The challenges around advising clients on their retirement income strategies have become considerably more visible since January this year, writes Dynamic Planner chief executive Ben Goss.
Covid-19 has impacted not just the way clients think about their wealth, but also their health and longevity too.
Now is a time for financial advisers really to help clients understand the nature of different risks and to plan accordingly.
As of 7 May 2020, the Dynamic Planner MSCI Risk Profile 5 benchmark was broadly flat year-on-year.
The FTSE All Share was down 17%.
At its lowest point so far this year on 18 March, Risk Profile 5’s benchmark was down 10.65% year-on-year and the All Share down 30.5%.
Should clients continue to take out so-called ‘safe’ withdrawal rates? Should they reduce or pause withdrawals and, if so, when, by how much and for how long? For clients in or approaching retirement in 2020, these are vexing questions.
Ben Goss on risk: Four client conversations for today’s markets
The average client receiving an annual review by firms using Dynamic Planner has a ‘low-medium’ attitude to risk (5/10) and an average household portfolio size of £242,000 ($297,000, €274,000).
Their average age is 62.
According to the October 2017 paper Why are older investors less willing to take financial risks?, they typically become more cautious in their outlook over time, dropping on average half a risk profile during retirement.
As someone looks to retire, the ideal of course is that they have a clear understanding of their financial needs, their time horizon and a guaranteed income to cover them.
In practice, though, none of these is likely to be true under the most benign of circumstances.
At a time like this, when concerns over their own and their loved ones’ mortality are greater than ever, headline market indices are deep in the red and spending patterns have been disrupted for who knows how long … well, the need for good financial advice is clearer than ever.
Ben Goss on Risk: Look beyond ‘averages’
With a portfolio of £242,000 an index-linked annuity might provide 2.9% (£7,000 a year) for a 62-year-old – a modest level of income compared with the average UK household income of £29,400 (Source: Office for National Statistics).
The alternative of remaining invested at Risk Profile 5 would, over the long term, be expected to deliver a return of 5.1% a year (£12,000) before charges and inflation, which with a state pension for a couple (£17,500) happens to add up to £29,500.
At first glance, the long-term argument to stay invested is compelling – higher headline expected returns with the flexibility of accessing capital. The risks involved for clients are, however, particularly clear at the moment.
I want to focus on two in particular – investment risk and drawdown risk.
Investment risk
At Risk Profile 5, the strategic value at risk (VaR) – that is to say, that which is generated by the benchmark asset allocation 95% of the time – is 13% a year and losses can be expected to be worse than this 5% of the time.
At the time of writing, the benchmark has operated well within this expectation this year.
This level of loss is clearly material for someone contemplating or in retirement.
That said, so long as they remain invested and their level of withdrawals is sustainable (see below), they will not crystallise these losses and, over the long term, should be expected to deliver the average return.
Our own research shows, however, that there is a correlation between those with lower risk tolerances and those who will sell in a falling market and so an accurate attitude to risk assessment – and one that reflects the likelihood older clients may become more risk averse – is crucial.
Importantly the client’s risk profile is being captured in our risk questionnaire as they get older and so an arbitrary additional reduction in the overall risk they take on top of this could lead to double counting.
What is often not being captured is the additional risk put on the solution because of this type of client spending their investment each month.
Strategic risk is of course only one aspect of investment risk.
The tactical risks that managers take in constructing an income focused portfolio are equally important to understand. Managers trade off consistency of income through dividends or yield and total return, with maximum drawdown and capital preservation.
There is no free lunch for investors and so being clear about the income characteristics important to each client is key.
Drawdown risk
The search for the ‘sustainable rate of withdrawal’ is like that for the Holy Grail.
There is no single sustainable rate, of course – it depends on the nature of risks taken in the portfolio and the client’s plan.
With the capabilities of modern technology and analysis, advisers do not need to use the general heuristics such as the ‘4% rule’ or ‘risk assets and non-risk assets’ or ‘60% equity: 40% bond’.
Clients expect and deserve more.
What the industry has come to understand are the accentuated risks faced by clients who are drawing down fixed sums each month when markets are falling rapidly and, in particular, when these falls happen earlier in their retirement.
Each withdrawal steepens the fall in value of the portfolio and reduces the ability of the portfolio to recover – with unfortunate timing, the risk of running out of money grows. Add in longevity risk – the ‘risk’ that the client lives longer than anticipated – and this is further exacerbated.
Mitigating sequence of returns risk
How then to mitigate sequence of returns risk? Here are three possibilities:
* Understanding the client’s capacity to take risk starts by helping them understand their future financial needs and wants – and talking through the difference between the two. This base ‘needs’ level of expenditure is what the plan should be designed to support, ideally with some cushion for the period of the plan. More discretionary expenses can be layered on top to provide an ideal picture. If that cushion is not in place, it may mean withdrawals ideally do need to be reduced or paused for a period in times of stress.
* Ensuring the client has the capacity to meet their needs and continue to withdraw income – not just at the bottom of a single simulated event like a stockmarket crash, but throughout the period of investment including continuing poor returns post-crash – is fundamental to assessing their risk capacity. A good stochastic model will do this. Deterministic assumptions, such as ‘the market returns to pre-crash levels within a year’ will significantly underplay the impact of sequence of returns.
* Fixed monthly withdrawals require a monthly view of risk when managing money for drawdown. This means the manager is able to take action to remain within a monthly risk budget, as opposed to an annual one, to maintain a level of return within the risk target. If a fixed level of withdrawal is important to your clients, then monthly risk-managed decumulation strategies are helpful.
For people preparing for or in retirement, the need to understand and test what their financial needs really are and then to build, monitor and manage an investment strategy and solution that matches those needs is an ongoing process.
For advisers helping clients, the use of risk-based cash flow planning and risk targeting strategies always were important tools – today they are invaluable.
Ben Goss is CEO of Dynamic Planner
