Investment is an area that will have a big effect on a client's outcomes in retirement. The challenges and risks are also different in retirement so the strategies employed need careful consideration.

In accumulation, the investment challenge is relatively simple. There's often a defined goal or end point so the time horizon is usually known. Investment risks are also generally known and well understood. Clients have some degree of 'human capital' - the ability to generate economic value through work - which allows them to meet expenditure and replenish or add to their assets where required. In accumulation, investment is usually about getting the best performance.

In retirement, the challenge is arguably far greater.

For clients choosing to draw income from investments:

  • they move from having a single goal with a single time horizon to having many goals with different time horizons and an uncertain total time period
  • their capacity to earn and add to the pot, if needed, is lower than in accumulation
  • the portfolio's primary function may be to deliver flexible income but there may also be a need to support ad hoc lump sum withdrawals to cover major purchases (a new car, overseas travel or home repairs), later life expenses such as care costs, or ultimately to leave a legacy

As well as the investment challenge changing, clients also face additional risks both to their assets and potentially to their lifestyles if they are depending on their savings to provide an income. These risks can significantly impact how long their assets last and ultimately the retirement lifestyle they can afford. So a retired client's investment objective is as much about risk management as it is about delivering returns.

In this module, we look at some of the investment strategies you might consider to address the challenges facing your clients as they enter retirement. Of course it's not possible here to cover every investment strategy open to you, but in general terms the strategy you choose to adopt needs to be:

  • flexible enough to be able to deal with changes in client circumstance and the market environment
  • aligned to the various goals that clients have in retirement
  • aware of the extra risks that clients' investments face in retirement
  • tailored to individual client goals and managed on an on-going basis

Various different investment strategies might be appropriate for clients who have moved into retirement. They can be broadly placed into two groups.

Natural income

Investing in assets such as bonds, property and higher dividend equities and using the income generated to fund expenditure has been a widely used strategy for many years - particularly for clients with large asset values. This approach has its benefits but also its limitations.

  • The prize pro - The client usually only spends the income generated by their assets so they never spend their original capital - making it a highly sustainable strategy.
  • The crucial cons - To some extent your client's flexibility to decide what income to take from their assets is limited by the yield that's available. At the moment this may be problematic given the low interest rate environment.

While it's possible to find higher yields in the market, these usually come with significantly higher risk of default and/or greater volatility.

In addition, if your client's assets are their main source of income in retirement, they're likely to want relatively predicable and reliable income payments to meet the regular costs of their lifestyle. Yielding funds and/or securities are not always set up to deliver this. Equity or bond distributions tend to vary in frequency and size and may be delivered unevenly throughout the year. This means your client may get a high distribution one month and then a very low distribution the next.

However, it is possible to help 'smooth' income for clients throughout the year by allowing distributions to accumulate as cash over the year and then transferring this to their bank account annually. This will not address variations from year to year but may help provide a little more certainty in the very short term. But this does require regular management and may not be possible for all clients in the future as the number of clients drawing income from investments in retirement increases dramatically while the average size of accumulated assets may fall in the coming years. For example, there may be a large group of new clients who may have lower asset values, are fee sensitive, looking for a lighter touch service and do not want to pay for ongoing advice annually.

A natural income strategy has historically worked for many clients seeking a regular income from their assets and will continue to do so since it removes the issues of sustainability and sequencing risk (provided the client does not spend more than the portfolio generates in income). However, it may not be right for everyone.

It may work for a client who:

  • has an income requirement which is low relative to the size of their assets, or a very long time horizon (they're young and the level of income they can generate from other strategies is also low)
  • has the capacity to accept variable and or irregular levels of income - possibly because they have other sources of regular income
  • can accept risk to their income and/or volatility in capital value
  • places a high priority on some future expenditure or leaving a bequest - therefore, they don't want to spend their capital but still want to supplement their income
  • is able to accept the risks discussed above.

Total return

In other countries with a similar pension system to the one introduced here under the freedoms (the US, Australia, New Zealand and Ireland) a common approach is to invest in total return portfolios (which do not distinguish between the sources of returns - whether income or capital - they just treat return as return) and make the required level of withdrawals as and when required by the clients (i.e. regular or ad hoc).

This approach is popular as it tends to be more flexible (in terms of the range of income objectives that can be met) than other strategies so it is potentially more likely to meet the needs of a wider range of clients. However, it is not without its risks.

A total return portfolio needs to generate returns (typically above inflation) in order to be able to sustain and grow income withdrawals in the longer term. And this means investing in potentially volatile assets. But taking fixed regular withdrawals from a volatile portfolio can create risks which could make their income less sustainable. If they're unlucky, and their portfolio suffers a significant fall in the early years of drawing an income, academic research tells us that this can severely impact a client's retirement plans.

The key risks to consider are:

  1. Volatility and 'Pound Cost Ravaging'
  2. Sequence of Returns

We'll look at each of these in turn in the following sections.

1. Volatility and 'Pound Cost Ravaging'

Pound cost averaging is a well understood concept. Investing regularly into a volatile portfolio can help increase returns - when asset prices fall, the same amount invested can buy more shares or fund units.

Retirement, however, typically involves withdrawing a fixed amount at regular intervals. If the value of your client's investments drop then the fixed amount being withdrawn becomes a larger proportion of their overall total pot - and they'll have to sell more units or shares to meet the withdrawal.

This means that it's harder for the remaining assets to recover from a fall. So if a client takes money out when markets have fallen, the impact of their withdrawals could be magnified and lead to their pension pot running out faster. Once a client takes money out of their assets, it may not recover when the market rises. They've locked in their investment losses.

The following example shows this effect:

  • two investments with the same overall performance
  • one with steady 5% annual returns
  • one with returns that swing 15% higher then 15% lower than the steady returning portfolio.
Chart showing the pound cost averaging

If your client invests £5,000 a year, after 30 years they'll have accumulated:

Steady investment final value Volatile investment final value Result
£332,000 £340,000 Volatile investment has returned £8,000 more

The volatile portfolio produces a better result over the saving period because:

  • due to the asset price falls along the way, the client pays less for assets on average;
  • the client is able to buy more and therefore deliver a higher final asset value.

So in the saving stage, some level of volatility can help if your client is saving regularly.

Now let's consider what happens when your client moves into drawing an income in retirement. If they start their retirement with the £340,000 they have accumulated and withdraw 5.5% (£18,700 a year) then the result is quite different:

Steady investment final value Volatile investment final value Result
£157,000 £126,000 Volatile investment is £31,000 less

In our example, the steady portfolio performs significantly better than the volatile portfolio. The effect of withdrawals means that assets are sold more quickly, which reduces the portfolio's ability to 'bounce back' from market falls. In other words, it's pound cost averaging in reverse - often now referred to as pound cost ravaging. And as we show, pound cost ravaging is more powerful than pound cost averaging.

What happens when clients make withdrawals?

Portfolio behaviour can have an impact on the level of withdrawal that's 'safe' for your clients to take from their portfolio. To help explain this, let's look at what varying the level of withdrawals does to the sustainability of two different portfolios. In our example:

  • a client has a £1 million lump sum invested and a 30 year time horizon
  • portfolio A has a volatile path of returns
  • portfolio B has a more steady path of returns

Portfolio A has the higher average annual return and outperforms portfolio B in 21 of the 30 years. So in accumulation, where the client leaves the portfolio untouched (shown in Chart 2), it's the obvious choice as it results in a higher value at the end of the investment period.

Chart 2 - Portfolio performance (no withdrawals)

But if the client needs to take income, the situation reverses. In chart 3, the client is taking withdrawals each year equivalent to 5% of the initial amount invested (£50,000 a year) from their portfolio, on a monthly basis. In this instance, the value of the portfolio that produced the best return in accumulation has been significantly eroded because of regular withdrawals.

Chart 3 - Value of retirement pot

This effect is exacerbated with higher withdrawals. If you increased the income taken to £58,000 a year, portfolio A would be wiped out before the end of the 30 year time horizon while portfolio B would last for the whole period.

Being able to explain to clients the impact of their chosen withdrawal levels - and any change to these - is critical to achieving a successful outcome for them.

Source for examples and charts: Standard Life Wealth, 2015: The importance of portfolio behaviour on sustainability in decumulation.

2. Sequence of returns

Volatility can pose a threat to the value of a client's assets when they're drawing an income from investments in retirement, but it's not just volatility that's important. The sequence of returns can also play a major role in the sustainability of their assets. In the example above, one of the main reasons why portfolio A performs worse than portfolio B when drawing income (aside from the effect of pound cost ravaging) is that it suffers a fall early on, from which it never recovers.

Finance professor Moshe Milevsky has written extensively on sequence of returns risk and was one of the first to identify that volatility by itself is not the only issue. His research suggests that the order in which returns are received can make the difference between a person's income stream lasting as long as it needs to and them running out of money early.

In his 2006 paper 'Retirement Ruin and the Sequencing of Returns', Professor Milevsky looked at the effect a sequence of annual returns has on the longevity of a portfolio where the investor takes regular withdrawals. Based on Milevsky's research, we've produced an example showing the effect on two different portfolios. 9% is taken out of portfolios I and II each year (a fairly hefty percentage that was chosen to accelerate the maths).

  • Both portfolios have the same volatility - akin to a volatile equity market. This ensures volatility does not affect the results.
  • Over three year rolling cycles, Portfolio I returns 27% in the first year, 7% in the second, -13% in the third and so on until it runs out of money.
  • Meanwhile, Portfolio II returns -12% in the first year, 8% in the second year, 28% in the third year and so on.

Our table below shows the results. Again the portfolio with the higher average return is not the one producing the best outcome for the client. If the client held their assets in Portfolio II, they would run out of money 10 years earlier than if they held Portfolio I.

The order of returns and losses is very important to sustainability

  Portfolio I Portfolio II
Volatility 20% 20%
Average return 6% a year 7% a year
Return sequence 27%, 7%, -13%... -12%, 8%, 28%...
Withdrawal rate 9% 9%

Ruin age

94 84

Source: Standard Life, based on original research by Moshe A. Milevsky, Retirement Ruin and the Sequencing of Returns, 2006.

In our example, Portfolio I was lucky and entered the market at the right time; just before the market went up significantly. Meanwhile Portfolio II was unlucky and went on to draw income just before the market fell. The loss that Portfolio II sustained in the first year was compounded by the fact that withdrawals were made at the same time. So despite higher returns than Portfolio I in the following years this was not enough to prevent it from running out 10 years earlier.

In subsequent research, Professor Milevsky identified that poor returns in the early years following retirement (the point when the client begins to draw income from their assets) have a much greater impact on sustainability than poor returns later on in the retirement journey. This is because at this point the time horizon is longer - so the effect is compounded for longer.

 Impact of sequencing on sustainability

Source: Asset allocation and the transition to income: The importance of product allocation in the retirement risk zone. Moshe A. Milevsky & Thomas S. Salisbury 2006. Assumes a 5% escalating withdrawal rate from a portfolio of 60% equities and 40% bonds.

The chart shows that if a client experiences poor returns in the first five years of a 30 year retirement journey, their probability of failure (the chance that the portfolio will not last the whole 30 years) increases from an average of around 31% to around 84%.

For this reason Professor Milevsky tagged the early years after withdrawals begin as 'the retirement danger zone'.