Investing through retirement while drawing down demands a different mindset to investing for accumulation, Natasha Browne hears
Investing for decumulation requires an entirely different approach to investing for accumulation. It may be perverse, but in some cases a poorer performing portfolio may be more desirable than a well-performing portfolio in this context. This is related to the effects of what has been branded ‘pound-cost ravaging'.
Pound-cost averaging occurs where contributions to an investment vehicle like a pension plan help boosts its returns. As the capital invested continues to grow, the benefits of positive returns are compounded. But pound-cost ravaging is the reverse. If the pensioner withdraws money while it is invested, there is less capital to compound.
Speaking at an event last month, James England, a senior business development manager at Standard Life Wealth, explained that volatility could help increase the size of pension pots in accumulation. Someone putting away £100 per month will benefit even when the value of their investment is down because their contribution buys more units, which can recover over time with "a very beneficial mathematical impact".
But he added: "If you're in the reverse situation - you've got pension drawdown and you're taking out £1,000 a month, the value of the portfolio or fund drops. You're still taking £1,000 that has to be taken from a disproportionately large proportion of that portfolio because it's worth less and then sold and can't recover. Volatility suddenly becomes very problematic and a very undesirable characteristic in decumulation."
This comes after research from the International Longevity Centre-UK warned that asset price volatility could also see pensioners on drawdown suffer annual income drops of up to 50%, which would significantly impact on their living standards.
However, it is not just volatility that can help or hinder a fund depending on whether it is in accumulation or decumulation. There is an element of luck that can fundamentally alter a retirement income stream. England highlighted the research of Canadian professor Moshe Milesvsky to demonstrate this point.
Milesvsky came up with the concept of the "ruin age", which refers to the age when a pensioner runs out of finances. He proposed portfolios one and two to illustrate how timing, rather than pot size, was crucial to creating a sustainable retirement income.
Both portfolios are subject to 9% annual withdrawals and feature equal levels of volatility. The chosen withdrawal size is particularly high to demonstrate the sums. Each goes through a recurring three-year return cycle until it runs out of money, with one of the portfolios running dry ten years ahead of the other.
The return cycle of portfolio one is growth of 27% in the first year, 7% in the second year and -13% in the third year. Portfolio two experiences negative growth of -12% in the first year, with this turning positive to 8% in the second year and 28% in the third year. As such, it has a higher return of 1% per annum overall.
England said: "Which one do you think runs out first? And by how much? When we ask that question, often people say they think portfolio two will last longer because it's got a higher annual return. Surely, the higher the annual return, the longer the money will last. But they'd be entirely wrong in that the higher performing portfolio on an annual basis runs out ten years earlier than the lower performing one."
The reason for this is that portfolio one got off to a significantly better start in the first year. But as England points out, it is impossible to control when people decide to retire and decumulate their pots through drawdown. It cannot be designed to occur after a crash, rather than at the height of the markets, to ensure the pot grows steadily in the recovery phase.
An alternative approach
England said: "Managing money in decumulation is completely different from accumulation. There are dangers, risks, in decumulation that aren't so problematic in accumulation. What I'm really on a mission to do is to try and get that message out to people.
"We really need a different investment mindset at retirement. It's less about ‘how do we outperform the market, how do we outperform a peer group of funds'. It's more about ‘we've built up this money, we've now got the issue that we need that money to last for as long as we live'. We don't know how long we're going to live for so it's about consolidating that money, controlling it, and trying to make it last as long as possible. And that is a completely different mindset from somebody investing in their 20s, 30s or 40s."
The Budget 2014 opened up drawdown to a significantly larger number of people approaching retirement. The minimum income threshold for accessing flexible drawdown was cut from £20,000 to £12,000. Figures published by the Association of British Insurers (ABI) just six months after the reform was announced showed demand for drawdown had already climbed 55%.
England said Standard Life estimated a fivefold rise in take-up of drawdown post-freedom and choice. He added: "That's a huge increase in people taking drawdown versus annuity. It's a great opportunity for our industry, but poses big risks for clients, and frankly, for society if we get it wrong. So it's a big responsibility for our industry."
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