There are three great hurdles facing any investor who relies on a pot of savings to deliver a regular income: inflation, longevity and sequence of return risk. If correctly managed, investment risk can clear these hurdles to create an income-generating portfolio that will live as long as you do – or even longer.
Building up a decent portfolio of savings – whether it’s inside your pension or not – is a battle in itself, but managing that pot of savings so that it delivers a reliable, inflation-proof income that lasts for as long as you might need it requires an entirely different kind of campaign.
For those planning their retirement income, the process is broken down into two stages: the ‘accumulation’ phase, where you’re still in work and making regular contributions to your pension pot and the ‘decumulation’ phase where you’re no longer making contributions and instead are relying on your pension pot to provide the income you need. It sounds simple enough but beware, life looks very different when you go from ‘accumulation’ to ‘decumulation’.
Once you start trying to live off the pension pot that you’ve worked so hard to build up over a lifetime of work, you
immediately take on three major risks. If these risks aren’t adequately managed there’s every chance that one or more of them will derail your dream retirement.
Shouldering the risks The big three risks that come with the management of your pension pot are:
1. Longevity risk
This is literally the risk that you live too long for your pension pot. To counter it, you’ll need to take a view on your likely life expectancy which these days is about 18 years and 6 months for the average 65 year-old man and closer to 21 years for the equivalent British woman (Source: ONS as at 25h September 2018.)
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2. Inflation risk
Inflation is the secret killer. It suddenly becomes an extremely destructive force when you reach retirement and stop drawing an income from work.
Let’s imagine that you retire today at age 60 with a pension pot of £100,000. If we assume that inflation runs at 2.4% over the course of your retirement (roughly the 10-yr average for UK CPI) then inflation will have eroded the real value of your pension savings by 20.84% after just 10 years and by 38.65% after 20 years – and that’s without spending any of the pot ( Source: Infaltion.eu)
To combat inflation, you’ll need to keep at least part of your pension pot invested in ‘risk assets’ such as equities,
commodities or real estate that have a strong track record of beating inflation.
Of course, this presents risks of its own,
most notably, sequence of returns risk.
3. Sequence of return risk
This is also colourfully known as ‘pound cost ravaging’ as it describes the increased risk presented by a fall in returns that comes early in your retirement as opposed to later down the line.
The value of investments and the income they produce can fall as well as rise. You may get back less than you invested.
As these Tables illustrate, while the order of return makes little difference when you’re still accumulating, the same can’t be said when you move into the decumulation stage and start drawing a regular income from your pot (we’ve picked some extreme return figures for the sake of illustration).
As this example demonstrates, despite generating the same average annual return over the first five years, the fact
that Portfolio 2 suffered its two worst annual returns at the outset means that even after just five years, Portfolio 2 is already almost £13,000 (22%) down on Portfolio 1 when in decumulation!
Inevitably, this means that Portfolio 2 will either be exhausted far sooner than Portfolio 1 or that it will be forced to substantially reduce the income it pays if it’s to avoid being eaten away – and that’s after just five years of what could be 40 or more years in retirement.
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Fighting back
Not surprisingly, the average UK retiree has been slow to appreciate how these three risks can potentially wreck their retirement. This is partly because, under the old annuity-based regime, it was the annuity provider who took all the risks. In the new world order, the risks rest firmly on your shoulders. All this means you need to find a decumulation strategy that combines the following things:
Decumulation strategy item 1: Inflation-proofing
The first requirement is to take inflation out of the equation. In order to do this, a decumulation portfolio will need to include lots of potentially inflation busting assets such as equities, commodities or inflation-linked bonds. This kind of exposure requires dynamic risk monitoring to ensure that buying opportunities aren’t missed and that any subsequent market upheaval doesn’t affect the portfolio too meaningfully.
Decumulation strategy item 2: Capital preservation
Naturally, capital preservation needs to be central to any decumulation solution. This means finding a fund manager who can defend your capital by stopping any run on the fund’s value and who can hedge key risks from the outset.
Decumulation strategy item 3: An unconstrained remit
It helps to have an unconstrained investment remit as decumulation requires diversification across the broadest spread of different asset classes. You should be suspicious of any single-asset class ‘decumulation solution’. Don’t forget that investment companies have only had three years to launch new products for decumulation investors.
Up until the new pension freedoms arrived, most Britons took an annuity in retirement and were done. This means that a lot of decumulation solutions currently on the market are simply accumulation funds in sheep’s clothing.
Diversification: the key to decumulation Diversification is crucial if your goal is to manage your pension pot so that it grows enough to keep inflation at bay while still paying out a good level of income but without taking on so much risk that it literally goes off a cliff. If you diversify your pension pot across a wide range of different asset classes and markets you also have a chance to benefit from less correlated alternative asset classes such as property and hedge funds.
Building a watertight, multi-decade portfolio will require significant allocations to all of these asset classes, as well as the freedom to move quickly in and out as the outlook changes. Assuming you want to spend your time in retirement doing something other than monitoring and adjusting your portfolio, you’ll need to find a reliable fund manager that can do all this for you in a flexible and cost-effective way. If you do, there’s every chance that your pension pot will provide you with a safe and secure income throughout your retirement whether you choose to spend every penny in your pot or to preserve a portion of it to pass on to the next generation.
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