Retirement planning is a holistic exercise, taking account of the full extent and makeup of a client’s assets, together with their commitments, aspirations, age, state of health, lifestyle expectations and, of course, attitude to risk.
The possible combinations are numerous, and the risks associated with making the wrong choices are large, since many decumulation decisions are irreversible. Getting things wrong at the point of retirement can harm a client’s quality of life, independence and eventual legacy.
Good advice is key. Advisers cannot see into the future, and outcomes will inevitably be affected by some combination of markets, longevity, health and unexpected events; but an adviser can ensure that a retirement plan is prudent and tailored to the client and that the client’s expectation is realistic.
The decumulation toolkit
Wealth available to support retirement income includes pension savings, other investments, any investment property, and ongoing business income, and the principal residence. All this needs to be measured against an intended retirement income as an initial sanity check.
The decumulation toolkit is well established, comprising annuities, money market funds, bond ladder, smoothed funds, multi-asset funds, principal protected and outright equity, and equity release.
At one end of the spectrum, it is possible to create certainty of outcome. Annuities provide a guaranteed income stream for life, eliminating any concern about market movements or about the ability to fund income. That certainty can be achieved on a nominal basis or, more prudently, on an inflation-adjusted basis.
But certainty comes at a cost. Annuities mutualise longevity risk and provide excellent outcomes where clients live beyond their life expectancy, but they provide very poor outcomes in the case of early demise.
Depending on their personal circumstances, clients may or may not be motivated to provide a legacy, and this will largely define the attraction or otherwise of an annuity solution.
Market-based solutions feed a degree of uncertainty into retirement planning, with the intention of allowing the client access to continued growth.
In the zero-interest rate world of recent years, advisers have tended to shun annuities and to rely on market-based planning, often simply running a client’s accumulation portfolio forward into decumulation without intervention.
On an expected outcome basis, this approach works well. Market growth partially or fully offsets income withdrawal and expected inflation, while providing an attractive legacy across all longevity scenarios.
But expected outcome reflects only the mean outcome of an infinite number of possible future outcomes; these may be widely dispersed and are very likely to include negative outcomes, where the portfolio is unable to maintain the target retirement income over time.
Negative outcomes, or tail risk, can be caused by poor market performance over long periods, by market shocks in the early stages of decumulation, or simply by living longer than expected.
Smoothed funds provide some protection against market price shocks, and can be a useful tool for advisers, particularly when dealing with clients of a nervous disposition. There are many smoothing mechanisms available, and each brings its own risks and rewards.
