Managing longevity risk

How to overcome sequencing risk in portfolios

Sequence of returns risk is a challenge, particularly right now with markets volatile in response to the impact of Covid-19.

The danger is that the timing of withdrawals from a retirement account could have a negative impact on the overall rate of return available to the investor.

We have witnessed the first bear market since the pension freedoms were introduced in 2015 as a result of Covid-19, with people relying on their pension fund to produce an income in retirement, being perhaps the most affected by such sudden market falls.

As Jon Scannell, distribution director for Legal & General Retail Retirement Income puts it: "We’re navigating a particularly unusual time right now but market volatility is inevitable."

While he says we all know to avoid falling into the trap of trying to time the markets, many people may be facing the problem of the market's own timing working against them.

He adds: "Those approaching retirement are likely to be in more secure investments and, therefore, better protected from volatility. However, for recent retirees the timing of withdrawals and level of drawdown at the end matters a lot."

So, sequence risk is especially damaging to clients drawing a retirement income, as there really is no way back if a portfolio is depleted by having to sell assets at low prices.

Hence, it really does need to be part of the conversation that advisers have with clients, to avoid it rearing its head later as an unwelcome surprise.

Mr Scannell adds: "The impact of ‘pound-cost ravaging’ early on in retirement can have a significant impact on the value of their assets and can, ultimately, leave them having to make difficult decisions about reducing or stopping their withdrawals to avoid eroding their pension savings.

"While you may have had these conversations upfront with your clients, it’s likely a difficult conversation at the point of having to make these changes. Having a level of guaranteed income to secure essential spend in retirement can, ultimately, provide clients with greater security and flexibility."

The cash buffer

Historically, people have used cash buffers as a way to reduce sequence risk, Adrian Boulding, chief innovation officer at Spire Platform Solutions, explains.

If the client’s portfolio contains enough cash to meet, say, the next three years of required pension, then asset sales can be deferred during the times when markets are low.

But the problem with this is the opportunity cost, as with Bank of England Base Rate stuck at just 0.1 per cent, cash in a portfolio is sitting idle earning only a nugatory return.

Also, the FCA is getting increasingly unhappy at large amounts of cash held in portfolios and increasingly asking whether that really is in the clients’ best interests.

Mr Boulding suggests one solution may be to incorporate an annuity into the portfolio.

He adds: “An annuity behaves very much like a corporate bond, and unsurprisingly, insurers themselves often invest the premium they receive for selling an annuity into corporate bonds.

“In terms of portfolio construction, the annuity should be seen as a replacement for some of the corporate bonds that the adviser or discretionary fund manager would otherwise have recommended.

“When the client is shown how two portfolios project forward stochastically – one containing corporate bonds and the other with the bonds hollowed out and replaced with annuity – they will see how this re-construction has de-risked the portfolio. For the same pension withdrawals, the risk of running out is reduced and the projected portfolio values in later life are higher.”

Where cash buffers negate sequence risk at a high opportunity cost to clients, using an annuity neatly passes that sequencing risk across to an insurer.

Anyone making a withdrawal from their pension while also suffering a hit on their underlying investments will struggle to make the money back, meaning they may have to reduce their income now or face the prospect of running out of money sooner than expected.

The difference in retirement outcomes as a result of the timing of negative investment returns can be significant, Tom Selby, senior analyst at AJ Bell, says.

He gives an example of where someone taking a 5 per cent inflation-adjusted income from their fund who suffered a 20 per cent hit in their first year in drawdown could see their pension pot run out after 18 years – three years sooner than if they suffered the hit 10 years into retirement.

By contrast, someone who enjoys 4 per cent growth throughout their retirement could take the same income for 25 years.

To put this into context, while on average life expectancy at 65 is 18.6 years for men and 21 years for women, a man has a 1 in 4 chance of living another 27 years, while a woman has a 1 in 4 chance of living another 29 years.

Mr Selby stresses: “This is exactly why drawdown clients who are taking an income from their capital need to build a sustainable withdrawal strategy and review that strategy regularly.

“There are various strategies in conjunction with regular reviews investors can use to mitigate the risk of sequencing risk or ‘pound-cost ravaging’.

“If clients have any other cash investments they might consider drawing on these first rather than selling down capital at a low point in the market to fund their retirement spending.

"This will give their underlying investments better opportunity to recover value after a market dip.”

Using just the ‘natural income’ a client’s investments produce can also mitigate the risk of pound-cost ravaging, although they may have to accept a variable income as a result.

This would have been particularly difficult in 2020, however, with many companies slashing dividends or stopping the payments altogether.

Why sequencing risk is a problem for decumulation investors

Chart 1 and chart 2 show examples of a £100,000 portfolio across a 35-year timeframe. 

Chart 1: No withdrawals

The reason that the ‘poor performance at outset’ line recovers over time is because when markets are weak, the portfolio is able to reinvest at lower prices (because no withdrawals are being made in this example).

Portfolio value therefore has the ability to recover and return to the long-term average over time.

Source: Brooks Macdonald

Chart 2: £5,000 per year withdrawal

If the portfolio enjoys good performance at outset, portfolio growth is able to overcome the amount of income being withdrawn, and portfolio value increases over 35 years.

If the portfolio suffers from weak returns at the outset and £5,000 of income has been withdrawn every year, the portfolio never has enough time to recover those initial losses

Source: Brooks Macdonald

According to Billy Burrows, retirement director at Better Retirement, there are two schools of thought; the first is to invest for the long term and reduce income withdrawals if there is a market crash and increase income if there is higher than expected growth; the second, is to manage the sequence of returns risk by adopting a variation on the three bucket approach.

Mr Burrows says: “That is cash or very low risk funds to pay income for 2 to 3 years, a medium risk fund and a longer term growth fund. The cash fund should then be regularly topped up from the other funds depending on market conditions.”

Although in theory this is fine, Mr Burrows explains in practice it is very difficult to know when to sell units in the growth fund to top up the cash fund.

"Personally, I think anybody who is not trying to manage sequence of returns risk, no matter how basic, is asking for trouble,” he adds.

Covid-19 has had a limited effect on funds which employ a lifestyling strategy, one which automatically switches pension savings into another fund which may be of lower risk.

Taking income

Caroline Cochrane, a director at Crandles and Co, says one can avoid the sequence risk by taking income without having to sell assets.

Annuities are not affected by sequencing risk as there is no investment element to the contract.

She suggests the following:

1) An individual could retain a sum in cash, often around two years income, which is drawn on for monthly payments and when markets stabilise sell another portion of funds to top up the cash account within the pension.

2) Or, depending on the income required and the assets within, one could draw the natural income from the pension. This would leave the capital invested but relies upon the variable income generated from dividends, interest payments and such like.

She adds: “Of course one must balance the pros and cons of all options and so a combination of all would likely be the best option.”

If a client has no capacity for loss then a lifetime annuity is the best option and this provides a guarantee for the rest of their lives, Ms Cochrane explains.

She adds: “If a client has low income needs and does not require a specific amount each month then the natural income from assets would be most appropriate.”

The lower the attitude to risk the lower likely income generated and this must be accounted for.

Ms Cochrane says: “Having funds in cash will provide a known income, for as long as the cash lasts and those with higher capacity for loss and higher risk may consider this the most suitable for them.

“For those with a higher risk appetite one could always invest with no buffer against sequencing risk as they may consider the advantage of all funds being invested more attractive than the consequences of sequencing risk in a falling market.”

Patrick Ingram, head of strategic partnerships at Parmenion, says reducing exposure to uncertainty can be managed by setting an appropriate balance or ratio between a client's level of guaranteed income with their minimum income and target income levels.

He adds: "If you can practically flex down from target withdrawals to minimum acceptable withdrawal levels you will be able significantly to avoid the impact of sequence of return risks and if you don’t have an exposure to potential falls in income because your secure income levels are high, the challenge is significantly offset."

ima.jacksonobot@ft.com

Why balancing varying needs against the pension pot is vital

With longevity comes different needs and varying calls on the pension pot, which our forebears may not have had to consider.

For example, some families now rely on the older generation to help fund the youngest generation's educational or housing needs; other people who are enjoying good health later on in life are thinking more about taking the holidays of a lifetime they had always dreamed of while working. 

Indeed, some clients have been very well paid all their lives and have sufficient funds to do everything, have a comfortable retirement, be able to afford long term care and still have funds to pass to their family, but this potentially will not happen for many clients. 

In theory, according to Emma Byron, managing director for Legal & General Retail Retirement Income, people ought to be able to maintain a sustainable income in retirement, leave a legacy on death and fund care costs if required in the future.

In practice, trade-offs often have to be made. "Therefore the main priority for most will be to have enough income to enjoy a comfortable retirement."

But recent research from the Pension and Lifetime Savings Association has shown that for a ‘comfortable’ retirement, an individual would need approximately £33,000 per year (£47,500 for a couple).

‘Comfortable’ is defined as the ability to cover three weeks of holiday in Europe each year, two cars replaced every five years, £91 per week on food, up to £1,500 per person on clothing and personal expenses a year, and the opportunity to replace the kitchen or bathroom every 10 to 15 years.

She comments: "While it’s easy to imagine that those seeking financial advice are likely to be able to cover this amount from modest returns on their investment portfolio, even a £400,000 pot in drawdown, combined with a state pension of £18,221 per annum, may not provide enough for a ‘comfortable’ and sustainable income."

Care or home help needs

While mortality decreases due to medical advances, morbidity - the rate of disease in a population - increases, because people no longer die from certain conditions, instead they are spending more time with disabilities or in an unfavourable state.

So how can advisers help clients balance their  retirement portfolio to allow for income while also keeping a capital sum invested to help pay for future needs such as care or leaving an inheritance.

The Pensions Policy Institute says to be able to retain the sums of money required to fund long-term care would only be available to those with large amounts of savings. 

These individuals should consider personalised advice that considers the entirety of their financial situation including property and other financial savings. 

They may want to optimise their tax situation as holding a large amount in a pension that needs to be withdrawn at once could present a hefty tax bill as it will all be treated as income.

Passing on an inheritance

For many people at retirement age and above passing money to loved ones will be a primary consideration. 

Rules introduced in 2016 mean that Sipps are now extremely tax efficient on death, and can be passed on tax-free to nominated beneficiaries if the holder dies before age 75 and at their beneficiaries’ marginal rate of income tax if they die after 75. 

Tom Selby, a senior analyst at AJ Bell, says because of this generous tax treatment, where passing money on to loved ones is a priority, it can often make sense for the pension to be among the last assets a client touches.

Mr Selby adds: “Although death might be certain (if unknown) for all clients, long-term care needs are much harder to predict and so tricky to plan for.

"There are insurance products available for those who want to insure against this risk – such as immediate needs annuities – but the market is relatively limited at the moment, in part because the care costs an individual might face are difficult for insurers to quantify.”

One option, if a client can afford to, is to earmark a portion of their pension pot for long-term care (if needed) and invest this in relatively low risk assets. 

However, the trade-off here will be that a client might sacrifice the possibility of longer-term growth – particularly if their investment time horizon is 10 years or more.

Mr Selby says: "This is one area where good quality advice involving regular client reviews can be of crucial importance." He adds this needs continual oversight, especially if care needs have to be factored into the plan. 

Other income needs

But for Caroline Cochrane, director at Crandles and Co explains, pensions were not designed to be passed to the next generation and clients should be aware that although pension funds can be passed as pensions to their children and others, the primary reason for a pension is to provide an income in retirement.

There are still bills to be paid, holidays to be taken, hobbies to be enjoyed, gardens to be tended to and food to be eaten.

Not for nothing have successive governments pandered to the 'grey pound', seeing the potential spending power of a generation of people who want to spend retirement doing the things they enjoy.

Home improvements, also, are a common reason why pension clients often opt to take their 25 per cent tax-free cash upfront, so they can create a living space in their homes, where they foresee themselves spending a lot more time than while they were working.

However, upgrades and maintenance itself also needs to be considered - and this will end up being a call on the income from the portfolio. 

Therefore, Ms Cochrane says clients passing these funds to the next generation should consider this as a bonus and not as part of retirement planning unless there are very substantial funds.

The flexibility of pensions means that if the client requires care then income payments from the pension can increase to meet some or all of these costs - although not all powers of attorney allow changes to be made to a pension plan.

Additional pension payments will be taxed, so if a client has funds which are not pension then they could purchase an immediate needs annuity and if paid to a care home has no tax charge on income.

As a result, Ms Cochrane believes equity release is increasingly being signposted as an option for funding needs, such as long-term care or significant home improvements. 

She adds: “If a client’s income and pension funds are not sufficient to provide for them for their lifetime then one should consider the option of equity release on the family home.  

“Often this is the largest asset but is not accessible unless one sells or arranges equity release. Equity release can be flexible, not only providing a lump sum if required but also a regular income.”

Trade-offs

Essentially, as Ms Byron comments, humans are "naturally drawn to the here and now. When considering trade-offs, present bias refers to the tendency to favour the pay offs of something happening now vs in the future.

"That means clients are likely to think in shorter time horizons, finding it difficult to fully engage with the more holistic planning conversations you have together. Trying to use their shorter term goals as a way of showing the longer term impacts may be one way to highlight this bias."

This is why she advocates discussing their basic income requirements, as shown by the PLSA, and developing plans that secure this amount can provide added flexibility for the rest of a client’s assets.

Cashflow planning 

Billy Burrows, retirement director at Better Retirement, says a detailed cash flow will help to identify the amount of income required in the future and a good adviser will model a number of scenarios including the need for expensive health care in later life.

Adrian Boulding, chief innovation officer at Spire Platform Solutions, agrees. 

He says: “It’s really useful for clients to see their income needs planned out to an advanced age, say age 100. This cashflow approach can show how essential needs and lifestyle expenditure will change as age creeps up on us. 

“And how the residual capital is projected to behave, so the client can feel reassured that those longer term aspirations such as inheritance, or home alterations are catered for.

“Incorporating an insured product that provides a guaranteed income for life into the portfolio de-risks these long term projections, as the client can see that essential bills will always be covered, in even scenarios that look at periods of poor investment returns.”

ima.jacksonobot@ft.com