How to ensure clients do not outlive their savings

When pension freedom was introduced by the government three years ago soundbites flew around about individuals splurging their lifetime savings on flash sports cars or buying second homes to fund their twilight years.

What has evolved however is a culture of transferring out of defined benefit (DB) plans and into other vehicles. Last month, Royal London used a freedom of information request to obtain figures from the Pensions Regulator that revealed 100,000 people transferred out of DB schemes in 2017, up from 80,000 the year before. Separately, the FCA has said £20.8bn flowed out of DB schemes in 2017.

Aside from the high-profile scam cases, the beneficiaries of this have primarily been savings vehicles including defined contribution (DC) pension schemes, investments through discretionary fund managers and platforms. Indeed, UK advisers are “busier than ever” as a result of pension freedoms, according to research by ratings consultancy AKG.

The big question

As more money flows out of pension schemes, there is clearly a challenge for the industry to create suitable drawdown products to meet the needs of those approaching or in retirement, particularly as the previously traditional approach – the annuity – is no longer the favoured path.

Pensions Policy Institute (PPI) research published in May has revealed drawdown products accounted for 30% of individuals’ pension pot purchases since freedoms were introduced, while annuities only accounted for about 12% – a huge drop from 90% in 2013.

Everyone’s circumstances are different, but the age-old question for advisers and wealth managers has resurfaced: how much an investor can draw in income each year without outliving their savings?

Is the 4% rule dead?

A commonly-accepted annual withdrawal rate is 4% of a retirement pot adjusted for inflation. This is based on an argument raised in the early ’90s by US financial adviser William Bengen who said investors could safely withdraw funds at this level over a 30-year period and not run out of money – assuming a portfolio split 50/50 between domestic equities and bonds.

Bengen’s rule-of-thumb is commonly used by investors and advisers, but Legal & General Investment Management (LGIM) has argued that the theory no longer holds true.

In a paper entitled Is it time to retire the 4% rule? LGIM analysed the 4% rule over the last 15 years for a portfolio split 50/50 between equities and bonds and found a large discrepancy in capital values depending on when a retiree began drawing down.

It found those starting drawdown in 1993 saw their capital gain by 46% in real value by 2008, but for retirees who started between 1998 and 2001 their portfolios have suffered a 30-41% capital loss.

In actual terms, this means that a 65-year-old retiree in 1993 wanting to purchase an annuity at 80, following a 15-year period of 4% drawdown, could see a monthly income of around £1,900. However, if they were to invest from 2000-2015, an annuity would provide just £600 a month.

“Investors need a more dynamic strategy when it comes to withdrawals at retirement,” say the authors of a paper, John Southall, head of solutions research at LGIM, and Andrzej Pioch, a fund manager in the multi-asset funds team at LGIM.

Dynamic approach

The pair adds: “A key finding is the need for investors to embrace a more dynamic approach to the level of distributed income, adjusting it to client requirements and to diversify the retirement portfolio more broadly.”

This, they say, includes spreading investments over different asset classes and, more importantly, understanding the investor’s risk appetite.

According to Alan Beaney, investment director at RC Brown Investment Management, it is better to start with tailoring the investment strategy to a client’s requirements, rather than create a strategy that is suitable for all pension portfolios.

He says RC Brown’s rule of thumb is taking 5% out of the portfolio each year, income plus capital, which usually means the portfolio should at least maintain its value in real terms depending on the strategy.

“If clients take out more than 5% per annum they will run the risk of eroding their capital and in the most extreme circumstances will run out,” says Beaney.

“The greater the money that you take out each year it is sensible to build a cash or near-cash buffer of one to two years income to hedge against market setbacks.”

Beware inflation

Andrew Herberts, head of private clients at Thomas Miller Investments, says above all income and capital preservation need to be thought of in real terms, in other words nominal growth is needed for real income preservation to counteract inflation.

He says: “One of the main risks to an investor’s income is the effect of ‎inflation, so if one assumes a reasonably long life, one cannot just sit in a fixed interest portfolio and clip coupons because in time, inflation will erode the real value of those coupons.

“The biggest mistake pension investors may make is being too risk averse and becoming gradually impoverished as inflation eats away at the pension pot.”

Ticking all the boxes 

David Marchant, chief investment officer at Canada Life Investments, says a retirement fund should tick three boxes: low volatility, growth and yield.

“If you are 65, 70-years-old and you are taking money out over time, you don’t want volatility as it will kill your performance, you want some growth to be able to keep up with inflation and want a yield because you have to live off it.”

Marchant manages the LF Canlife Managed 0-35% fund which he says contains only sterling-denominated assets to avoid currency risk and minimise volatility.

The portfolio is 26.5% UK equities, 16.2% in UK property and the rest cash and fixed income, the latter split a third each between short duration, corporate bonds and UK government bonds.

Marchant says: “[The fund] focuses on corporate bonds for high yield and short duration because it gives a bit of protection and lower volatility, and UK equities through the LF Canlife UK Equity Income fund. Income shares tend to be lower volatility and provide a yield.”

The Oeic version of the LF Canlife Managed 0-35% fund, launched in January last year, has returned 2.85% and 2.58% over six months and one year respectively versus the IA Mixed Investment 0-35% Shares sector’s 0.5% and 0.9%.


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