With the average UK life expectancy being 82, one of the greatest challenges facing people living in the UK is the ability to fund a 30+ year retirement, whilst ensuring that their pension pot can support their expected standard of living.
Future retirees need income solutions that can provide spending confidence through retirement. It is important to avoid not only drawing down assets at an unsustainable rate, but also underspending out of fear of outliving the pension pot.
Decumulation strategies are steadily attracting attention; they delay the need to fully annuitise savings, but still provide an income stream whilst remaining invested, allowing the best chance of retaining some capital to eventually purchase an annuity or leave a legacy to loved ones.
Understanding the relationship between assets, income and retirement goals is key. As we are living longer, in what is a historically low interest rate environment, flexibility is also required in the decumulation stage.
To ensure a successful decumulation strategy in retirement, we encourage investors to consider three core elements as detailed in this article.
1. Withdrawing a sufficient and sustainable income
During the decumulation phase of retirement, investors effectively convert a portion of their assets into income based on a ‘withdrawal rate’. It is important to determine a sustainable withdrawal rate (SWR) which prevents any income taken from fully exhausting the pension pot, thereby retaining the ability to purchase an annuity during a later stage of retirement.
Whilst there is no uniform solution to finding the correct SWR for an individual investor, we would argue that a sufficient income can be best achieved by investing across a diverse range of asset classes. In order to achieve a sustainable income, we believe investors should avoid aggressively chasing yields which can put capital at risk, and instead focus on resilient and natural yields that are backed by robust business models.
2. It’s imprudent to be too prudent: Decumulation strategies require a growth engine
Contrary to conventional wisdom, if an investor wants to take income withdrawals, we believe decumulation strategies require a strong growth engine to avoid the pension pot running dry. To us, growth assets include all those which have a positive correlation with equities such as high yield corporate bonds, emerging market debt and listed property.
Traditional fixed income assets, such as developed market sovereign bonds, can no longer be relied upon to provide the decent levels of sustainable income achieved historically. The policy response to the coronavirus pandemic has seen absolute yields on government bonds plummet, dragging down yields on other defensive assets. Even though yields have recently increased on the prospect of a post-pandemic economic recovery and the perceived threat of rising inflation, they remain at historically low levels.
Nevertheless, compelling returns can still be earned across a range of asset markets and securities, and most notably from those assets classified as growth. Whilst we think it is important to always have a balance, by having a growth engine and accessing the relatively higher income and capital growth potential available from growth assets, a retiree could expect to receive a higher level of income over 10 years than if they relied on defensive assets alone. It is however paramount to acknowledge that growth assets are not without risk and investors may wish to consider a strategy which strikes a balance between achieving compelling total returns and portfolio volatility.
3. Focus on lower volatility to avoid the worst of market drawdowns
Sequencing risk refers to the danger associated with the ‘sequence’ in which returns are generated and withdrawals are made from a portfolio. The risk is highest in early years of decumulation when the portfolio value and time horizon are at their greatest. Unsurprisingly, withdrawals in bear markets are worse than in bull markets given the retiree takes a proportionally bigger bite out of a shrinking balance.
Thus, sequencing risk is to a certain extent a matter of luck, but it threatens the preservation of capital and its ability to underpin a sustainable income drawdown. Sharp drawdowns can be particularly harmful to investors with nearer-term horizons such as retirees.
Inherently lower portfolio volatility is key for decumulation strategies. We believe it effectively acts as ‘hidden alpha’ as it can help generate greater levels of income because it allows sequencing risk to be managed more effectively.
We view active management as a crucial factor in dynamically adapting risk within an investment portfolio to account for changing market conditions, but without sacrificing income – a necessity for those in retirement. Such versatility is important given that retirees need to withdraw income irrespective of the market environment.
Checklist
Whilst investors approaching retirement have significant freedom and choice, coupled with a plethora of potential headwinds to consider – this can be hugely overwhelming.
By considering this three point checklist – determine and source a sustainable withdrawal rate; use ‘growth’ assets to avoid the pot running dry; focus on lower volatility to avoid the worst of market drawdowns - we believe investors will be better placed to enjoy, rather than endure, their retirement.
Jason Borbora-Sheen is a co-portfolio manager on the Ninety One Diversified Income and Ninety One Cautious Managed funds. The views expressed above are his own and should not be taken as investment advice.