The industry must find new ways to take care of all those swapping guaranteed income for the uncertainty of the market
I attended a presentation entitled ‘Successful Withdrawal Strategies for UK Retirees’ the other day. It was pretty depressing. The first point made by presenter David Blanchett, Morningstar’s head of retirement research, related to Bengen’s 4 per cent withdrawal rule.
Blanchett reminded us the rule did not suggest 4 per cent of the investment increasing in line with inflation was a reasonable rate of withdrawal for a 30-year term. In fact, it suggested 4 per cent of the fund increasing with inflation was a maximum withdrawal rate.
Anyway, it has worked out pretty well in the US so far, based on a 50/50 bond and equity portfolio with all income reinvested. That was the good news.
The bad news was that Bengen’s rule did not work out at all well when using the same approach to historical UK market data. In fact, the money ran out.
Blanchett also presented forecasts for inflation and a 60/40 equity and bond portfolio, and calculated how likely it was that data could support 4 per cent of the amount invested increasing with inflation for 30 years in future.
Now, of course, forecasts are just forecasts and are no more reliable as an indicator than past performance. But they have to be factored into the thinking, even though we know no one knows what is going to happen next week, let alone in the next 30 years.
It was not an encouraging picture. Based on a retirement period of 30 years and total annual fees of 0.5 per cent, there was a 34 per cent chance of success. With a total charge of one per cent per annum there was a 25 per cent chance and with a charge of 2 per cent per annum, just an 11 per cent chance. If the retirement period was reduced to 25 years, these numbers increased to 56 per cent, 46 per cent and 27 per cent respectively.
So, what do we do about this? Reduce the withdrawal rate? Encourage clients to defer retirement? Keep our fingers crossed? I think there may be some more attractive options.
First, reduce costs across the entire value chain. Where the rubber meets the road is in active management. The future looks challenging for a few players. In fact, the future for most active fund managers may be uncertain.
There are now many more funds than there are stocks traded on the stock exchange, and direct investment in shares can be cheaper than buying a fund. Perhaps one way to reduce the cost might be to have a Sipp invested in direct securities rather than funds.
More index funds
Second, more index funds. But not conventional ones. Perhaps new indices could be created where the criteria are based on companies with a history of producing returns which work well for people looking for income in retirement and bonds which might be held to redemption.
You may remember the study based on monthly US share data from 1968 to 2011 which looked at 10 million indices weighted randomly.
These ‘monkey’ index funds consistently delivered much better returns than the traditional market weighted approach. There must be possibilities here.
Think about the client’s home
Third, be more open-minded about the entire client wealth: not just their investments but other assets, such as their home. I predict great opportunities for the equity release market, not just as a last resort but in the planning process. After all, most of the clients we are talking about will have children in their 40s who are likely to own their own homes.
Using equity release to provide income rather than a lump sum can be quite an attractive proposition as part of a retirement plan, as well as a back-stop if – or when – the pension fund runs out of money.
I do appreciate the many challenges of advising in this space, not least the time cost and the low initial commissions if it is an income rather than lump-sum arrangement. Perhaps a solution would be to work on a fee basis instead.
Finally, we need to talk about annuities. When long-term interest rates increase, annuity rates start to recover and clients work longer, the dynamic will start to change.
The Bengen rule is based on the premise the fund is exhausted at death. So is the annuity ‘rule’. When we start looking at a maximum income of 4 per cent with a significant risk of it not lasting a lifetime, compared with a guaranteed income which will, an annuity has to be on the table at some stage.
In any event, we need to find new solutions in the retirement income space. It is a huge market that is growing exponentially. A recent Office for National Statistics report showed that £5.4bn was withdrawn from defined benefit schemes in 2014, compared with £34bn in 2017.
This represents a massive opportunity but it also presents a challenge. How will we take care of all these people swapping guaranteed income, albeit with some caveats, for the uncertain environment of the market?
If we cannot come up with some ideas, then many of these clients should be left where they are.
Malcolm Kerr is an independent consultant. He will be speaking at the flagship Money Marketing Interactive conference on 3 May – book your place now at http://mmi.moneymarketing.co.uk/