Managing the risk-reward trade-off in drawdown

It used to be that retirement represented the finish line after years of working and saving.  

On reaching that point, most people would either use their pension savings to buy an annuity that would provide a guaranteed income post-retirement or begin drawing on their final salary pension. 

That remains the case for some, but they’re definitely in the minority. Those reaching retirement now mostly remain invested during retirement and have to navigate the complexities that come with the flexibility of drawdown arrangements. 

As we approach a decade since the pension freedoms were first set out, that challenge is one that continues to exercise pension companies, investment managers and financial planners alike. The market volatility in recent years has underlined the need to get the decumulation phase right. 

 

Time versus money 

 

Creating a sustainable retirement income while also preserving your wealth is far from straightforward, as many are discovering. There is one overarching risk among all the complexities and nuances: running out of money.  

There are various reasons why this may happen, including the specific investment risks around drawdown. It can be easy to fall into the trap of drawing down too much too soon due to human error, fraud, over-optimism about investment returns and/or dipping into retirement funds to cover short-term emergencies. 

Some people use up their savings too quickly and succumb to longevity risk - underestimating how long they could live for. This is a common mistake, according to the Institute for Fiscal Studies. Its research found that people in their 50s and 60s typically underestimate the likelihood of living to 75 by some 20 percentage points and to 85 by up to 10 percentage points. If someone’s actual life span exceeds their life expectancy, the financial implications are potentially severe. 

 

Risks 

 

Drawdown has other risks to navigate. Sequence risk is often talked about. It is when poor returns in early retirement take chunks out of the pension pot and so reduce how much income can be sustainably taken from it. That can be exacerbated by ‘pound-cost ravaging’, where income continues to be taken from a drawdown fund even as its value is being eroded by market volatility. Advisers can add a lot of value in helping clients avoid these pitfalls.  

Trying to avoid or minimise sequence risk or ‘pound cost ravaging’ can, however, lead to another big risk: the risk of investing too cautiously, resulting in low investment returns which are insufficient to meet their longer-term needs. 

 

The importance of advice 

 

There’s no silver bullet that takes all these risks out of the drawdown equation. They’re a natural side-effect of the flexibility that drawdown can offer. But there are effective ways of mitigating them, so that the drawdown phase can be enjoyed without sleepless nights. 

Professional financial advice first and foremost is essential, especially when it comes to creating a sustainable income withdrawal level, picking an appropriate investment strategy and taking income in the most tax-efficient way. A good financial adviser can also help take the emotion out of decisions that have potentially significant consequences.  

The costs of not taking financial advice for retirement decisions can be heavy. Research by the Financial Conduct Authority found that savers who didn’t seek advice were more likely to move their entire pension into cash, for example. 

 

No magical product 

 

The investment-related risks can also be tackled by building and maintaining an appropriate investment strategy. Although there’s no magical drawdown investment strategy out there, there are a few key tenets to proper portfolio construction. 

Firstly, taking a total return approach that seeks to maximise overall returns through both income and growth, as opposed to focusing on one or the other. Our Income Oriented model range offers the best of both worlds and can be very helpful for clients in drawdown. 

Secondly, always be mindful of costs. This is supported by diversification, which should be at the heart of any well-constructed portfolio. As we all know, market returns are unpredictable. So at PortfolioMetrix we first focus on what is easier to predict and control:  risk. Diversification helps steer portfolio returns towards an outcome consistent with the risk taken as time goes on. 

Diversifying by spreading money across a range of different asset classes plays a big role in mitigating sequence risk and pound cost ravaging without reducing the total expected return. Maintaining a properly diversified portfolio reduces the volatility of returns and the impact of falls in one particular asset or market, therefore lowering the impact of poor returns early in retirement.  

Rebalancing can be especially valuable for retirement portfolios too, as it helps ensure that income is being taken from assets that have recently done well and not from those that have underperformed and might bounce back in future. Rebalancing and carrying out regular reviews also ensures the portfolio remains aligned to the investor’s risk profile.  

This is what we call ‘flying in formation’ at PortfolioMetrix – constructing portfolio ranges in which achieved returns are precisely correlated with the level of risk undertaken. It is particularly crucial when drawing an income from a portfolio. 

Delivering this outcome sounds very simple but very few of our peers do so consistently. It is crucial as it enables advisers to select portfolios that align with their clients' risk budgets and, subsequently, exhibit behaviour in line with expectations. This helps avoid taking unnecessary risks in retirement when aligned with good financial planning. 

Some investors also seek to mitigate risk by maintaining different pots of cash, such as for the short-, medium- and long-term. Keeping a small pot of cash available makes sense in the short term, as investors can dip into it in the event of an emergency, rather than raiding their investments. 

However, while keeping significant amounts of money in cash rather than growth assets may help reduce sequence risk, it exposes the investor to more inflation risk and lowers expected investment returns, which may ultimately increase the chances of eventually running out of money.  

 

Best of both worlds 

 

Successful drawdown investing invariably means accepting some of the risks that come with remaining invested during retirement. There’s no way around that - it’s part and parcel of the risk-reward trade-off.  

That’s where the experts come into play. Financial advisers have a vital role to play in helping investors navigate the decumulation landscape, not least when circumstances or market conditions change. Advisers also help shape the investment strategy that’s key to mitigating decumulation risks and making drawdown work.  

Ultimately, good financial planning allied with the correct investment strategy can give clients that all-important peace of mind and help ensure a financially secure retirement. 

 

Nic Spicer is UK Head of Investments at PortfolioMetrix