Henry Cobbe looks at how advisers running decumulation portfolios can judge and balance the four main drivers behind the risk that a client will run out of money during their retirement.
Advisers running decumulation portfolios have to consider the key retirement risk known as ‘shortfall risk' - essentially the possibility a client will run out of money in retirement.
Shortfall risk has four main drivers:
Sequencing risk: Risk and return expectations vary depending upon different time horizons. This can be mitigated by ensuring the asset allocation is appropriate for the time horizon.
Longevity risk: This is the risk that clients outlive their assets and it can be mitigated by applying a matching ‘safe withdrawal rate' for a given time horizon, based on life expectancy. Advisers can thereby get statistical confidence the retirement pot will last the course. Briefly, the safe withdrawal rate is a commonly used term to define the percentage of the initial investment that can be withdrawn each year for a given investment term and not lead to portfolio failure to a given level of statistical confidence.
Interest rate risk: Also known as duration risk, this is the sensitivity of a retirement plan to interest rates. As a retirement portfolio is trying to match a future stream of withdrawals over time - a bit like a bond in reverse - it is highly sensitive to interest rates. This requires a targeted approach to duration management that is appropriate to the time horizon of the portfolio.
Inflation risk: Portfolios should be well diversified with an income bias to preserve value in real terms while sustaining regular withdrawals.
Why is asset allocation different for different time horizons?
Clients with the same risk profile but different time horizons should have different asset allocations. This is because the risk, return and correlation assumptions that are used to create portfolios differ for different time horizons, so it is wrong to use long-term assumptions for a short-term or medium-term portfolio.
In the world of accumulation, it is all right to assume very long-term estimates of risk and return - at least to start with. In decumulation, however, it can be inappropriate. Risk and return estimates should match the client's time horizon.
What retirement portfolio should look like?
Only advisers know, or can estimate, the inputs into a client's retirement maths. To help advisers offer decumulation strategies that are fit for purpose, retirement portfolios should offer a range of risk-return levels to suit a client's risk profile. But they should also consider time horizon to suit a client's life expectancy, and the safe withdrawal rate that matches that asset allocation.
Putting it all together
At Copia we want to help advisers create a compliant investment solution for clients in decumulation. Decumulation is different. And getting it right - both from an investment and a compliance perspective - is not easy. That is why we recently launched the Retirement Income range of portfolios - labelled by risk level and time horizon - and we also offer advisers with a safe withdrawal rate table matched to each asset allocations and for each time horizon.
In addition, because of a lack of risk-profiling tools that can properly assess suitability for decumulation, we have asked an independent actuarial consultant to develop one specific to our portfolios.
Retirement investing is different, but with the right tools and options, advisers can aim to get the best outcome for their client given their client needs and circumstances.
Henry Cobbe is head of Copia Capital Management
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