One of the key findings of the FCA’s thematic review of retirement income advice is that firms are not adequately assessing risk for retirement income clients. Many are not using a different approach to assessing risk appetite in retirement, nor are they sufficiently exploring capacity for loss.
In the context of retirement income, capacity for loss is defined as the ability to withstand a reduction or change in retirement income. The FCA recognises that this could come from either a capital loss reducing the value of savings, and so the income that can be sustainably withdrawn from those savings, or inflation reducing the purchasing power of a fixed income.
Of course, assessing clients’ risk appetite and capacity for loss is just part of the diagnosis. Identifying an income withdrawal strategy and an investment approach that is aligned with this assessment is where the real challenge lies. But what might this involve?
While the FCA review does not insist that different investment approaches are needed for clients taking retirement income from those used for clients accumulating wealth, it is implied. A key theme of the review is that products and services recommended by firms need to be suitable for a client’s specific circumstances. The review also makes it clear that the nature of risk for clients taking retirement income is different from those accumulating wealth. Taken together this suggests that different investment approaches are needed, but few firms are doing this.
See also: BNY Mellon’s Parkin: The changing nature of retirement advice
The FCA review found that only 30% of firms were operating portfolios that are specifically designed for retirement income, and this is consistent with our own research. Others have suggested the proportion may be even lower. It seems that many firms will have to think again about offering dedicated retirement income portfolios.
Income requirements
Much focus has been put on using stochastic analysis to determine how likely a total return portfolio is to sustain a client’s income requirements. While this is a valid approach, it is fraught with danger. Any analysis will be based on capital market assumptions which may or may not be an accurate description of future returns. More importantly, no matter how many scenarios we model, there will be only one market outcome and that is the one that matters. It therefore makes sense not just to focus on the probability that a given investment strategy will meet client needs but consider how it might be specifically designed to do so.
Surprisingly, income-led strategies have historically been the least used approach to deliver retirement income. There are many reasons for this but one of the most cited is that it has been difficult, if not impossible, to generate a reasonable level of income without taking significant risk and/or being focused on a limited investment universe which could exclude more profitable opportunities. However, since yields have returned to “more” normal levels, interest in using natural income, that is the income generated from assets in the form of interest and dividend payments, appears to be rising.
It’s important to recognise though that just using the income share class of a fund focused on total return is unlikely to be the best approach . If the fund manager is not actively managing the portfolio with income as a specific goal, then the level and stability of income may not meet most clients’ needs. Furthermore, some income focused funds may aim to maximise yield, and this may come at the expense of capital growth which could damage the ability to support income over the long term.
Income distribution
Portfolios that are managed to generate a stable and growing income distribution in cash terms are likely to be more aligned with client needs. Their income focus means they should be able to deliver outcomes consistent with clients’ capacity for loss as defined above. Even if clients need more than natural income alone can deliver, income-led strategies may still be useful. Income focused portfolios can be managed to have inherent characteristics that make them more reliable when drawing on capital. These include potentially lower volatility, lower downside, and faster recovery from market stresses than more growth-oriented funds.
See also: Retirement income advice – easier said than done
Another barrier to using natural income for some has been the operational complexity of managing this for clients. Not all platforms are able to simply pay natural income directly and income can sometimes get diverted to pay for fees or be unwittingly used to rebalance portfolios. Some platforms can manage natural income more effectively, however in any case an easy approach is to use the accumulating share class of an income-led fund and meet income payments through selling shares. Provided withdrawals are aligned with the underlying natural income being generated then the overall outcome for clients should be very similar to taking the income.
Advisers will likely need to utilise a suite of solutions to meet the varying needs of retirement income clients. These will include secure income options alongside investment funds and perhaps other new approaches that have yet to see the light of day. But given the obvious alignment between the features of income-focused funds and client outcomes, an increasing use of natural income seems inevitable.
Richard Parkin is head of retirement at BNY Investments
