Sustainable income
A lot has been written about sustainable levels of income and I do not have anything particular to add to the debate about whether it should be 3 per cent, 3.5 per cent or 4 per cent, but obviously if income levels are too high, there is a higher risk of running out of money.
There is an interesting academic debate about sustainable income and I think it helps to take a practical approach. The lower levels of sustainable income – for example, 3 per cent – is too low for many people, especially those with modest financial wealth. In some cases it makes sense to consider taking income in excess of the sustainable level if needed, providing there are other sources of income available in the future.
If we keep strictly to the sustainable income levels, this would put drawdown out of reach for many clients.
Investment strategy
If an annuity is an insurance policy that guarantees retirees do not run out of income, drawdown is an investment solution from which income withdrawals are taken. This is stating the obvious, but the success or failure of drawdown lies with investment performance.
There is not one best way, but there are a range of investment strategies depending on various factors such as the client’s circumstances and the advisory firm’s approach to drawdown. It is a well known fact that investing before retirement is different to investing after retirement.
What separates pre-retirement and post-retirement attitudes to risk are time and money. Before retirement clients have time to recover from a period of poor returns and they do not need to withdraw money. After retirement, time is not on their side and money is needed to meet income requirements. Getting the wrong sequence of returns can have devastating consequences.
There are many different investment strategies for drawdown, including:
- Investing in managed or multi-asset funds and selling units when income is needed.
- Investing in high yielding funds and take the running yield as income.
- The bucket approach – short-term cash – mid-term safety and long-term growth.
- Guaranteed funds and structured products.
- Combination of annuities and drawdown.
The more you think about investing for drawdown, the more complicated it can become, especially when balancing the need for income certainty with flexibility and investment control.
It is easy to underestimate the risks associated with drawdown. Chart A compares the income from annuities, gilt yields and the returns from the FTSE 100. This acts as a good reminder that shocks to the system, such as the Dotcom bubble crash in 2000 or credit crunch in 2008, have a negative impact.
Managing sequence of return risks
Sequence of return is the new buzz phrase for drawdown and by now all advisers should understand this concept. However, understanding is not enough, we must have strategies to actually reduce sequence of return risk. Most advisers will be aware of this risk, but it is easy to make the mistake of considering it purely theoretical.
If an explanation of sequence of returns risk is needed for clients it can be explained as follows: “It is the risk that investment returns are lower than expected or negative in the early stages of drawdown, resulting in capital being eroded quicker than anticipated.”
