With the unprecedented Budget changes heralding new investment avenues for retirees, how can advisers pick the right solutions for their clients?
The changes will, from April 2015, give individuals at retirement, in the words of the Chancellor, "the complete freedom to draw down as much or as little of their pension pots as they want, any time they want. No caps. No drawdown limit. No one will have to buy an annuity [...] people who have worked hard and saved all their lives, and done the right thing, should be trusted with their own finances".
With this new freedom comes greater responsibility for individuals and their advisers to plan the decumulation stage of their lives.
This should not be underestimated. Financial regulation in the UK has increasingly emphasised a duty of care on the part of financial advisers to provide advice that is suitable for client requirements, and the consequences of getting it wrong in relation to an individual in decumulation are much greater than for people making provisions in the early stage of their working life.
Challenges of retirement planning
Up to the decumulation stage the pound-cost averaging effect of putting aside a fixed portion of a person's salary goes a long way to mitigating the impact of volatility on securities and/or investment fund holdings.
In the early stage of accumulation, when contributions are high in relation to the amount saved, volatility risks are also mitigated by the long-term time horizon of someone who is just beginning their working life.
Inflation risk is mitigated by a person's earnings, and contributions, normally rising at least commensurately with the cost of living (the period since the 2008/09 financial crisis is exceptional). Liquidity risk is not really an issue when spending needs are fully covered by earnings.
Clients and/or their advisers also have to think about a risk that is specific to decumulation - longevity risk. That is the risk of living longer than you expect and running out of money because you ran down your savings too fast.
An illustration of this risk has been provided by professor Moshe Milevsky in his 2006 paper Retirement Ruin and the Sequencing of Returns. For certain retirement savings pots he shows the age at which an individual would reach 'retirement ruin', given fixed withdrawal amounts and an assumed 7% rate of return on fixed income assets.
He then provides a guide to how this age might alter for different sized pension savings pots and withdrawal amounts. The time in which a person can run out of money in retirement is even quicker today than illustrated by Milevsky's paper, primarily because returns on quality fixed income assets are lower than 7%, and also due to increasing life expectancy.
Professor David Blake points out in a recent discussion paper (The consequences of not having to buy an annuity, June 2014) that individuals underestimate their life expectancy. For men in their 60s, the underestimate, based on survey data, is about five years and for women it is three years, and the underestimate increases with age.
When retiring, individuals were forced to buy annuities and hence were covered for this longevity risk. Now, however, the recent Budget changes relaxed this obligation and were widely applauded as payout rates on annuities have become so low due to the above mentioned factors of low interest rates and increased life expectancy.
With retiring individuals given complete freedom on retirement planning from April 2015, advisers may look to other investments that provide regular income, but with a higher return, so that individuals at retirement can fund a better lifestyle based on whatever savings pot they have built up.
Obvious alternatives are equity income funds and property, which normally return more than quality bonds over the long term, and cover for inflation risk. However, equity income funds generally show significantly higher volatility than gilts have shown historically.
This kind of volatility can be devastating to retirement planning. As mentioned, volatility risk is mitigated in the accumulation stage of a person's life by the pound-cost averaging effect and a long-time horizon.
However, in decumulation, volatility can mislead retired individuals into thinking they can sustain bigger withdrawals when stock prices rise to speculative levels, and if they maintain fixed withdrawals when prices are depressed, capital and hence future withdrawal capacity can be impaired.
While property has shown lower volatility than equities, it carries a higher liquidity risk as there are times when it is difficult to sell (or withdraw money from a directly invested property fund), hence is generally not suitable for a full decumulation strategy.
Solutions to retirement planning
A multi-asset fund can give a better risk-return combination than single-asset funds based on one of the most robust principles of modern portfolio theory; diversification – adding imperfectly correlated (and even better uncorrelated or negatively correlated) assets contributes proportionately to returns but less than proportionately to overall risk.
Some providers have risk targeted multi-asset fund families, with each member managed to a specific risk target (typically a volatility band), which can help when matching products to client needs.
In general, the more comfortable an individual is with taking risk and the more assets they have (larger pension pot, equity in own house or buy-to-let properties, and maybe even an annuity to cover basic spending needs) the more suitable is a higher risk target and vice versa.
Defaqto Diamond Ratings
However, with nearly 700 multi-asset solutions available, this presents advisers with a complex landscape to understand and navigate.
Defaqto Diamond Ratings help advisers by providing an independent assessment of where funds and fund families sit in the market based on both performance and a range of key qualitative attributes, including cost, scale, access and manager longevity.
Importantly, if an adviser is considering risk targeted funds, a sensible way to start their research is by looking at fund families, not individual funds. Choosing particular fund families rather than matching funds from many different providers to a client's risk profile should make an adviser's proposition more consistent and flexible at the same time.
When an adviser wishes to swap funds, this is much easier within a fund family rather than moving from one provider to another. Further, by using a number of funds from a smaller number of providers, advisers may also have more power to negotiate better client terms.
This presents a complex research challenge which we have addressed by uniquely featuring fund families in our Diamond Ratings, alongside our regular individual fund ratings.
Ultimately, Diamond Ratings help advisers understand and evaluate the market, and give them (and their clients) assurance about the propositions that they have chosen.
In summary, Diamond Ratings:
• Are a natural evolution of our established research into managed funds
• Are whole of market across the sectors they cover
• Uniquely rate families of funds to give advisers an insight as to whether the intended gradations of risk and return have been delivered
• Combine a quantitative assessment of both performance and numerous other qualitative data points
• Are backed by Defaqto's independent brand.
Diamond Ratings currently cover:
• Risk targeted fund families
• Multi-manager and multi-asset (return-focused) funds across the four relevant IMA sectors; and Index trackers – exchange-traded funds and open-ended funds.
Advisers can learn more and access the Diamond Ratings on www.defaqto.com/advisers/ratings/diamond-ratings
What's more, Diamond Ratings are now available, in full, within our research software for advisers, Engage, enabling you to compare a shortlist of funds and fund families, and to research the market generally. Find out more and register for a free trial at www.defaqto.com/advisers/solutions/engage