In the first of a new series on different aspects of the decumulation phase of retirement planning, Henry Cobbe argues liability-relative investing may be complicated but the key questions for retirement maths are not
Investing for decumulation could really be called ‘upside down investing'. In essence, it is the mirror image or opposite of accumulation.
Instead of regularly paying money in to grow a pot, you are regularly taking money out to run it down. The objectives are different, the risks are different, so the strategies should be different too.
When making a retirement plan for a client nowadays, advisers have to consider three questions:
* How much do they have now?
* How much do they need on an annual basis?
* How long do they have to live?
The tools for assessing suitability in retirement are not fit-for-purpose unless they include these three questions. This is because these three questions are the key inputs for retirement maths.
Managing retirement maths
The retirement maths facing advisers is similar to that faced by the trustees of pension schemes - essentially, how can a pot of money pay out enough money for long enough?
If the pot can comfortably support it, there may be a surplus. If the pot cannot support it, there may be a deficit. So, just as collectivised company pension schemes have surpluses or deficits, so do pension schemes managed for individuals - and it is up to advisers to manage it.
Decumulation investing requires a different portfolio management approach to the asset-optimised approach used in accumulation - one that is not simply designed to grow a pot, but rather to make it last.
In investment terms, to ensure the retirement maths works, we need to ensure the market value of the decumulation portfolio of assets is equal to or greater than the present value of future payments (liabilities) from the pot. This is the principle of ‘liability-relative investing'.
The key sensitivities in managing liability-relative portfolios are:
1) the market performance for the portfolio of assets (risk-return level);
2) the life expectancy of the client (time horizon); and
3) the sensitivity of the portfolio to changes in the interest rates used to discount back future withdrawals over different time periods (duration).
Accumulation portfolios only consider risk-return level. They do not consider time horizon or duration. They are not designed for decumulation, in other words, so they should not be used for it.
What is a safe withdrawal rate?
The safe withdrawal rate is the percentage of initial value that can be taken out each year to the extent that the client's portfolio is perfectly depleted at the end of the expected investment term (and not before) even under the worst-case investment scenario over that time. It is, to put it bluntly, the ‘die broke' number.
There is no single number for a safe withdrawal rate. It depends, first, on what a client's asset allocation is - the higher the risk of their portfolio, the lower the safe withdrawal rate figure - and, second, on their time horizon.
Best practice would suggest advisers should agree a safe withdrawal rate with their client and then review this every year. This is because the key inputs to retirement maths will have moved on. Pot size will change with markets, life expectancy/time horizon may change with health, and income requirements may have changed with living costs.
Thus, while liability-relative investing may be complicated, the three key questions for retirement maths are not. And only advisers know their clients' needs and circumstances to ensure those inputs are suitable.
Henry Cobbe is head of Copia Capital Management
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