In March 2024, the FCA brought forward a thematic review of retirement income advice, calling into question the level of risk customers were exposed to in their investments and if the strategies were fit for a decumulation approach rather than accumulation.
The review came after nearly a decade of transition for the advice industry following the pensions freedoms legislation in April 2015. Before this legislation, most used their pensions to purchase an annuity, which established a system of guaranteed regular income in retirement. After April 2015, people were allowed more freedom with how they dealt with their pension pot, with some choosing to invest separately.
However, the choice creates a potentially more volatile situation for those entering the retirement stage, causing the FCA to raise the question of how these investments were being handled. While advisersfound themselves prepared and expecting to offer accumulation strategies, the FCA said not all firms were accounting for the “differing needs of their customers in decumulation,” and called for a reassessment of the risk profiling for this group.
Chet Velani, managing director of EV Financial Solutions, said: “This is where this different measure comes into place. Up until nine years ago, it wasn’t even really a consideration for a lot of advisers.
See more: BNY Mellon’s Parkin: A natural response to the FCA’s retirement review
“So we’re still stuck in a way of using a process that’s better suited to accumulation. But what our research is starting to show is that as people start to consider an income objective, a lot of the funds that are being used for drawdown are not suitable.”
In accumulation strategies, risk is often measured by volatility, making cash and bonds ways to de-risk a strategy. But Velani explained that in decumulation, volatility is not necessarily the right metric for risk, as the objective is having a sustainable income rather than increasing the pot size.
The change in objective, while using the same strategies as accumulation, has led to clients taking on more risk than they intend to, the EV solutions team found. In the FCA’s review, they identified that cautious-to-medium risk retirees are often being exposed to too much risk, a category that, according to EV, accounts for 85% of retirees.
Bruce Moss, founder of EV Solutions, said: “If you are trying to do something different with your money, you would think you would need to invest it differently. But that’s not what typically is going on. People are trying to work out how much risk tolerance people have, and traditionally, that has been done on volatility. But actually it should be done on what your goal is.
“If you’re trying to accumulate money, then yes, volatility is not a bad proxy, because you don’t want massive amounts of volatility. But if on the other hand, you are decumulating, and you’re retired and you’re trying to provide an income for the rest of your life, then you have a very clear objective. You don’t want your income to go down, you want your income to last for a lifetime.”
Doug Brodie, CEO of Chancery Lane Income Planners, said ultimately an investment strategy for someone retiring should ensure that capital cannot be lost, as there is not a way to replace lifetime earnings, and it must deliver reliable income. Though he pointed out that as onboarding processes are cut down in time, clients may have a more unclear picture of risk.
“The definition of risk has to be rewritten for all, because retirees now need income to fund retirement and not capital,” Brodie said.
“Just as annuities deliver a 100% capital loss in return for income, so hybrid investment solutions must be seen to be splitting capital and income risk. The gap currently exists because the rules to date have been written by the institutional industry to meet the needs of schemes and funds, but not for individuals.”
See more: How should risk tolerance assessments differ between accumulation and decumulation?
As adjustments occur to fit decumulation, findings from EV have shown a gap in the market for products that offer low enough risk levels to fit client risk appetite. In their findings, while a significant proportion of clients sit at the low end of the risk spectrum, with about 25% of clients at a risk level of three or below on a scale of 10, there is a lack of products available at this level.
“There is a great opportunity for asset managers and product providers to create some new and efficient investment solutions for retirees wanting income,” Moss said.
“Not all of the 85% of retirees, with a low-to-medium risk profile, will want to buy an annuity, they value the control and flexibility that drawdown gives them. These retirees are currently not well served by the market, as there are few options for them and their advisers to consider.”
However, some advisers feel there are appropriate options in this range, and caution that strategies aiming for this range could become complex and expensive solutions.
Richard Parkin, head of retirement for BNY Investments, said he does not believe there to be a gap in product for those in the retirement range.
“As an industry, we have no shortage of investment product. The challenge is how these products are used to meet the specific risks facing those decumulating wealth,” Parkin said.
“We need to recognise that retired client circumstances and needs are very different from those accumulating wealth and consider what that means for how we think about and manage risk. In particular, we need to think about risk to income not just volatility of capital. The two are related but not identical.”
He said instead of a change in product, this issue can be resolved in recognising that low volatility does not mean low risk for those in the retirement stage, and changing the way that risk is thought about and discussed with clients.
Moss also believes there could likely be misconceptions about the way clients are understanding their risk.
“If most consumers are in the low, medium-to-low risk category, and a lot of the solutions are in the high to medium category, an awful lot of people have been put into solutions which actually don’t match their risk,” he said.
“It’s not certain, but it’s probable that they are taking more risk than they realise they’re taking.”
While markets have performed well in recent years, Brodie warned if this environment were to change, it could lead to problems depending on how the client is invested.
See more: Why we simply can’t lose the value of human relationships in ongoing advice
“Those using total return strategies will get caught short in a market downturn – there is no way out. Multiple year downturns will see retirees whipsawed by sequence risk and we fear that will lead to the next big miss-selling crisis as many advisers won’t have relevant answers, and the investment managers will abdicate any responsibility,” Brodie said.
“The markets fall roughly 26% of the time, so a 60-year old retiring for 26 years is likely to have seven of those years with negative returns.”
While the old faithful of using an annuity protects against this sort of market downturn, riskier investments could lead to a fall in income. Yet, there are ways to protect against downturns while still investing in a fund, Parkin claimed.
“If someone is taking more risk than they have the capacity for then a market downturn could impact the level and or length of time income can be sustained. But it’s important to recognise that market values are not always relevant,” he said.
“For example, our multi-asset income fund is managed to pay a stable and growing level of income. If the client just takes this level of income, then they become almost agnostic to the capital value of their investments and so can withstand market volatility. The risk they face is the ability of the fund to maintain and grow income which we manage by carefully controlling the mix of assets and diversification across the portfolio.”
Moss added it is important to factor in that since the 2015 legislation was put in place, markets have done well, performing now near all-time highs, but this “will not continue”.
“At some stage the market will fall, and at some stage, people will find that they’re actually suffering significant loss. It’s been fun, it’s actually worked out quite well since 2015. We’ve had pretty strong equity markets, things worked out well for consumers, but it will not continue.”
