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Play it by year

In my last few articles, I have identified the nature and extent of the main three risks of pension drawdown – interest rates, increasing life expectancy and investment performance. In this article I will pay attention to strategies which not only seek to minimise the investment performance risk but turn it into a calculable advantage.

Over the years, I have presented seminars on a number of investment strategies and here I will relate these to drawdown. First, I feel it is important to be aware that the reason why many drawdown clients have lost money in the last few years has been concentration on a single investment fund.

Many of the earliest drawdown contracts invested in a single with-profits fund. Quite apart from the subsequent demise of most with-profits offerings – in particular, Equitable Life – the crucial aspect of such a strategy is that the fate of the future retirement income rests with the performance of a single fund.

During the 1990s, it is a matter of record that many drawdown contracts invested in a single managed fund. This was simply an updated version of the original with-profits mistake. If this single fund performs badly, the client will be withdrawing retirement income from a falling fund. If the fund continues to fall in value and the client continues to withdraw money from it, the fund could fall to such a low value that even subsequent outperformance will not be able to rescue future pension prosperity.

Even more recently, I am aware of a number of financial advisers who have been instructed to diversify clients’ drawdown strategy between at least, say, four or six funds. This is without doubt an improvement on past practice but a number of advisers have simply diversified their clients’ pensions between four or six managed funds. Noting that most managed funds invest almost entirely in UK equities, this leaves the client almost entirely reliant on the performance of a single investment market.

To cut a very long story very short, blind diversification between funds which might be expected to perform very similarly over a period of time is unlikely to help the client. What investment strategies could be utilised to the likely or probable benefit of the client?It is important to note that drawdown requires encashments of part of the fund at regular intervals over a long period of time. Surely an investment strategy should recognise this fact and combine assets to attempt to ensure that these encashments should not have to be made out of funds which are performing badly at any particular point in time?Suppose a client has a fund, after taking tax-free cash, of 200,000 and plans to withdraw 10,000 a year for the foreseeable future. Does it not make sense to arrange his investments between assets which might be appropriate for a range of investment terms?For example, the first two years’ encashments could be invested in readily realisable and very low-risk investments – deposits being the obvious choice but, alternatively, a low-risk structured fund.

Then we can consider the money which is likely to be required in three to five years. Perhaps a good corporate bond or property fund could be considered. Against deposit of around 5 per cent over one year, gilt redemption yields over almost every term are around 4.5 per cent and thus offer attractive shortto medium-term value only if one expects interest rates to fall quite significantly.

Many commentators believe high-grade corporate bonds offer little better value, with few AAA, AA and even A-rated bonds offering redemption yields less than 5 per cent. It appears to remain the case that whatever value can be identified in corporate bonds lies in the mid-range and higher-yield sectors.

A well managed strategic bond fund (those concentrating on lower investment-grade and higher sub-investment-grade issues) or higher-yield fund could be appropriate for the shortto mid-range money within a drawdown contract. An annual return of around 6.5 per cent appears realistic for strategic bonds, it appears.

Commercial property is a continuing success story. Over each of the last three months, the Investment Property Databank index (to be found at shows that total returns from property – rental income and capital growth – have been around 1.5 per cent, indicating an annualised growth rate of 18 per cent.

Rental yields have been around 0.5 per cent a month during 2004, indicating a reasonably confident outlook for commercial property to yield at least 6 per cent a year for the foreseeable future. Note that rental yields should be expected to fall if capital values rise.

Talking to a number of leading property fund managers, I believe annual returns of, say, 8 per cent to be realistic, allowing for the fact that most of these funds contain quite significant amounts of cash.

The drawdown plan for years one to five is shown in the first table below. Looking ahead at years six to 10, few would argue that equities or equity-based funds should appear. I am going to project equity returns at 8.5 per cent a year for the purposes of this example, without repeating explanations for this reasoning in my previous articles.

For a typical risk-minded client, I would suggest that planning for this tranche of years should not concentrate entirely on equities and perhaps a 20/40/40 strategy between bonds, equities and property might be appropriate. This would lead to the strategy shown in the middle table.

For years 11 to 15 (using a 60-year-old retiree as an example), one might conclude that a largely equity-based allocation would be most appropriate but I would contest that the allure of commercial property is too strong to ignore. I suggest a 80/20 split in favour of equities. The final portfolio is shown in the last table, with the addition of a total expected return. The portfolio anticipates a return of a little over the 5.5 per cent a year required to match the client’s withdrawal expectations.

Note that we have only used 170,000 of the client’s initial investment and have not taken account of changes to longer-term returns and income needs. I also have not yet considered possible rebalancing of this portfolio in future years.

My next article will deal with all these crucial issues but for now I hope I have illustrated the benefit of a well-structured portfolio for drawdown. Think on the following point, though, before my next article. Although we have notionally allocated cash for the first couple of years’ income, suppose equities have enjoyed a couple of tremendous years’ returns. Do we stick to our original plan or do we retain the cash and take some profits out of the equity part of our portfolio?


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