Investors in decumlation cannot afford to take as much risk as they do during the accumulation phase of their lives, so they need to change their investment strategies. The question is: what strategies should advisers recommend? What should their centralised retirement proposition be?
Clients have a lower capacity to sustain losses when they are in drawdown. This is partly because they face sequencing risk, meaning any large early losses can have a hugely disproportionate impact on the long-term potential to take both capital and income from the portfolio.
It is also partly because of reverse pound cost averaging, which means they draw down more units or shares when values are low and less when they are high, exacerbating the volatility of their investments rather than smoothing it out.
The combination of these factors reduces the longevity of their finances and the danger they will run out of cash before they die.
Bucketing is an approach to reducing risk during decumulation advocated by many advisers. It involves dividing the client’s portfolio into, say, three sub-portfolios with different timeframes.
The short-term bucket would be focused on providing for the immediate future – to cover the client’s expected expenditure over the next year or two, possibly longer. This bucket would be invested in very low volatile assets that could be drawn on without any expectation they would fall in value. Such assets might consist of cash deposits or short-term bonds.
For most, the appropriate currency would normally be sterling unless the client has planned overseas expenditure. A general strategy of holding other currencies might be tempting in the face of Brexit but it would increase risk.
The next bucket would be for the medium term – perhaps three to seven years. These investments might be longer-term bonds or even lower volatility equities. Enthusiasts for structured products might also feel they could fit in here. The aim would be to have a degree of income and growth on the basis the client could afford some volatility in capital values within this bucket over the longer time scale.
The third bucket would be firmly aimed at long-term growth, with a strong equity bias. Given that someone retiring in their 60s could quite possibly live for another 40 years, it is important to keep an eye on protecting the long term.
But while all of this sounds entirely sensible and is indeed the conventional wisdom among most advisers, there are a few wrinkles to be ironed out in practice, especially when deciding to use the model as a centralised retirement proposition across a firm.
First of all, how do you decide on the relative size of the buckets? How many years’ expected expenditure should they represent? Some argue that it should be long enough to run for the duration of a bear market. A series of perhaps two or three years might be adequate. But it is always worth remembering that the early 1970s UK stockmarket high was not achieved again for nearly 10 years by some measures. So choosing the size of the safe bucket is not straightforward.
Then there is the question of how much of a client’s portfolio an adviser should recommend be placed in investments almost bound to decline in value? Enough of a total portfolio to cover just one year’s expenditure might seem excessive on this basis.
And how should the buckets be rebalanced over the years, as the client’s expenditure eats into the first bucket and needs topping up from the second or possibly third bucket? Advisers who are comfortable with making market-timing decisions should find this less challenging. However, others might find it trickier.
In normal times, ordinary asset allocation rebalancing should provide most of the answers. But trying to do it in a bear market could mean reintroducing some sequencing risk and reverse pound cost averaging.
There are few discretionary fund managers who run their model portfolios to meet the needs of advisers practising bucketing. However, running a client’s portfolio from typical DFM portfolios will require a degree of compromise with a standardised approach.
Of course, there are those who might say with some justification that the bucketing approach is just another way of describing a portfolio with a mix of different assets, which should be drawn on at different times. They might argue that clients in decumulation should simply invest in rather lower risk portfolios.
Danby Bloch is chairman of Helm Godfrey and consultant at Platforum