Historically, conventional thinking was that in the five years prior to retirement, you adjusted the asset allocation gradually away from growth investments which had been appropriate during the so-called ‘accumulation phase’, such as equities, towards non-equity investments which would provide a secure and growing income stream in retirement, often using annuities. This was fine when interest rates were 5% but when ten year benchmark gilt yields are below 1% as now, this isn’t going to work as inflation is higher than this level and the absolute level of income from say a £1m pot, is insufficient to live on. The risk of running out of money is very real. (Source: Bloomberg)
This is where alternatives such as infrastructure funds and other non-equity income generating assets such as specialist property vehicles have been making inroads into investment strategies as many yield up to 5%. However, they are not of the same risk as gilts and each carries their own risks which can be susceptible to changes in government tax policy, regulations and even Brexit. All of these are up in the air at the moment in the UK within this Brexit fuelled political environment.
An alternative approach, increasingly being considered, is to retain a higher equity weighting in perpetuity which can provide up to a 4% income yield without taking added risk relative to standard equity market risk. This has looked like a good strategy over the last ten years but we have enjoyed a ten year bull market in equities and so clients have enjoyed buoyant capital markets as well as a growing and secure income stream. This is when the often-ignored disclaimer comes in regarding past performance which should not be relied upon as a guide to the future. It should not be forgotten than in the ten years prior to 2009, the equity markets halved twice following the bursting of the Technology bubble and the Credit Crisis of 2008. Just imagine how it would feel as you retire on this equity income strategy for that £1m pension pot to reduce by 50% whilst you are drawing upon it, meaning there is less to recover when it eventually does. Also, consider the news headlines as well as the banks were going bust and company dividends being cut as the global economy collapsed. You would be watching your fund valuation 24/7 and worrying yourself sick.
This is referred to, in technical circles, as sequencing risk or pound-cost ravaging. In simple language, it is the risk of volatility affecting your capital and the income you are withdrawing from it, just at the point when markets are experiencing a prolonged and severe downtown. Let’s be realistic, if an investor decides to go into drawdown at age 55, he should plan his income stream for 30 years, in which time he could well experience at least two major market setbacks for whatever unforeseeable reason which doesn’t really matter as it is the outcome of collapsing equity markets that matters. At its extreme, the banking crisis of 1929 wiped out many a fortune from which there was little recovery for many years. Hopefully we have all learnt lessons from that episode but then again, that was what effectively happened in 2008 although Quantitative Easing saved the day and we avoided a prolonged depression.
So, what to do? As ever, a mix of well-diversified assets is crucial because you never know where the next crisis is going to come from or what effect it will have. A serious analysis of your attitude, appetite and tolerance to risk is vital. These are all different and need to be fully understood. You don’t want sleepless nights the next time the proverbial hits the fan and you want a strategy in place that will prepare you for that event because it will happen. Most important of all is to have a near-cash or cash buffer of at least 18 months’ income so that if you need to turn off withdrawals from your invested pot, you can, without starving. Similarly, you need a buffer replenishment strategy which is dynamically reactive to market levels and your fund valuation. In the good times, when values have grown above what is required, you should consider buffer replenishment and possibly even push up to a two-year buffer if markets are really racing away. This is similar to the methodology behind a with-profits bond where reserves are built up in the good times to be used in the bad times, thereby delivering a smooth, but sometimes lower return, over time. The lower return will be experienced during buoyant times and is the price paid so that higher returns can be enjoyed during lean times. The key is to know your required future cashflows and what portfolio value is your minimum threshold for long-term sustainability, both on the upside and downside, with a corresponding investment strategy that kicks in as thresholds are breached.
Investing during drawdown or the so-called ‘decumulation phase’ is complex and requires a dynamic approach which is often best provided under a discretionary investment management arrangement so that buffer replenishment and withdrawal cessation can occur in a flexible way relative to market conditions and ongoing fund values. Relying on a periodic annual review means that all dynamism is lost and will result in missed opportunities to replenish that all important buffer.
The value of an investment with Rowan Dartington may fall as well as rise. You may get back less than the amount invested.
Past performance is not indicative of future performance.
The information contained does not constitute investment advice. It is not intended to state, indicate or imply that current or past results are indicative of future results or expectations. Full advice should be taken to evaluate the risks, consequences and suitability of any prospective investment. Opinions provided are subject to change in the future as they may be influenced by changes in regulation or market conditions. Where the opinions of third parties are offered, these may not necessarily reflect those of Rowan Dartington.