Over the last few weeks, I have been looking at certain aspects of pension
drawdown which might have escaped the attention of retirement income
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's 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
What exactly do we mean by investment risk? It is far too glib to say this
refers to the possibility of the drawdown member's 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's 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's 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
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
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
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's 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