Overview
For much of the 20th century, pension provision in the UK consisted of three elements: Final salary schemes (also known as defined benefit pensions), State Pensions and annuities. All of these have one common trait - durability. Whatever happened, UK retirees never needed to worry about running out.
A new landscape
The retirement income marketplace has now changed. These sources continue to pay a lifetime income, but there are fewer people retiring these days with defined benefits pensions. What’s more, most people now favour income drawdown over annuities1 . The popularity of drawdown raises the real risk that people could run out of money during retirement. This is a relatively new risk. Even when drawdown was first introduced in the mid-1990s, it came with important safeguards: A limit on how much could be withdrawn and a requirement to buy an annuity at age 75 to provide a guaranteed income for life.
Since the introduction of ‘pension freedoms’ in 2015 that has changed. People can now take what they want, when they want using the drawdown options available.
Providing a sustainable income in retirement
The prospect of retirees taking too much income is a concern. The latest data from the Financial Conduct Authority (FCA) suggests that for pension pots up to £249,999, the most popular withdrawal rate is 8% or more2 , which seems excessive to provide a sustainable level of income throughout retirement.
The conventional wisdom, based on the work of American financial planner William P Bengen, is that an inflation linked income of around 4% from a balanced portfolio is a safe withdrawal rate to ensure money won’t run out over a 30-year period. However, this may be overly conservative in some circumstances. Analysis by the investment research organisation, Morningstar, reveals that someone retiring in mid 1982 could have enjoyed a safe withdrawal rate, based on a balanced portfolio, of more than 11%, inflation linked, over 30 years3 !
Helping employees to manage investment risk in retirement
There are several reasons why one cohort of retirees may enjoy a higher safe withdrawal rate than another. For example, higher investment returns and lower inflation rates. A further reason is sequencing risk. This is the potentially devastating impact of selling investments in a falling market in the early years of retirement. Chart 1 shows how two funds with an average market return of 5% can end up in a different place depending on when market falls occur.
A diversified portfolio of bonds, equities and cash can help mitigate the impact of volatile markets. Beyond this, there are specific strategies developed to combat sequencing risk including:
- Living off natural income or yield
Use the interest, dividends and income generated by a retirement fund and withdraw this each year. Sequencing risk is mitigated because income isn’t taken from capital. Capital values could still be eroded by market falls but, as the assets aren’t realised, they should recover.
- Fixed percentage of the fund
A variation is to take a fixed percentage of the fund value each year (as opposed to a fixed percentage of the initial fund value). In years where markets are falling, less income is taken, but the opposite is true when markets are rising – income will increase.
- Cash buffer
This approach involves dividing the fund into sub-funds or ‘buckets’, typically cash, bonds and equities. The cash bucket might equate to 2-3 years income to ride out market falls. Significant market falls, without a relatively quick recovery are rare. US data suggests that the average length of a bear market is 289 days, or about 9.6 months, so a cash buffer could be used to combat sequencing risk.
- Guardrails
Guardrails protect the fund by imposing limits. An initial withdrawal amount is defined, say 4%. This amount may then be adjusted each year based on the previous year’s performance. Broadly, if the fund has risen over the previous year, by a certain amount, the income can be increased, while if the portfolio performed poorly, within certain parameters, income is reduced.
- Rising equity glide path
This involves starting with a low exposure to equities, usually between 20-40%, rising over time to between 40-80%. The benefit of this approach is that the equity exposure is lower in the early years when sequencing risk can be most damaging. However, if markets rise during the early years, there is an opportunity cost, as some of these gains will be lost out on.
- Smoothed multi asset funds
A further option to manage volatility is to use a smoothed managed fund. These are diversified funds that seek to cushion investors from the volatility of investment markets by including a smoothing mechanism. The smoothing mechanism means the value of the funds will move up and down, but rounds off the sharp edges of stock market investing. When markets fall, the value of the fund may fall, but by less than the actual movement in the price of the underlying assets and market rises may also be reduced to smooth the returns over the longer term.
While the evidence suggests that over most time periods markets rise, the impact of sequencing risk can be too damaging to ignore. Strategies like these can help mitigate the impact of sequencing risk effectively, while maintaining exposure to real assets and the potential for growth.