Globally in recent years, we have witnessed two huge shocks: Covid and war in Ukraine. Whilst the full effects of these events are still being discovered it is evident that market volatility is back on the agenda. This raises sequencing risk and the effect of pound-cost ravaging when drawing down one’s pension.
It feels to us that risk is widely underappreciated and return expectations in the future should be lower.
Typically, clients save and accumulate assets with the objective to grow their wealth given a stated level of risk. Each year the value of clients' assets are reviewed with a focus on the risk/reward characteristics of their portfolio, viewed in an annual framework.
However, once a client enters retirement everything changes. Clients need to take regular withdrawals to fund their retirement and are unable to add to their savings given they are no longer earning. As a result, the focus moves to the sequencing of returns and drawdown risk and these risks need to be managed on a monthly basis - much more regularly than when compared to traditional growth-based accumulation models.
Additionally, the past 20 or so years have been extremely favourable to investors. Equities, bonds and property have markedly appreciated and the traditional balanced fund has done exceptionally well.
Equally, the typical asset allocation for a low-to-medium-risk pension portfolio relies heavily on government bonds and property. However, in a world of low or negative yielding debt, pension needs have become very difficult to meet. Consequently, investors are required to take higher risk to satisfy their income requirements, and this has higher associated drawdown risks, which in turn can impair their capital.
Demographics in the UK mean that the cohort of the population approaching retirement will grow significantly over the medium-term. These people will require solutions to fund their retirement over an increasingly extended life-expectancy.
We believe there is an unmet need in the advisory market that requires a purpose-built solution that is truly fit for purpose. There are six key areas that we think investors should consider:
- Traditional growth-based accumulation models expose clients to additional drawdown and sequencing risk. Annuity options or ‘With Profits’ strategies remain unattractive for most given the high premiums and/or the lack of platform access. The ‘pots’ approach of holding a cash buffer protects against sequencing and drawdown risk but exposes the client to significant cash drag and the risk of impairing their capital over the longer term.
- The main objective of any such approach should be to mitigate sequencing and drawdown risk with a focus on capital preservation which better matches retirement needs. Any such portfolio should be thoroughly tested through many market cycles, including periods of severe market stress.
- Portfolio construction should be the main line of defence. We (together with our partners at Dynamic Planner) are of the view that a drawdown portfolio should hold less fixed income and use more uncorrelated, diversifying, assets than traditional accumulation models, thereby aiming to keep clients invested as much as possible to avoid issues around cash drag and value destruction.
- We believe a decumulation portfolio should aim to maintain the long-term strategic asset allocation and avoid tactical trading. However, when markets come under severe stress, it is important to pivot significantly more defensive to preserve capital by using mechanistic drawdown and VaR risk triggers.
- Maintaining a liquid portfolio is key to being able to pivot a portfolio quickly as and when required by these triggers. We believe liquid uncorrelated strategies with low correlation to traditional asset classes enable investors to benefit from positive returns in a negative environment for traditional asset classes.
- Of course, such an approach can sacrifice some performance in favour of significant downside mitigation in periods of market stress. However, such an approach should result in a smoother return profile that better mitigates sequencing and drawdown risk and focuses on capital preservation. We appreciate this is a move away from an accumulation mindset, and a client might expect lower returns than an accumulation portfolio in a booming market, but in retirement, when one is not able to add to the pension pot, we believe it is more appropriate.
To address much of the above, we have created a simple, liquid and closely monitored solution with long-term capital preservation and sustainable income at its core aiming to deliver 5% annually while preserving the original sum invested.
Mark Harris is head of DFM Solutions at EPIC Investment Partners. The views expressed above should not be taken as investment advice.