinction between the asset allocation that is appropriate for running down a pension fund or other portfolio and the asset allocation that’s right for the building up stage of retirement planning.

This was the contention that our case study, Smith Jones Financial Planning risk committee, was examining. It is an important and timely issue, especially in light of the Budget changes to pensions, which will have the effect of opening up pension fund income withdrawal to many more clients. As usual, the committee drew on the contents of Taxbriefs Advantage to help inform their views.

So why should a client with 10 or 20 years to retirement be prepared to take more risks with their portfolio than a client who is considering how to run down their retirement fund over a period that could easily stretch over a period of 20 or more years?

Capacity for loss

The issue revolves around a client’s capacity for loss. How much capital loss can a client afford to take when running down their investments, compared to the period when they are building them up? For the sake of simplicity and because it’s likely to be the biggest part of many people’s savings, the focus of the discussion was pensions.

Some clients are able to live on the natural income from pension portfolios, that is, the interest and dividends from bonds and equities – and rents if they have any let property.

Such people can be reasonably sanguine about fluctuations in the capital values of their investments but they won’t want to see wild swings in their investment income. By contrast, in their earlier accumulation stage of life, they would have sought total investment returns and would not have much minded whether these derived from capital growth, rolling-up income or both. So security of income becomes more important in retirement for these investors.

The right order

But to survive financially in retirement most clients need to dig into their capital on a regular basis. For these people, capacity for loss is lower than it was in the accumulation stage – and the faster they run down their capital, the greater their vulnerability to the impact of capital losses.  

In the final years of a person’s life, the impact of a potential loss is all too clear. If you have £100,000 and you are drawing on it at a rate of £20,000 a year, a £40,000 loss represents the difference between having enough money for three years or having enough for five years. So far, so obvious.

It is less obvious but also valid for clients in a less extreme position. The order or sequence in which investors make losses and gains can have a substantial effect on their future lifetime income. If an investor makes gains early in their retirement before incurring later losses, they are likely to be in a much better position than if they make early losses followed by gains later on.

A simple example illustrates the point. John has a pension portfolio of £200,000 and draws £20,000 a year from it in addition to any excess income. Very early in the first year, the portfolio doubles to £400,000 and stays unchanged in value for the next  five years, during which he draws  a total of £100,000, leaving £300,000. The portfolio then halves to £150,000. He still has 7.5 years of withdrawals left.

Mick is in exactly the same position but the sequence of his losses is reversed. In the first year, his portfolio halved in value, leaving him with £100,000. Five years later, after drawing a total of £100,000 at the same £20,000 a year rate as John, he is left with nothing. He has no investment left to double in value.

Running down a fund amounts to pound cost averaging in reverse. When the price of units is low, you sell more of them and when it is high, you sell fewer. So the effect of taking regular withdrawals of capital is to exaggerate the impact of the fluctuations rather than to smooth them out or average them. Jan Holt of Just Retirement has memorably labelled the phenomenon “pound cost ravaging”.

There are several ways of tackling this. One approach is to adjust the pension portfolio to make it less susceptible to fluctuations. Another is to divide the portfolio into different time horizons, with progressively less risky investment pools for the most immediate years – maybe a cash or short-dated bond pool for the next three to five years. Later on the answer might well be to take out insurance as the risk gets greater and as the investor gets older – a process known as annuitising.

The Smith Jones risk committee agreed decumulation was a riskier strategy than accumulation and clients should be helped to understand that their investment portfolios should reflect it. 

Danby Bloch is editorial director at Taxbriefs Financial Publishing 

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