Paths of peril
In the section above on lifestyling, we showed how the sequence of investment returns can have a major influence on fund size outcomes.
If anything, sequencing or “path dependency” risks are even greater in drawdown, where on-going vigilance is essential and, in respect of which, clients and advisers should not assume that accumulation fund strategies will be appropriate for decumulation, so do not “leave it and grieve it”!
Dream a little dream
The use of deterministic investment assumptions across the industry can lead advisers and clients into a false sense of security when it comes to setting decumulation strategies.
A client has £100,000. Let us assume that the underlying investment fund grows at a steady net 6% per annum year in and year out. The client wants to take regular withdrawals, rising at 2.5% per annum to help offset the impact of inflation.
On that basis, the chart below shows the progression in fund values for four different levels of starting income, ranging from £5,000 to £10,000. It can be seen that, for a starting level of income of £5,000, there is still plenty left in the pot (more than £50,000) even after 30 years. Choosing a higher starting income of £6,000 would exhaust the fund after 26 years, while a starting income of £8,000 sees the client running out of money after 17 years, and a £10,000 starting income means that the fund will not last beyond 12 years or so.
The next table below shows the change in time until the fund is exhausted, comparing 4% per annum compound fund growth rates with the 6% illustrated in the chart above.
Exhaustion of initial £100,000 fund assuming 6% & 4% growth rates
Starting income 6% p.a.
growth 4% p.a. growth £5,000 35 yrs 24 yrs £6,000 26 yrs 19 yrs £8,000 17 yrs 14 yrs £10,000 12 yrs 11 yrs 0 20000 40000 60000 80000 100000 120000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Impact of Decumulation Assuming 6% p.a. Fund growth for
Given Levels of Starting Income Escalating at 2.5% p.a.
£5k initial £6k initial £8k initial £10k initial
All gone Pete Tong
Markets don’t move in straight lines. Advisers are taught at their grannies’ knees that pound cost averaging is a good thing: making regular contributions to a saving plan means that, when fund prices dip, you get more units for your monthly contribution.
The opposite is true when decumulating. As many pension drawdown clients and investment bond policyholders taking regular withdrawals have found to their cost, decumulating during a market downshift can be a recipe for disaster.
The chart above is based on a £100,000 fund at outset (1 January 2000), and shows four different levels of starting income, each escalating at 2.5% per annum. The fund performance is that of the FTSE All Share index. It can be seen that even taking a seemingly cautious £5,000 initial income would have resulted in the pot halving in value by 2003, at which juncture it would have fallen by almost two-thirds if the initial income had been set at £10,000.
So if eating equities in decumulation is hazardous, how about some magic beans in the form of fixed interest? But wait a minute, if 5 year gilts are yielding 1% to maturity, 10 year gilt are yielding 2.5% and 15 year gilts are yielding 3%, how do you suppose those raw materials (which remember are volatile – gilts have been producing negative total returns once in every four years on average) will support an income requirement of 5%, 6% or more? And don’t even think about what might happen to returns on bonds if (when) a 30 year bull market in fixed interest goes into reverse following the end of QE.
There is a huge challenge for advisers to structure and provide on-going management/advice around decumulation strategies that recognise that markets can and do go down as well as up and are aligned with the client’s capacity for loss. (Note also that bonds have tended to fall fairly frequently and, further, that equities and bonds can both fall at the same time.)
The 4% rule (US)
In the US, where retirees have had much greater flexibility than hitherto has been the case in the UK with regard to accumulated pension assets (there is no compulsory annuitisation and no state- controlled drawdown maxima), various strategies have been deployed to reduce the risk of running out of money early. One of the most popular is the somewhat folksy “4% rule”.
Under the 4% rule, retirees follow a strategy of limiting their withdrawals to no more than 4% of the residual fund (not untypically having a fairly high weighting in equities) in any one year. The idea being that, for a couple aged 65, this should mean that their retirement pot lasts at least until they reach age 90 (25 years of 4%).
0 20000 40000 60000 80000 100000 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Impact of Decumulation Based on UK Equity Total Returns
for Given Levels of Starting Income Escalating at 2.5% p.a.
£5k initial £6k initial £8k initial £10k initial
A fundamental problem with this strategy, if undertaken on a “set it and forget it” basis is that, just like UK drawdown, it can be derailed if underlying investment returns are poor or, even if returns average out as positive and good over the medium to longer term or further, if low or negative returns are experienced early on, meaning that the sustainability and level of income can be dependent on the “sequence of returns”.
Sequence of returns (Eric Morecambe effect)
In the section on drawdown, we discussed the impact of the order in which investment returns are experienced and how this can have a huge impact on the resulting at-retirement pot, even if the overall average investment return over the period under review is the same, which we tagged as “the Eric Morecambe effect” (“all the right notes, but not necessarily in the right order”), otherwise known as the impact of the sequence of investment returns.
In the example below, we took a set of investment returns that amount to 7% per annum compound over 10 years and assumed an initial investment of £100,000 and annual withdrawal of £7,000 taken at the end of each year. Firstly, we assumed that the 7% average return was achieved in each calendar year. We then ran a scenario with the highest returns in year 1 and the lowest in year 10 and, finally, then ran the numbers a third time, with the order of the investment returns reversed.
It can be seen that there are huge differences in underlying fund value (and, thereby, the on-going sustainability of the withdrawal amount) depending on the sequence of investment returns, with the “high returns first” scenario resulting in a residual fund value which for a period is more than 2.5x that of the “low returns first” scenario.
Sequence effect on residual fund: returns of 7% p.a., withdrawing £7,000 p.a.
Year 7% p.a. deterministic 7% p.a. high returns first 7% p.a. low returns first
Return Residual fund Return Residual fund Return Residual fund 0 £100,000 £100,000 £100,000 1 7% £100,000 21% £114,000 -11% £82,000 2 7% £100,000 18% £127,520 -3% £72,540 3 7% £100,000 15% £139,648 3% £67,716 4 7% £100,000 10% £146,613 6% £64,779 5 7% £100,000 8% £151,342 7% £62,314 6 7% £100,000 7% £154,936 8% £60,299 7 7% £100,000 6% £157,232 10% £59,239 8 7% £100,000 3% £154,949 15% £61,288 9 7% £100,000 -3% £143,300 18% £65,249 10 7% £100,000 -11% £120,537 21% £71,952
If, by contrast, the average investment returns of 7% per annum were delivered at that same rate in each year (which is what is implied when using deterministic forecasting), then the residual fund value remains a constant £100,000 at all times.
These examples serve to show why decumulation presents a very different set of risks from accumulation. If an investor was simply building up assets without any withdrawals, all three sequences of investment returns used in the table immediately above would produce identical returns by the end of year 10 (a fund of £196,715 in each case). The residual investment value is only impacted when investors make withdrawals from their portfolios.
The examples also highlight the hazards of using non-stochastic assumptions when planning and managing decumulation strategies and not taking into account a realistic range of upside and downside near term asset return outcomes.
Lessons
Deterministic assumptions engender a false sense of security. Use stochastic modelling to assess upside and downside risk and the probability of attaining the client’s income and capital goals.
Automated “set it and forget it” drawdown structures that eat into capital can be highly risky given the inherent volatility of markets – bond funds and equities are both capable of bouncing around and producing negative returns from time to time.
The client’s capacity for loss should be front and centre, and choppy markets demand extra vigilance, especially in the case of investors that cannot get by on just the “natural income” (dividends etc) that the underlying portfolio produces.
Either, do not eat your capital (see the next chapter on equity income investing), buy protection, and/or see whether you can reduce volatility without denting longer returns through asset allocation strategies.