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Evidencing Capacity for Loss in Decumulation

workman tools 700Since pension freedoms, many retirees opt to remain invested using drawdown products, electing to carry the burden of ongoing investment, sequencing, and longevity risks.

Moving from accumulation to decumulation, brings different challenges, including the shift from risk appetite to capacity to absorb capital and income loss.

How is this recorded and managed?

A change in advice principles

A modern view of capacity for loss in decumulation is derived from a ‘principles’ based advice approach.

Pre-pension freedoms, the amount of funds available drove the product choice, with arbitrary fund limits in place before entertaining drawdown. Below this, and it was an annuity.

This simplified approach doesn’t really cut it anymore, now we see a split between ‘safety first’ and ‘probability driven’. This allows differentiation between retirement goals, requirements for longevity risk management, and evidencing capacity for loss.

Within the ‘safety first’ approach, the essential spending is covered, typically with a guaranteed product. The ‘probability-driven’ approach covers discretionary spending, with longevity risk owned by the individual.

Evidencing Capacity for Loss

To demonstrate how capacity for loss is measured for each element, consider a case study[1] for a 65 year old couple, with a 50/50 balanced portfolio and attitude to risk.

They need £20,000 pa; £8,000 for essential expenditure, and £12,000 for discretionary spending.

Essential income is CPI linked to age 100, with a probability of success of 95% to reflect a high level of certainty. This dictates that £335k is required, equating to a sustainable withdrawal rate of 2.4%.

Discretionary spending is plotted to age 85, with a 70% probability of success. £174,500 is required, equating to a sustainable withdrawal rate of 6.9%.

(Please refer to the full article for the worked case study).

Summary

Measuring capacity for loss in this way in decumulation pins down what the money is really for.

Taking income from drawdown can be complex, and demonstrates the part advisers play in managing client expectations.

Read our new Think report which includes a full version of the case study above.

Tony Clark, Proposition Marketing Manager, Just 

[1] Sourced with figures from FinalytiQ

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