Pension freedoms and the growing demand for drawdown offers an exciting opportunity for financial advisers, writes Nick Johal, but having investment portfolios that can combat pound cost ravaging are vital
Since April 2015, the financial services industry has introduced a wide variety of new products and services to meet the challenge of pension freedoms. Though, in reality, it is the multi-asset funds that have hoovered up most of the available investment. Throughout this process, however, the need for products with defined returns - particularly for investors in the early period of decumulation when their longevity risk is highest - has been overlooked.
In the early phase of a long drawdown period, investors are in many ways exposed to the greatest risks. In contrast to an accumulation investor, they have to make their pot potentially last for more than 30 years and avoid the risk of ruin.
As these investors draw an income, should the portfolio make significant losses in this phase they effectively double-down on the loss. This pound cost ravaging can leave investors' portfolios below their original investment value for many years. Unlike accumulation investors who can overlook short-term volatility, these drawdown investors cannot.
In this early period, it is vital to use investments that carefully define returns, risk profiles and volatility. In fact, research from Moody's and Standard Life demonstrates the impact of pound cost ravaging in the early period of decumulation is more powerful than pound cost averaging over the lifetime of an accumulation investor.
The challenge for professional advisers offering support to clients in decumulation therefore moves from choosing investments that can perform well within a client's risk tolerance to acting more as a liability-driven investor on their behalf. This involves carefully reducing volatility while longevity risk is high.
With 10-year gilt yields currently below 0.5% a year, the favoured investment for traditional pension fund managers to match their liabilities has been seriously compromised: liability-driven investors must cope with a world where $13trn worth of bonds globally are trading at negative yields.
A popular 1980s saying applies here - ‘TINA' (there is no alternative) to equities. However, equities are a risk asset class and, with higher volatility, have the potential to generate plus or minus 20% returns in any given year. And, while the +20% would benefit retirement portfolios, it is not a required outcome - after all, a little less than 7% per year compounded over 10 years will double a portfolio's value. But a -20% return has serious consequences.
This is where structured investments can fulfil a useful role as part of a diversified portfolio. Popular payoffs in the UK are structured to cap the upside return and build in a buffer on the downside. This increases the probability of generating an acceptable capital return or income in the region of 5 to 10% a year, depending on the level of risk taken.
These investments are not risk-free. They experience credit risk, market risk and investors will forgo dividends. However, these market-linked investments have a proven track record of delivering attractive returns. For example, even during the FTSE 100's largest historical drawdown of just over 30%, capital would have been protected on a FTSE 100 defensive autocall - subject to the solvency of the issuer.
For advisers not keen on building a portfolio of structured investment plans for their clients, several alternatives exist; structured investments managed portfolio services and unit trusts have proliferated over recent years. For example, Brooks Macdonald has designed a flexible decumulation strategy to address inflation and sequencing risk, using structured investments as a key tool within the strategy.
While often overlooked and tainted by perceived legacy issues, structured investments offering defined risk/reward trade-offs are compelling investments with demonstrable track records that could certainly help solve some problems for clients who are approaching or in retirement.
Nick Johal is a director of Dura Capital
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