12th November 2018
BlackRock Investment Managers conduct an annual piece of research (in the US) of around 30,000 individuals and get their sentiment and preparation for retirement. Obviously it is heavily slanted to the financial. One of the surprising things, for me at least, was that the #1 concern for the majority of respondents was not health or social interactions or purpose, it was ‘running out of money’.
I guess running out of money in retirement does bring up all sorts of miserable and unfortunate images in our minds, and that is probably enough of a motivation for us to want to do something about it! Sequence risk is something that can result in us running out of money, and which we covered in a little detail last week, and this week we aim to share some ideas in how to minimise the impact of that very occurrence.
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As in our previous blog on Sequence Risk, the assumption in all of this is that we are in retirement, as in we are drawing an income from a retirement pot, most likely an Approved Retirement Fund. If you are a member of a Defined Benefit Scheme you unlikely need to be concerned about Sequence Risk – although the scheme’s solvency is a very real risk that is worth reflection, which we will do in the near future!
As we know when we are drawing an income from an Approved Retirement Fund (ARF) we will be taxed on it based on our circumstances and income at that time. We also know that if you are aged between 60 and 70 you will be taxed as if you take 4% of the fund, and if you are over 70 you will be taxed as if taking 5% of the fund. That alone will drive many of us to take the 4% or 5% even if we don’t need it, but lets park that motive for this episode and look at this in the broad light of day!
Sequence Risk arises when we, in retirement, are drawing our income from the fund and we are met with a sequence of unfavourable market returns, typically for several years in a row and which is of greatest impact when it happens in the early years of starting to take the income. In our 3 scenarios last week we saw that the 3 investors all took the same percentage of the fund value each year, each achieved different sequences of positive and negative annual returns (though the same average long term return), and all ended up after 25 years with very different remaining balances in their Retirement Funds. One investor, after 25 years of withdrawing 6% every year (which increased each year in line with inflation) had more than they started with, one had ran out of money and one had 40% of what they started with…..all due to sequence of returns.
Remaining invested in a portfolio which will deliver above-inflation returns is the only sensible approach to take in retirement, particularly when we want to draw an income every year which is increasing each year in line with inflation. And this part should really not be over-looked particularly if we want to ensure we can afford the things we can now. That flight to Dubai to see your grand-kids which costs €1,000 today will, if it increases in line with 3% inflation, will cost you €1,343 in 10 years time. Like most things in financial planning the solutions are a combination of behavioural and strategic……
A Couple Of Strategic Investment Solutions:
A) ‘Bear Cash’: Bear cash is just a term I have created here but it simply means holding a few years of living expenses in cash within your portfolio. It is a simple approach but can be an effective one. Imagine you have your €1m at retirement date and intend placing it all in an equity portfolio and drawing a certain percentage each year as income. In our previous scenarios the trouble starts when the portfolio gets off to a negative start in the initial years, and the investor continues to draw the income from it. The solution here is to have 2 or 3 years of spending money in a cash fund within your portfolio which you will draw from during times of bear markets in the initial decade or beyond. The impact of this is that you are not selling off your equities (which will be down 20, 30, 40, 50%) during times of bear markets, and instead will be selling off your cash funds which should be relatively static in price. When markets recover (they always have) one can revert to taking the income from the equity portion of the fund, and replenish the cash reserves for the next bear!
B) Lower Volatility: Another solution is to opt for a less volatile portfolio for your entire pot, and to draw our income from that. In theory, the idea here is to reduce the volatility of the entire portfolio to such a degree that a negative sequence of returns is avoided. It may well do that but one of the major challenges with this approach is that if volatility is low then it is very likely that your average annual return will also be low. This unfortunately is the approach that most pensions that we see are defaulted to, often with the person whose pension it is having any great awareness of what is going on. After charges you may really struggle to keep up with inflation, and that then reduces the lifespan of your savings.
C) Annuity: An option which very few people are opting for, whereby you hand your entire pot to an insurance company and they guarantee you a certain percentage for as long as you are alive. You can build in an additional payment to your surviving partner if you pass away before him or her. On death if there are any funds remaining they are kept by the insurance company, they do not pass to the estate. The rates which people are offered on annuities are currently well below the 4, 5 or 6% which investors would hope to achieve by keeping ownership of the funds and drawing as needed.
A Couple Of Behavioural Solutions:
A) Spending: May seem like an obvious one but as we said already, the problem of sequence risk really compounds when we continue to draw an income from a portfolio that is in the middle of a temporary market decline, it is not an issue when the markets are on the up (which they are in 3 out of every 4 on avearge by the way!). Again, this is an obvious one. When markets are falling, and your retirement pot is invested in same it is best to not be drawing an income from it, so curb your spending! In periods of bear markets, particularly in the initial decade aim to not draw any income from your pot. If you are totally dependent on the income from the pot then this will be hard to do obviously. If at all possible an approach would be to reduce the income being drawn from the pot, and to utilise other resources that one may have to sustain them for the period the bear market.
It is simple, but perhaps not easy! By doing this you can ensure that 100% of your pot is invested in an asset-class that has delivered average annual double-digit return over the past 100 years……
B) Keep The Withdrawal Rate Conservative: The imputed distribution rules which set out that you will be taxed as if drawing 4% of the pot, irrespective of whether you are taking it or not. 4% would be deemed to be conservative enough to see us through and to leave a decent legacy to our loved-ones. In the scenarios from last week the income draw-down was 6%, which again may well be totally suitable and sustainable depending on the portfolio one selects and the returns achieved.
There really is no perfect solution, there will be an element of trade-off which needs to be considered and then a decision made on the basis of the information at hand. When it comes to drawing the income we will want to ensure that we have as few worries as possible, but also to make our pot last as long as we possibly can…..and that is where being aware of the options, and the pros and cons of each become so so relevant.
I wish you well!
QFA |RPA | APA | Qualified Coach
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