James Fouracre: In decumulation, the preservation of capital becomes paramount
Following the Mansion House reforms, a raft of government consultation papers followed.
One gathering significant momentum is the proposed architectural amendments to decumulation - the defining question posed: how do defined contribution (DC) schemes best support their members at the point that they wish to access their pension, to in turn, offer a more streamlined to and through retirement process?
Notably, under the outlined proposals, trustees will have a statutory duty to offer decumulation services to members either in-scheme or through a partnership with an external provider. And, the data supports the ambition. Government survey findings report that only 28% of those aged between 55 and 59 had a clear plan at retirement, with 17% reporting that they didn't know they had a choice.
The architectural innovation remains only half the task - the other; investment portfolio construction in decumulation. The increasing importance of progression in decumulation is twofold - firstly, the aforementioned regulatory surge of support, and secondly, the evolution of DC membership. The ‘baby-boomers bulge' now results in close to a million DC members entering pre-retirement each year - the number of members and assets moving through the lifecycle is demanding increased sophistication.
Underestimate sequencing risk at your peril
In post-retirement, the sequencing of returns really matters. The sequence of returns - when gains and losses occur - can mean the difference between ‘retirement ruin' and a healthy income. Assume a hypothetical pot of £500,000 and an income requirement of 8% (the average rate of annual withdrawals, as reported by Financial Conduct Authority retirement income market data). The pot is invested in a conservative investment strategy that looks to deliver 5% per annum on average. If these returns are consistently 5% every year, a £40,000 income will last for 20 years. But, if the portfolio loses 15% in the first year (as many 60:40 portfolios did in 2022), the income will only last for 14 years - even if its performance recovers to deliver that 5% average annual return. That is a dramatic impairment of retirement outcomes. The only way to reduce this sequencing risk is to ensure the portfolio avoids any large drawdown when the portfolio's value is highest - that is, the start of the decumulation phase.
Most DC investment strategies try to mitigate this risk by using a sliding asset allocation - typically reducing the portfolio's exposure to equities, in favour of bond, credit or other duration-linked diversifiers. While this lowers the expected return, it should also reduce the exposure to drawdowns - 2022 and a new investment regime challenges this thinking.
The impact of sequencing risk
Source: Ruffer analysis. Based on a theoretical £500,000 starting portfolio with returns compounded quarterly and £10,000 withdrawn at the end of each quarter for a £40,000 annual requirement.
A new investment regime
Was 2022 a one-off hit as the investment world transitioned from the historically low interest rates that have suppressed fixed income's protective power? Or are we entering a regime of higher, more volatile inflation, driven by a changed economic landscape that has shifted to deglobalisation, renewed labour bargaining power and great power conflict?
We sit firmly in the latter camp. We expect higher nominal interest rates as well as negative real yields and unstable correlations between asset classes to continue for some time to come. This will bring more interest rate volatility and a greater need for investors to manage duration risk.
For those setting asset allocation for post-retirement DC pension portfolios, the answer to the inflation question doesn't need to be a straight yes or no. If there is even a chance that we have entered a new regime, the current typical asset allocation at this part of the lifecycle will no longer work. And a few changes can go a long way to improve the resilience of retirement outcomes.
A feature of the last 30 years has been low and stable inflation. Dissecting the bond-equity correlation for different levels of inflation showers that US CPI of around 2.5% is the key turning point. Below 2.5%, the correlation is negative, above 2.5%, the correlation turns positive.
As well as failing to protect against equity losses, in a world of higher inflation volatility, duration-linked diversification may also not be the volatility dampener that is needed to make retirement outcomes resilient. Bond volatility is likely to head higher along with inflation volatility.
A decumulation solution
In decumulation, the preservation of capital becomes paramount. This aligns to Defined Contribution Institutional Investment Association (DCIAA) research which finds that ‘safety' is one of the six priorities for pre-retirement savers. The avoidance of large drawdowns can defend against sequencing risk and help secure the desired retirement outcome.
Reflecting on member needs at the point of retirement, what does a decumulation strategy look like? We think improving member outcomes is derived from: a diversified source of returns, a sophisticated investment toolkit, positive correlation during bull markets, negative correlation during times of market stress and partnering with a provider who has delivered an extended track record of genuine downside protection during bear markets.
As a final thought - it would be remiss not to reference the government's encouragement of schemes to explore a collective DC (CDC) decumulation model. As has been well-documented, the uptake in accumulation has been limited. The governments proposed phased roll-out of CDC means whilst it is unlikely to be imminent, the time may come to reflect in more detail on this in due course.
James Fouracre is director of UK institutional at Ruffer
