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Your client&#39s future is in the balance

Over the last few weeks, I have been looking at certain aspects of pension

drawdown which might have escaped the attention of retirement income

advisers.

Among the issues I have examined, improvements in life expectancy and the

risk of interest rate reductions should both be acknowledged as adversely

affecting any decision in favour of drawdown. Against this, last week I

concluded that the interest rate risk must be considered in context.

Although falling interest rates would tend to depress annuity rates, the

client&#39s increasing age would partly balance out not only this influence

but potentially the influence of a decreasing investment fund.

The possibility of the investment fund falling is, of course, the other

major adverse factor to consider when looking at pension drawdown. However,

this week I would like to identify and quantify the true nature of this

investment risk and then suggest practical and provable ways of reducing

this risk.

What exactly do we mean by investment risk? It is far too glib to say this

refers to the possibility of the drawdown member&#39s fund falling in value.

Last week, I pointed out that even if the fund falls quite considerably in

value, and even if this occurs during a fall in interest rates, both these

adverse factors could be outweighed – up to a point – by the positive

factor of the member&#39s increased age at the time of annuity purchase.

Let us be clear about what we mean when we refer to a falling fund. During

a drawdown seminar earlier this year, one of the delegates voiced the view

that, of course, the fund will fall in value over the term of the drawdown

contract because the member will be making regular withdrawals. However,

against these withdrawals must be balanced the investment growth achieved

on the drawdown fund. Although this point is very obvious and simple to

understand, I fear advisers sometimes lose sight of this point. If the

member&#39s withdrawals represent 7 per cent of the fund, which achieves

investment growth of 6 per cent, then the fund will only be depleted by a

net 1 per cent.

Far too many advisers identify investment risk as referring to the average

rate of growth achieved on the fund over the drawdown period. But this

represents only one part of the risk. The other aspect is the risk that

particularly poor performance in the early years of a drawdown strategy,

especially if coupled with relatively high levels of withdrawals, could

decimate the residual fund to the point that even very high levels of

investment return in the later years may not be able to rescue the

situation.

The ideal drawdown portfolio will seek to achieve consistent investment

returns above a target annual rate of return, with a particular emphasis on

avoiding volatility in the early years of the strategy.

However, consistency and the avoidance of volatility always come at the

price of reduced returns, we have traditionally been told. This is where I

would like to return to a previous series of articles I wrote relating to

volatility, diversification and, more particularly, correlation of

investment asset classes.

Our textbooks advise us that risk and volatility within a portfolio may be

reduced by diversification. The more the portfolio diversifies, the lower

will be the reliance on any one of the constituent investments. Fine,

except that diversification will notmaterially reduce risk where the

selection of investments within the portfolio are likely to behave largely

the same at any time.

As an example, my firm was asked to review a suggested drawdown portfolio

which sought to reduce risk by diversifying between six funds. However, all

six funds were either entirely or largely invested in UK equities. Quite

simply, if the UK equity market fell, so would the value of all, or almost

all, of these funds.

For diversification to be effective, investments in the portfolio must not

be highly correlated with each other. The portfolio should, therefore,

include assets with low inter-correlations, meaning they will behave

independently of each other so that the poor performance of one of the

investments is unlikely to reflect in the poor performance of the others. A

portfolio diversified in this way will reduce risk and volatility

significantly.

A little reminder, here, of one of the most relevant parts of my previous

articles. Looking back over the last quarter of a century at the years in

which UK equities did not produce returns of at least 13 per cent, it is

important to note the assets which did produce returns in excess of this

figure. This, I hope you will appreciate, is not just a simple bit of

research. It could be argued that it gives pointers to which asset classes

behave well when equities perform badly, indicating low or negative

correlation.

The table of investment performance (below) does not need an investment

genius to work out that, although other major asset classes feature

occasionally as strong performers when UK equities underperform, property

is consistently there or thereabouts. Therefore, I will continue to suggest

that property should be an integral and significant part of any portfolio

which seeks to reduce risk by diversification away from equities.

Diversification is a strategy which should be considered for many

investment portfolios but for pension drawdown this is even more important.

By formulating such a portfolio, the chance that one or more of the

constituent assets will be performing well at any given time is

exceptionally high. To be fair, so is the chance that any one or more of

the assets will be performing badly.

But herein lies the rub – the drawdown member should not bother unduly

from year to year about the value of all his investments as he only needs

to make withdrawals of a relatively small percentage of his portfolio

(maximum 10 per cent). If his portfolio really has been structured in a

low-correlation manner, then the chances that at least one of his

investments has been performing well is very high. It is from this

investment, perhaps, that this year&#39s withdrawals may be made.

Think through this principle for each future year and, hopefully, you can

see the particular attraction of this strategy for drawdown members. More

about this in future articles. Next week, I would like to continue this

theme of investment strategies beyond pension drawdown to investment

portfolios generally, looking at the key issues raised in the Sandler

consultative document.

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