For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
This week we initiate a series on investing for the post-retirement market. We are strong believers that a different approach is required when investing for clients in decumulation, compared to those in the accumulation phase of their lifecycle. There are various reasons for this, the most obvious being that their objectives are completely different.
A much more complex challenge
In accumulation, the client’s objective is fairly straightforward. They have a certain amount of capital and a certain amount of savings capacity. They will generally be wanting to build their capital for a future expected expenditure, typically retirement. Ignoring all the complexities of tax and product structures, the investment part of the job is to earn the maximum return for the client’s risk tolerance over an extended timeframe. Hence the rise of risk profiles centralised investment propositions.
Post retirement clients’ needs vary much more, but typically fall into 3 broad categories: basic ongoing income needs, discretionary expenditure (typically in early retirement), and later life and legacy. This is a much more complex advice and investment challenge. We will focus primarily on the ongoing income requirement.
Providing a consistent income that grows in line with inflation is the single most important post-retirement challenge. There are two basic approaches to solving this problem and most clients will end up with a blend of the two. One is a unit encashment/capital growth strategy, the other an income strategy. For the income strategy, advisers can choose between the certainty of annuities, or retain control via collective investment schemes such as unit trusts or mutual funds.
There is a significant issue with the capital growth strategy which makes it a less than optimal approach to post retirement. It inevitably forms part of most clients’ portfolios simply because they need to draw capital, as their funds are insufficient to provide the income required otherwise. The issue is the impact of volatility, volatility is your friend in accumulation (although most clients don’t recognise this), as it provides the opportunity to build capital at low prices, i.e. pound cost averaging.
In post-retirement, raising capital out of a portfolio in weak markets can be hugely damaging, volatility is now the enemy. A period of negative returns can have material impact on the longevity of your capital if you are having to sell your assets to provide an income.
A simple solution
This pound cost ravaging effect is one of the biggest challenges for post-retirement investing but fortunately, there is a simple solution. The income on a portfolio can be much less volatile than the capital value. The income on a bond does not change as the price moves. Neither does the dividend stream from an equity change because of price moves, although the reverse can be true. So, maximising the sustainable level of income from a client’s portfolio will always minimise the risk that comes from capital volatility.
I am often asked what the sustainable level of income is to draw from a portfolio post-retirement? The reality is the answer is really a function of how much income that portfolio generates. Drawing a 5% level of income from a portfolio with no natural income is much riskier than drawing the same income from one that actually yields 5%. In the second case, no units will ever need to be sold, whatever the level of markets.
Hence, post-retirement risk is not defined by a client’s risk tolerance and the portfolio’s expected volatility, but the client’s income needs and the portfolio’s level of natural income. We believe drawing large amounts from a portfolio with no income is risky, drawing only the natural income is much less risky.
Natural income fan-boys
We are huge fans of natural income for post-retirement clients and in future notes we will cover how you can generate a consistent income stream via income management and risk and portfolio construction in the context of retirement income.