David Lane - Partner and Technical Director, LGT Vestra LLP
The general consensus is, new(ish) pension freedoms introduced in April 2015 look and feel ‘right’. The underlying principle of the reforms is that people in retirement should be able to experience a greater amount of control over their money. The way people retire is very different, the handshake and the watch have disappeared. People are generally living longer and expecting more from their later years. This brings huge challenges!
Firstly, the traditional haven for buying a secure level of income and providing an insurance policy against living too long (otherwise known as an annuity) has fallen out of favour. Annuity sales have reduced significantly since April 2015 and, with gilt yields being where they are, the cost of an annuity has become very expensive. That is a shame as an annuity for many people instinctively still feels right. That said if people are not annuitising their pension pots but remaining invested and drawing an income, then they are facing a number of threats. Let’s look at a couple.
The first is market volatility. Research seems to suggest that people who are either approaching or in retirement become more risk averse. That could be a problem where capital growth and/or a rising income are required. And yes, volatility does matter. Yes, it is appreciated that volatility is a measure of risk as opposed to being the measure of risk but in terms of planning for clients, “restricting volatility during the retirement phase can give a much greater certainty of outcome”[i]. In other words, there is a significantly reduced chance of the pension pot running out as “limiting the volatility reduces the number of potential outcomes and the extremes – both good and bad - are eliminated”[ii].
The second key challenge linked to the volatility aspect described above is how investment returns are delivered to an investor. The “sequence of returns” is, again, crucial to a positive investor outcome. Poor returns in the early days of a portfolio’s life combined with taking withdrawals can lead to “volatility drag” and permanent capital destruction. However, there are strategies that can help. For example, retaining cash to provide income for the early years of a portfolio can be helpful. Mixing and matching annuity and drawdown strategies. Putting in place an appropriately invested multi-asset portfolio that manages volatility and sequencing risk with regular re-balancing. This in itself is not a panacea as “those who engage in regular rebalancing should consider changes in relative valuations of asset classes from time to time... (as) correlations between asset classes can and do change markedly from one period to another”[iii]. What is clear is that the most effective solution differs from person to person and professional advice should always be taken to navigate these difficult waters.
[i] Andrew Tully “Combatting market volatility in retirement” November 2016
[ii] Andrew Tully “Combatting market volatility in retirement” November 2016
[iii] Ned Cazalet “When I’m sixty-Four” September 2014.