The sun started to shine again last week, not just on the east coast where I was enjoying the last week of the summer holidays, but across the worlds equity markets, that regained much of the previous weeks’ losses. When you ask for a reason, the number of different explanations is almost enough to make you realise that no one really knows what’s going on, but of course that can’t be true, can it?
Having sent out client statements for the month of August, it was reassuring that like July, everyone had made money and that wherever people were spending their summer, as one put it in an email, the gains were enough to pay for her penchant for pre-dinner Gin & Tonics, which was nice to know as I supped my Tesco’s ‘Value’ cider.
When developed markets, such as the FTSE 100 can move 3 to 4% in a trading week, it should bring home to investors how quickly gains can be wiped out as well as made and depending on your age and financial position, how this can easily change your future, especially when near to retirement.
The number of near or ‘at retirement’ clients that I’ve dealt with in the past year, mainly through writing this column, has significantly increased and although everyone is different they all share the same aversion. An unwillingness to use their pensions savings to buy an annuity, as the prospect causes people to almost convulse, especially when they realise £200k transpires into an income of around £12k a year (before tax) at age 65, with no dependents pension or link to inflation.
I can understand and do empathise with this experience and an analogy is something similar to the experience of one of my recently divorced clients, who after attending an over 40’s disco, thought he had struck gold when leaving the venue to go home rather inebriated with someone he said at the time looked like Madonna. The next morning was a different story, as reality kicked in and the said pop icon had turned into 1980’s soap star Hilda Ogden, shattering the ego and dreams of the said man. In a pension sense, this initial excitement can happen when a 25% tax free lump sum is paid out, which for many is the largest sum that they have ever had deposited into their Lloyds supersaver account, but then only to realise the rest of the fund leaves them in near poverty for the rest of their lives and a rather flat feeling.
I admit that most of the pensions I deal with are over £300k and may hold physical assets, such as farm buildings and factories that cannot be easily sold and actually produced a solid income. Others that I see have a different story, normally of bad advice, poor investment choice and on the part of the client, disappointment both pre and post retirement.
The type of retirement option that can cause clients to lose money and take the biggest risks is referred to as income draw-down. I recently read that in the last 12 months over 140,000 such plans were arranged, mostly by advisers, but others confident that they can ‘do-it themselves’ via the likes of Hargreaves Lansdowne, believing it is simple to execute such a strategy.
Although income drawdown plans are probably the highest risk products that I advise on, I am not saying that they are wrong and in fact give many an alternative option to buying an annuity, especially at the moment when interest rates and government bond yields are at an all time low (annuity income is generated and secured by using government and corporate bonds), but the strategy adopted by most flies partly in the face of conventional text book investment strategies.
When someone approaches retirement age, it is normal to start de-risking their portfolio, by reducing exposure to volatile assets, such as equities and going into assets such as bonds and cash, so if there was a correction a year before 65, the negative effect is minimised.
I don’t want to be too technical here, but when one goes into income drawdown, depending on how much cash is being withdrawn every year, there is something referred to as a Critical Yield, which basically sets out the return needed in order to retain the purchasing power of an equivalent annuity.
With returns on cash anywhere between 0% (James Hay) and 0.65% (Standard Life) and say a critical yield of 6%, what does the pensioner need to do to make up the difference?
Take some risk is the answer; but didn’t I just say that when one gets to retirement age the idea is to reduce risk in a portfolio and when the client has had this drummed into him or her 10 years before taking benefits, how do you think they react?
The bad cases that I have come across, usually involve a couple that have entrusted the fund to an Adviser who has constructed a portfolio of funds that overall produces a yield near to the critical yield, but unfortunately that becomes the focus, not longer term growth and capital preservation.
Take a combination of equity income, bond and property funds mixed with some far eastern toxic waste languishing for a year or two and then throw in a market dip and all of a sudden the underlying value of the pension fund is eroded. It is then that the buying of an annuity, giving a constant flow of income with no investment risk and taking away the need to have that awkward conversation with ones partner about cancelling next year’s cruise becomes an attractive alternative.
So what is the answer to getting income drawdown right? The first thing is to make sure that you have not just been thrown into a risk bucket, in that you have been given a high, medium or low risk box to tick and then been invested into a load of funds that your Adviser think fits that profile. Any portfolio should have the same objective, to achieve a desired return and at the same time preserve capital, whilst being able to change to market conditions, as liquidity is the key (ask anyone who had property funds during 2008/09).
Making the right choice is not simple and I haven’t mentioned time considerations, as one could also use structured (capital protected) products, that aim to achieve a return over a three to six year period, but again this involves finding out about the client and undertaking the right level of research.
There isn’t a right or wrong answer to the ideal asset allocation conundrum for an income draw down client.