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Thematic Review – the beginning of the retirement income assessment

14/12/2023

In January the FCA announced they would be carrying out a new thematic review, “assessing the advice consumers are receiving on meeting their income needs in retirement”. Rightly so, this has sent more than a few shockwaves throughout the industry. The decumulation landscape has changed drastically since pension freedoms were introduced in 2015, and nearly ten years later we must go under the microscope to see what the land looks like.

When building an investment portfolio for a client there are several key elements that need to be considered. However, we would argue some of the most important, and often the most misunderstood are volatility drag, sequence of returns risk and safe withdrawal rates. Let’s start with volatility drag as this could be an issue when trying to put together the right investment strategy for your client.

As we know, volatility drag in its simplest form is the difference between arithmetic and compound investment returns. To put it simply, the idea is that if a portfolio falls in value it needs to work harder to get back to its initial value. So, if you start with a portfolio value of £200,000 and it drops by 20% to £160,000 it is easy to think you just need 20% to get back to where you were. However, you need £40,000 to get back to £200,000 and £40,000 of £160,000 is 25%. That means that even though you lost 20% you now need 25% just to correct your position. As detailed below, these differences might seem small, but the compound impact of larger or consecutive drops can be quite significant.

 

A

 

B

 

C

Year 1

25%

Year 1

-5%

Year 1

25%

Year 2

5%

Year 2

-20%

Year 2

-5%

Year 3

20%

Year 3

-15%

Year 3

5%

Year 4

-15%

Year 4

20%

Year 4

-20%

Year 5

-20%

Year 5

5%

Year 5

20%

Year 6

-5%

Year 6

25%

Year 6

-15%

 

Using a withdrawal at the end of each year of 5% of the original investment, the amount remaining after 6 years as a percentage of the original investment is:

A – 77.02%

B – 64.01%

C – 74.96%

As you can see from the table above, while all three funds might have fitted for an accumulation strategy, they will differ considerably in decumulation. The difference between portfolio A and portfolio B is 13%. Why is this important? Running out of money is one of the biggest fears that many people will face in retirement. If a client has £150,000 in a pension fund and required annual income of £11,000pa then the difference between them achieving an annual growth rate of 5% instead of 3% would mean that the number of years before their pension runs out would be 23 years (achieving 5%), as opposed to 18 years (achieving 3%). In this particular example their pension fund would last them five years longer. This is why it is so important to consider the sequence of returns risk and make sure the portfolio is right for the client in decumulation. 

Alongside volatility drag and pound cost ravaging there is the 4% rule. The ‘4% rule’ came from the US in the 90s where financial planner, William Bengen began work on what has become known as ‘Safe Withdrawal Rates (SWR)’. The idea being that 4% would be the highest withdrawal rate as a percentage of the beginning balance at retirement and would allow for adjustment for inflation in coming years. It is sometimes argued that the 4% rule is a naïve and too generic, but the foundations make sense mathematically, and studies have shown that it has some success. Later research by Wade Pfau tried to anglicize the method by looking at the UK as well as 17 developed market economies. He found that in a best-case scenario the SWR would be 3.77%, or this could increase to 4.17% if the client were to accept a 10% risk of failure.

So, all in all, it is not a simple task for any adviser to look at a client’s pension funds, income needs and determine the right centralised retirement proposition. This is exactly why the FCA have decided to continue their work to establish how the pension freedoms have changed the landscape, how advisers are managing retirement solutions and income needs and where strategies are falling short of delivering the best outcomes for clients. Considering consumer duty, a great emphasis will be placed on trying to navigate foreseeable harm and delivering better client outcomes. The significance of a retirement strategy has never been so great.