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Pensions income – the longevity and inflation risk minefields

11 July 2018

As Anthony Gillham, fund manager of the Old Mutual Generation Portfolios explains, reaching retirement with a decent pension pot is a battle in itself; but managing that pot so that it lasts throughout a client’s retirement requires an entirely different kind of campaign. Ultimately, the only way to fight the longevity and inflation risks this entails is to utilise investment risk but, for most clients, this will be another minefield.

The advent of the new Pension Freedoms in 2015 was a watershed moment for the UK pensions industry and its advisers. Among other things, the new rules were the last nail in the coffin for the tired old annuity but in killing off the annuity they put British retirees in the driving seat in terms of managing their pension pots.

Unfortunately, very few are equipped to handle these new-found responsibilities. A very small minority of Britons have built successful portfolios of their own but none of this experience means much when it comes to managing a ‘decumulation’ strategy as the rules of engagement are quite different.

Shouldering the risks
There are three main risks that advisers must help clients to understand in order to make it through retirement without their pension pot ‘shuffling off’ before they do.

Longevity risk
This refers to the risk that your client lives too long for their pension pot. To counter it, they’ll need to take a view on their likely life expectancy which these days is about 20 years for the average 65 year-old man and closer to 23 years for the equivalent British woman[1].

Inflation risk
Inflation risk is the secret killer.It suddenly becomes an extremely destructive force when someone reaches retirement and stops drawing an income from work. Let’s imagine that a client retires today at age 60 with a pension pot of £100,000. If we assume that inflation runs at 2.4% over the course of their retirement (roughly the 10-yr average for UK CPI) then inflation will have eroded the real value of their pension savings by more than 21% after just 10 years and by almost 39% after 20 years – and that’s without spending any of the pot[2].

To combat inflation, pension investors therefore need to utilise investment risk by maintaining a significant exposure to risk assets such as equities and commodities that have a strong track record of beating inflation. Of course, this presents risks of its own, most notably, sequence of returns risk.

Sequence of return risk (or pound cost ravaging)
Sequence of returns is frequently known as pound cost ravaging as it’s a lot like pound cost averaging in reverse. It’s the increased risk presented by a fall in returns that comes early in a client’s retirement as opposed to later down the line.

As the Tables below illustrate, while the order of return makes little difference for a client in the ‘accumulation’ stages of their retirement planning, the same can’t be said for an investor in the ‘decumulation’ stage (we’ve picked some extreme return figures for the sake of illustration).

As this example demonstrates, despite generating the same average annual return over the first five years, the fact that Portfolio 2 suffered its two worst annual returns at the outset means that even after just five years, Portfolio 2 is already almost £13,000 (22%) down on Portfolio 1!

Fighting back
Not surprisingly, it has taken some time for UK retirees to grasp this concept, not least because until the arrival of the Pensions Freedoms it wasn’t an issue for most pension investors.

The same is pretty much true of the asset management industry. Although there has been a sudden boom in ‘absolute return’ strategies or ‘long-term income solutions’, very few reputable managers have taken the time to examine the problems presented by longevity, inflation and sequence of returns at face value.

From our perspective, any fund offering that’s serious about providing a genuine decumulation solution needs to focus on the following things.

Speculate to decumulate
The first requirement is to take inflation out of the equation. For us this meant creating three portfolios aimed at matching UK inflation which provide different levels of additional real annual income for a different level of investment risk.

In order to overcome inflation for decades at a time, a decumulation portfolio will need to include lots of potentially inflation-busting assets such as equities, commodities or inflation-linked bonds. This kind of exposure requires dynamic risk monitoring to ensure that buying opportunities aren’t missed and that any subsequent market upheaval doesn’t affect the portfolio too meaningfully.

Naturally, capital preservation needs to be central to any decumulation solution. This means finding a fund manager who can implement active downside protection to stop any run on the fund’s value and who can hedge key risks from the outset.

It helps to have an unconstrained investment remit as decumulation requires diversification across the broadest spread of different asset classes – be suspicious of any single asset class ‘decumulation solution’. This means investors can also benefit from less correlated alternative asset classes such as property and hedge funds. Building a truly bulletproof, multi-decade portfolio will require significant allocations to all of these asset classes as well as the freedom to move quickly in and out as the outlook changes.

All this requires market-leading information, analytics and execution and extensive financial tools and modelling. Putting all this together creates a fund with a return profile that doesn’t shoot out the lights. A decumulation fund should always stay well clear of any market nadir and only aim to capture part of the upside when markets are rising. It should plot a very predictable course, generating sustainable levels of inflation-proof income year in and year out.

This may sound a bit boring but there’s nothing boring about a fund that will live at least as long as your clients, providing income for them throughout retirement and quite possibly doing the same for the next generation too.

[1]Source: ONSas at 31 May 2018.

[2]Source: OMGI as at 3 May 2018.