A conservative but dynamic approach is the best way to avoid risk of ruin with DB transfer pots. Offering institutional risk techniques to retail investors can help deliver that says Russell Investments managing director and head of UK wealth management Nick French
Out of the blue, pension transfers are the talk of the town. Advisers we work with report a spike in requests from DB scheme members thinking about transferring to DC arrangements as market conditions encourage more people to take the plunge.
DB schemes are currently offering valuations of anything between 20 and 40 times pensionable income, reflecting record low interest rates, but also the costs of running DB schemes and ongoing derisking efforts.
For some DB members, these enhanced transfer values are too good to pass up. If you are retiring with DB income of, say, £30,000 a year, a £1m valuation and access to good advice on how to invest it, may represent a great deal.
Managing this capital to provide lifelong income is another question entirely. The biggest risk is of loss to the capital in the early years, which can severely curtail income in later life.
Let’s assume that a member transfers from DB to DC just before retirement and enjoys 20 years of life afterwards. If the member has other sources of income and chooses not to draw down any funds, any loss of capital in the early years will not impact the total pot at the end of the 20 years.
As can be seen , a lump sum investment of £1 million is expected grow to around £3.4 million if returns are largely negative in the early years and largely positive in the later years. If we invert the return series, so that returns are positive in the early years and negative in later years, the investment still grows to around £3.4 million.
However, the outcome is hugely different if – as is more likely – the investor makes drawdowns of an inflation-adjusted £50,000 every year. In that case, negative returns to the capital in the first three to four years of retirement have a considerably worse impact than negative returns in the final three to four years.
As can be seen here, losses in the early years can led to a member running out of money altogether in the final years of life. On the other hand, capital preservation and growth in the early years, can lead to a pension pot which is above the original transfer value some 20 years later, even when losses are sustained in later years.
The risks of investing naively and spending to zero are far from negligible: it can be tempting for younger retirees to aim for strong outperformance in the early years, given their expectation of many further years of life, and allocate to risky assets.
But the better strategy is more conservative, focused on capital preservation and less risky assets. For retirees with a sizeable pension pot, a conservative investment strategy will also help avoid exceeding the reduced lifetime allowance.
A conservative strategy provides more predictable returns too, which are essential for financial and tax planning. Additionally, a stable strategy helps to sidestep the perennial mistake of private investors. DC retirees suddenly find themselves with a large pot of money which must be managed for all their needs over a long period of time. Not all of them have the skills to perform this task successfully.
In times of severe market volatility, some are panicked into selling the riskier parts of their portfolios – usually shares. Typically, they will stay out of the market and reinvest in riskier assets only when they have recovered. This, of course, is just the wrong time to reinvest, and locks in losses.
Selling low and buying high is the curse of many investment portfolios and can be avoided if the portfolio is managed well.
So how should the portfolio be managed? The key to avoiding sequential risk – the risk of poor investment returns at a time when they do most harm – is a dynamically-managed portfolio. This enables disciplined caution at the beginning of decumulation and then, as time progresses, risk levels can be adjusted to respond and adapt to changing market environments and personal requirements.
By graphing dynamic and static portfolios at various levels of risk, two frontiers emerge: a static strategy frontier and a dynamic strategy frontier.
This shows that dynamic strategies provide higher expected wealth than static mixes at the same level of risk, expanding the efficient frontier outward.
There are, however, a great number of ways to manage portfolios dynamically. The choice is large and potentially confusing for investors.
We think funds should be simple to understand and transparent, so advisers can easily articulate to their clients the risks and returns without challenging conversations about asset classes and correlations. Describing funds by risk rather than asset class gives retail investors access to the kinds of risk techniques that have long been available to pension schemes to match assets to liabilities.