I spent last week out and about speaking to advisers. As usual, the conversations were full of fascinating insights into the practical day-to-day reality of managing clients’ wealth. The focus was on income drawdown and the challenges posed in getting it right.
The shadow looming over the discussions was, of course, pension freedoms. In asset management, we are obsessed with sequence of returns risk in drawdown, or pound cost ravaging as its sometimes known. There is a rationale for this focus: for those relying on income from drawdown to pay the bills and live their life, mitigation of this risk is profoundly important.
But what became clear to me in those conversations is how few of those clients in income drawdown are reliant on the assets for the predominant part of their retirement income.
They have other sources of income and wealth; generally final salary pensions and property. To this extent, income drawdown is a luxury, not a necessity, for advised clients. The risk of ruin is a not a real one for this segment.
This perspective from the ground level chimes with the research done by the Pensions and Lifetime Savings Association into the first cohort – what they call the pioneers – for pension freedoms. Three distinct groups emerged from the study: those taking action, those thinking about taking action and those disinclined to act.
The first group (400,000 strong) are the new entrants into drawdown, advised or non-advised, and it is their particular financial circumstances that underpin the picture of the drawdown landscape as currently constituted. These “actioners” are as follows:
- Wealthy, holding £50bn in defined contribution pension wealth in total
- The majority are already retired
- The majority already have access to other pensions in payment
- Forty per cent already have experience of Sipps or drawdown.
So, income drawdown offers them flexibility and choice without the risk of ruin. No wonder the advisers I spoke to are not obsessing over sequence of return risk for this client bank.
Harnessing the equity risk premium appears an eminently sensible strategy, so long as the drawdown pot is supplying discretionary and not basic income. After all, equities have historically outperformed other asset classes over every 20-year period for which records exist.
At a time when traditional insurance against falls in stockmarkets (for example, buying bonds) is historically expensive, and truly diversified multi-asset is hard to find, equities make sense if the client has other resources such that volatility can be ridden out and losses left uncrystallised.
The question is what happens if drawdown becomes the retirement income option of choice for another group identified by the PLSA research – the “investigators”.
This is a cohort of 1.75 million individuals still working but due to retire in the next decade or so, and largely reliant on DC pots for their retirement income. It is at this point that the risk of ruin becomes real. As we know, equity markets can go down as well as up.
Large falls in the FTSE have occurred several times in the last 30 years. It is in the nature of investment risk. For someone utterly reliant on drawdown, black swan market events become a genuine, if by definition, unquantifiable risk.
In such circumstances, riding out volatility without harm becomes a real challenge for those for whom drawdown is a source of basic income. Crystallising losses, cancelling units; these actions become hard to avoid when there are necessary bills to be paid. This is when drawdown moves from a discretionary income source to a more basic one (alongside the state pension).
We are not there yet, of course. The first truly DC generation of retirees have not yet, well, retired. But when they do, mitigating risk of ruin will become a real thing. Advisers will then truly come into their own.
When the stakes are so high, good ongoing advice becomes paramount.
Gregg McClymont is head of retirement at Aberdeen Asset Management