The fundamental consideration for any IFA advising clients in retirement is whether these clients have saved enough to maintain the lifestyle they want through a sustainable income.
Every client is different, so there is no simple answer or solution as to what constitutes a level of savings that matches their hopes and expectations. Consequently, planning for retirement is fraught with difficulty and one of the most complex services IFAs can offer.
Replacing the income lost once a client stops working can come from a number of different places and identifying these sources is one of the most important aspects of retirement planning.
These can include things like the state pension, workplace or final salary pensions, annuities or other investments. Through these, the IFA will try to find an outcome where the retiree is comfortable and not just surviving.
The theory of retirement planning
A sustainable withdrawal rate, that is the level of income a client can ‘drawdown’ from their pot over the course of their lifetime without running out of money, has dominated much of the theory behind planning for retirement. But, as retirees are living longer, and traditional investment vehicles such as bonds are providing poor yields (of around 2.5 - 3%), potentially difficult conversations will need to be had in order to balance expectations with economic realities.
The introduction of greater pensions freedoms changed this theory somewhat, with retirees no longer obliged to buy an annuity, yet pre-freedom thinking still persists where the emphasis is still on moving from higher risk accumulation strategies to lower risk decumulation ones. Added to this many accumulation products were simply repackaged for retirees.
Retirees face different financial risks once they stop working. Chief among these is longevity risk, where a finite savings pot can only last so long.
Risk in retirement
While longevity risk - whereby a retiree outlives their savings pot - is perhaps the most significant risk, shortfall risk is another consideration. Final salary, or Defined Benefit (DB) pensions are something of a rarity for the generation approaching retirement, so instead many retirees today are reliant on their Defined Contribution (DC) pensions. However, many people have undersaved into these schemes, so in order to sustain levels of income, investments with higher levels of return are needed. But as any investor knows, with higher potential returns, come higher potential risks.
This leads us onto sequencing risk, which occurs when higher returns are sought through growth strategies in retirement portfolios. But, should the markets fall, as they did in 2020, this can significantly impact on a retirees’ lifestyle.
Rethinking risk
At FE Investments, we believe there is a more robust retirement solution that ensures clients can comfortably sustain their income needs in retirement while giving the IFA the ability to balance and manage the risk.
With clients facing different risks in retirement, how risk is framed and thought of should change. No longer should it be thought of in terms of the value of their portfolio, but instead on the potential changes to the value of future income.
Traditional risk questionnaires then are no longer suitable for decumulation clients. Applying accumulation attitudes to risk to the decumulation phase could leave advisers exposed to accusations of mis-selling.
Decumulation illustrator
Given our different approach to risk in retirement, we have developed a tool for advisers, which helps them to have relevant, meaningful and impactful conversations with their retirement clients. Our Decumulation Illustrator tool reframes risk away from traditional volatility concerns to the risk of income viability – that is, the risk of running out of money.
If clients are to withdraw money from their investments, the expected return has to be sustainable given the withdrawal rate. A 4% withdrawal rate could easily increase to 6% once all charges are included.
Despite this, it is still common during retirement for investors to stay in low-risk portfolios because this matches their attitude to risk, even though they would have no chance of maintaining a withdrawal rate anywhere near 6%. For this reason, the decumulation tool places investors in a higher risk portfolio than they may have been invested in during accumulation.
Using the latest actuarial forecasts our illustrator calculates the likelihood that retirees’ assets invested in the FE Investments decumulation portfolios can deliver on their retirement goals compared to their existing accumulation solution.
Decumulation portfolios
Retirees need to accept that if they have to stretch their investments a little bit further, they will be exposed to market movements and the nature of their requirements means they will need to take a higher level of market risk.
We offer two model portfolios specifically for clients in retirement and recommend holding up to three years’ worth of income in our Initial Income Portfolio. The portfolio’s defensive positioning means that it takes a reduced level of market risk and insulates against large market falls. This means clients can drawdown from the portfolio on a regular basis with relative confidence.
Should markets fall early in retirement, as per a sequencing risk, the Initial Income Portfolio provides time for other high-risk investments to recover, potentially adding a number of years over which the portfolio will be able to pay out an income.
The remaining portion of the portfolio we would recommend placing in our Long Term Retirement Portfolio, one of our highest growth portfolios, that is still diversified across multiple asset classes. We believe this offers the best chance for your clients to meet their income needs over the longer term.