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Ups and downs of drawdown

This week, I will conclude my short series of articles in which I have examined and discussed the nature and the extent of the main risks involved in pension drawdown.

In my last article, I concentrated on investment strategies, noting the different types of asset class which could be included and identifying the possible or probably likely future rates of return from each.

I developed a model portfolio based on a client with a fund of #200,000, after taking tax-free cash, requiring an income of #10,000 a year (below). Note that the construction of this portfolio pays attention to the fact that different asset classes might be expected to be more appropriately encashed over different time periods – most obviously, cash or deposit monies over the short term and equities over the longer term.

I concluded with a number of points which remain to be addressed from this example and the underlying strategy. First, note that this portfolio anticipates a return of a little over 5.5 per cent a year (#11,325 as a percentage of the #200,000 available monies), which more than matches the client’s withdrawal expectations of #10,000 a year while maintaining the initial capital intact.

Moreover, we have only used up #150,000 of the initial investment and have not taken account of changes to longer-term returns and income needs.

As regards the unused #50,000, this appears to be superfluous if the client’s income needs do not increase over the coming years and if our projected returns from the different asset classes prove accurate or conservative. Of course, this money should be invested and, depending on the client’s attitude to risk, could be divided roughly proportionately to the assets in the main portfolio or perhaps with a heavier weighting towards more rewarding asset classes such as property and equities as, arguably, access to it is not likely to be required for the foreseeable future.

With regard to changes to longer-term returns, I would suggest that these should be an integral part of an annual review with the client, including a possible rebalancing of the portfolio. If I continue our earlier example, at the end of year one, I suggest a full review of the portfolio would be appropriate. This should include a valuation of the performance of the different asset classes over the previous year and a review of future likely returns from each of those investments.

For example, we assumed at outset that returns from strat-egic bonds were likely to be6.5 per cent a year, with returns of 8 per cent from property and 8.5 per cent from equities.

With #45,000 of the core portfolio invested in commercial property, if the actual return over the last year was only, say, 5 per cent, the revised projections must take account of a loss from the plan of #1,450 (3 per cent underperformance on #45,000).

Moreover, if at the time of that review the revised outlook for commercial property has fallen to, say, 6 per cent, future projected income returns from the portfolio must be adjusted downwards. The same calculations should be made for other constituent asset classes.

Of course, one would hope that underperformance and reduction in projected future returns will not apply to every constituent part of our portfolio and so we might expect some past or projected gains to at least partly offset or, ideally, more than outweigh any losses.

To illustrate these points,I will revise the example portfolio at the end of year one making the following assumptions and amendments (below).

Note that I have reduced or increased the initial investment according to their year one performance. I have assumed that all the portfolio return generated in that year (expected to be a little over #11,000) has been withdrawn by the client. From this review exercise, we have identified the fact that the client’s fund at the end of the first year has overall fallen in value slightly but this small reduction, coupled with lower projected future returns, has led to the estimated annual returns to the client falling by around #1,000 to a level only just higher than his income needs. If it were not for the existence of the surplus fund – which, in this example, it might be prudent to view as a contingency fund – the client’s attention should perhaps be brought to the possibility that his income needs might not be sustainable in the longer term.

A further enhancement on this review process might be to obtain an illustration of the level of conventional annuity which could be bought at that time from the residual fund. Although the fund has fallen slightly in value, the client is a year older and so, interest and mortality assumptions being equal, one would expect that the client could secure a higher annuity than was available at the outset. If this is the case, if the client has become nervous about remaining in the drawdown contract, consideration should be given to switching the client to the conventional route, albeit much earlier than anticipated.

In summary, although these procedures might appear a little unwieldy at first sight – and perhaps far more detailed than some advisers currently undertake – I would humbly but strongly suggest that clients’ expectations can be more accurately handled and potential ongoing problems with a drawdown contract (especially as regards investment performance and projected performance) can be identified and dealt with very quickly and, certainly, many years before the client actually loses more money and/or income than he or she is prepared to accept.

Finally, at the end of my last article I posed the question as to whether, in determining which asset classes to encash each year, should the client necessarily stick rigidly to the original plan? In other words, for example, should he always take withdrawals from the cash element in the first year or two? I would suggest not. If, by the end of the first year, equities have performed much better than anticipated – for example, if they have increased in value by 30 per cent – surely it might be sensible to take some of the profits from this fund, leaving the cash element for a rainy day when perhaps most or all of the other assets have underperformed in the short term. This is something to think about, surely?

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