The rapidly changing regulatory environment surrounding personal pensions means that investors are now able to access their pension savings via an unsecured income from the age of 55. 
The income can be as much or as little as the investor would like and is no longer subject to the Government Actuary Department (GAD) rules.
This new “pension freedom”, introduced in April 2015, means that many more individuals are accessing their pension savings flexibly rather than be restricted to the purchase of an annuity. This has led to increased demand for financial advice and appropriate investment solutions, which have been designed specifically for long term withdrawals.
Drawdown has been around since 1995 and so investing for decumulation is nothing new.
However, pension drawdown has commonly been seen as the preserve of traditional discretionary wealth managers. We have not, thus far, seen anything designed specifically for purpose within a centralised investment proposition.
Over the past two years, Parmenion Investment Management (PIM) have developed a robust new strategic asset allocation, specifically designed to support long term withdrawals, which aims to deliver a suitable balance of stable natural income and long term capital growth.
Independent, external stress testing provides the validation that the asset allocations are robust and able to withstand long term withdrawals in a wide variety of market environments.
Many investors are relatively comfortable with the concept that as one assumes more investment risk (volatility of returns) the potential for returns increases. Building on this concept, Modern Portfolio Theory (MPT) states that a combination of different assets with varying risk return profiles can be combined to create a portfolio which should deliver returns efficiently.
That is to say, a well-built diverse portfolio should deliver the maximum return for any given level of risk.
In the same way theory would suggest for a given level of risk the natural income, or yield, generated by a well-diversified portfolio should be relatively stable. However, our research has shown that portfolios built seeking a higher level of income only achieve that with an increase in volatility of that income, albeit within a relatively small range.
Source: FE Analytics
We can see in the stylised example above that the volatility of the income stream increases as the level of income generated increases. Thus, there must be an optimal mix of assets to generate a particular income.
However, when analysing the underlying portfolios in the efficient frontier above, we found that those “higher risk” portfolios which generate a higher natural yield actually contain high allocations to fixed interest and property.
Therefore, there is a juxtaposition between the volatility of income and capital.
This teaches us a valuable lesson. When focusing purely on delivering a high natural yield, one sacrifices some opportunity for capital growth. This is true even in modern structures in which investors effectively sell future potential capital growth in exchange for an income today through the use of call options.
Therefore, when investing for long term decumulation, one needs to deliver both an efficient income (i.e. the income stream is no more volatile than necessary) and reaonable opportunity for capital growth.
Using this research we developed asset allocations across ten portfolios with distinct risk grades. Here we have shown the asset allocation of Risk Grade 6.
Source: FE Analytics
We then back-tested our asset allocations to determine whether they can support long term withdrawals with very favourable results.
However, the sustainability of withdrawals is heavily influenced by market returns. This is known as sequence risk. If the years following entry into a drawdown portfolio offer poor market returns, then the sustainable withdrawal rate may be substantially less than the back-testing would suggest.
In order to validate our new asset allocations, PIM commissioned Moody’s Analytics to stress test them using their Economic Scenario Generator (ESG). Moody’s Analytics work with many large pension schemes and investment institutions to stress test asset allocations.
Their forward looking ESG modelling software attempts to forecast the range of portfolio returns in thousands of potential economic scenarios.
PIM asked Moody’s Analytics to test the allocations and report the 10th percentile (i.e. returns are better 90 per cent of the time), 50th and 90th percentile returns. This wide range of outcomes tests the portfolios under prolonged poor market returns, effectively capturing sequence risk.
In order to quantify the risk of drawdown versus an annuity, we asked Moody’s Analytics to assume that the investor is withdrawing an amount roughly equal to the prevailing annuity rate. We also asked them to project forward annuity rates so that we could calculate the capital required to purchase an annuity of equal value in the future.
For example, a 55-year-old could have purchased an annuity of £4,569 with a pension pot of £100,000. At aged 70, the median projected annuity rate, taking into account possible changes in inflation and bond yields, is 7.98 per cent.
Therefore, the capital required to buy an annuity of £4,569 at age 70 would be £57,226.95.
The results showed that for risk grades 3 to 6, there is a good chance that at the age of 75 the pot would be big enough to allow the investor to buy an annuity paying out the same income they could have bought at age 55. Furthermore, the results showed that in the 10th percentile outcome, the pot lasted for about 30 years in the majority of cases.
Source: FE Analytics
From this testing we can certainly see that there is a risk of entering drawdown versus buying an annuity. We define this as the risk as not being able to buy the same guaranteed income that one could have secured at outset, in the future, i.e. the gap between the yellow and blue lines.
However, the modelling shows that one could enjoy all of the flexibility of drawdown whilst taking the same level of income as could be achieved through annuitisation and might only run out of money if they were unfortunate enough to experience 26-27 years of sustained very poor market returns (the yellow line).
However, we feel that this modelling also demonstrates that the risk can be managed through sound financial advice, well-built asset allocations which have been designed for purpose and an educated discussion surrounding withdrawal rates, rather than reliance on heuristics such as the 4 per cent rule.
Obviously, ongoing engagement between client and adviser is crucial.
Steve Lennon is an investment manager at Parmenion. All the views expressed above are his own and should not be taken as investment advice.