Adviser firms want the best possible approach for making retirement income last the distance once their clients enter decumulation. To do so means having a particular risk focus, says Chet Velani, managing director at EV.
It’s no exaggeration to say that, in the FCA’s line of questioning in its thematic review, the regulator is clearly intent on pushing the financial services sector to fix the problems surrounding how consumers secure a satisfactory retirement income.
In its second questionnaire before Christmas, the FCA asked firms about the processes they have in place for “monitoring and adjusting the income solutions as market conditions and/or the customer’s circumstances change”. I was also interested to see firms probed on “how the investments/portfolios are selected and aligned to the risk profiles for customers in decumulation”. What is this but a strong indication that the regulator is concerned that retirees may not be obtaining the outcomes they should be getting?
While no one, without a functioning crystal ball, can foresee what the markets will do over the long periods when people save and invest for the future, what advisory businesses can do, and no doubt want to do, is adopt the best possible approach for making retirement income last the distance once their clients enter decumulation. To do this, firms must focus on risk to income, not investment volatility, in their modus operandi.
Shifting attention to income sustainability
When an advised client enters income drawdown, step number one is examining their risk profile. It’s vital to check how the client feels about the possibility that their money will run out during their lifetime or about how much decrease in their income might be tolerable.
An attitude-to-risk (ATR) questionnaire now comes in handy – but a questionnaire designed for accumulation is of little use. For clients who’ve moved into decumulation, attitude to investment risk should be parked; instead, attention should be placed on their attitude to income risk. The goal is to meet clients’ objective for sustainable long-term income.
While assessing capacity for loss is important, that risk needs to be viewed under the microscope of long-term income stability, not volatility in capital outcomes. Looking at capacity for loss in conjunction with income will ascertain how much potential loss could be borne without seriously undermining the client’s wished-for standard of living. This would, at a minimum, be the money needed to meet essential expenses, allowing for all income sources, including state and defined benefit pensions.
The methodology I’d now like to focus on is evaluating the risk of income sustainability attached to funds and portfolios. I believe this is important to avoid recommending investments disconnected from the risk profiles of decumulating clients.
The aim must be to ensure that unpleasant and unexpectedly large adjustments to income withdrawals are avoided. Any strategy for producing retirement income, of course, also needs to include processes for monitoring and adjusting the income solutions, in tune with changing market conditions and the client’s evolving personal circumstances. Cashflow management tools can earn their keep here.
Adopting a different view should pay
‘Income at Risk’ is simply a means of evaluating the risk involved in drawing an income by quantifying the potential downside risk connected with different investments. Digging a little deeper, it measures the risk of a drop in sustainable income (let’s define this as income that lasts for life) over a period of three years.
In this approach, it’s assumed that the sustainable income is taken from the fund at the same level for three years, and the potential for a fall in income, if the sustainable income is recalculated, is then measured.
Now, depending on how the fund performed over the three years, i.e. combining capital growth and income earned, it’s possible that the income could stay the same or go up if the total return on the fund has been positive. On the other side of the equation, if poor performance occurred, the sustainable income would need to be revised downwards.
The Income at Risk measurement approach utilises a linear scale for dividing into five, seven or ten risk levels. The highest risk comes at a one-in-four chance of c.16% downside in sustainable income relative to a diversified portfolio of developed market equities. It’s helpful that this methodology is independent of the age and life expectancy of the income receiver.
Getting ahead of the curve
I am certain that a major reason for income drawdown failing to deliver for many in the future will be that the funds and portfolios being used for drawdown are not focusing on the right risk. It should be the risk to income not risk to capital. Risk to capital is unsuitable because capital volatility is not the relevant risk. We need to be focused on outcomes and investment volatility is merely one aspect of the overall picture. The natural income of a fund is a key component in assessing the risk to income, and it provides necessary stability in the client’s income.
The FCA is bound to provide strong direction towards righting the perceived wrongs around retirement income. Being proactive and adopting an income risk suitability process which involves using an income risk questionnaire and risk rating funds for income, must be for the ultimate benefit of end-clients in decumulation and their advisers. It is eminently sensible to move on this now and get ahead of the curve.
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