Asset allocation can have a huge effect on a client's retirement income. Peter Carter weighs up some of the issues
Choosing the right asset allocation for the decumulation phase of retirement planning is a complex area as it will depend on how income is to be provided for the client. Over the long term, equities tend to outperform other asset classes, but how is this applied in the retirement income context and how do a client's circumstances affect the choice?
For most clients, there are two options when they take income from their pension fund; a fixed annuity or income drawdown. The investment strategies will however be very different.
It's all about timing ...
Increased life expectancy is a major factor. For those looking to buy a fixed annuity this is not a concern as the annuity provider will take this into account when calculating the amount of income which can be paid.
However, in the time leading up to buying an annuity, asset allocation can be very important. Being invested heavily in equities could be disastrous if markets fall immediately before annuity purchase.
Clients need to preserve capital value so moving into cash or a short dated fixed interest fund is an option. Although a lifestyling approach can be used it is not necessarily the best approach as it is mechanistic and can lead to missing out on good performance as funds switch from equities into cash/fixed interest.
They can buy an annuity protection fund. This is basically a long dated fixed interest fund which invests in similar assets to that of an annuity giving the client an element of interest rate protection. As interest rates fall, so will annuity rates, but the capital value of long dated fixed interest assets will rise. The idea is that the eventual annuity that can be purchased will be broadly the same.
Drawdown issues are different
In drawdown those reaching retirement at age 60 or 65 may have between 20 and 30 years in retirement and so continuing to invest in equities is probably a good idea. However, there are issues to take into account.
Selling units in volatile funds to provide income can erode the pension much more quickly. In table one the unit price of the fund increases each time units are encashed. Table two shows what happens when the unit price falls each time.
As can be seen more units have been surrendered in a falling market so even if the unit price recovers later on, there will still be fewer units and therefore a lower fund value. For example, if the unit price in both instances reaches 150p, the value of that where the unit price was rising would be £293,153, whereas in the other example the fund value would be £291,615. A small difference but in this example only £5,000 of income has been taken.
Take it from cash
This leads many advisers to look at taking any income a client needs for their pension from a cash reserve which is kept topped up from other investments. This leads to an unintended consequence. An example may help to explain. A client taking drawdown will be quoted a 'critical yield' which depending on the type will be the growth rate required to be able to buy an annuity of the same value at a certain age. For the purposes of this example we'll say that this is 8% p.a.
However, when cash is added to the portfolio which may only have a return of 4% p.a., the return required from the rest of the portfolio to make the required 8% goes up. So, if 20% of the fund is allocated to cash to pay income over the next few years, it means the rest of the portfolio has to perform at 9% p.a. - 12.5% greater than the original critical yield calculation suggested.
So what is the answer?
One of the innovations of 2007 was the launch of so called 'third way products' which offered unit linked equity investment products but with an underlying investment guarantee.
What these products can do is remove the headache associated with managing drawdown funds as they can provide a guarantee on either the level of income received or the amount of capital remaining after a certain term.
It remains to be seen how these products fare in the UK but early signs are encouraging not least from the number of providers that have, or are about to enter the market.
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