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Planning for your future

 
What to know about investment risk in the early years of retirement

By Matthew Yeates

 

  • Learn about the relationship between risk and retirement and how that has changed with pension freedoms.
  • Understand why retirees tend to be risk averse and how this can be overcome.
  • Grasp what the FCA concluded about risk and how advisers can incorporate  this into the advice process.

 

The Financial Conduct Authority's (FCA’s) recent Retirement Outcomes Review Final Report mentions the word ‘risk’ 63 times.

The report talks about longevity risk, the risk of scams and the risk of overspending, but the dominant theme is arguably the risk of over-cautious investors (mainly those without the benefit of advice) losing out by holding too much cash.

The paper sends a strong signal about the need to challenge clients’ inherent caution in later life.

It arguably also sounds another death knell for lifestyling funds that automatically take risk off the table as the investor approaches their retirement date. 

 

Breaking with tradition

In the days when nearly everyone bought an annuity, retirement represented the point at which you converted your pension savings into a guaranteed income for the rest of your life.

In that scenario, and with gilts also offering inflation-beating returns, there was some logic to the long-held tradition of gradually moving out of risk assets as you neared this important cut-off date.

But times have changed. Quantitative easing has made bonds look decidedly risky. Pension freedoms and longevity have forced a rethink of old traditions.

Back in 1980, when a man retiring at 65 could expect 13 years of retirement, a 15 per cent annuity was possible.

Research shows that in most circumstances, investors are better off leaving more of their portfolios in equities at and into retirement than they might have done traditionally.

Today, when that life expectancy has stretched 40 per cent to more than 18 years, the same annuity packages now generate less than 5 per cent a year.

Little wonder so many people are opting for drawdown – the FCA paper says twice as many pots are being used for drawdown than to buy an annuity since the pension freedoms.

But the longevity challenge that has contributed to the collapse of annuity rates remains for those in drawdown too.

There is now substantial evidence to suggest that the only way for many investors to make their money stretch throughout the whole of their retirement is to embrace a degree of investment risk.

Research shows that in most circumstances, investors are better off leaving more of their portfolios in equities at and into retirement than they might have done traditionally.

The reason is simple: people tend to be at their wealthiest as they near retirement age. This is the point at which their portfolios are at their biggest and the power of compounding has the most benefit.

For most people, this is not the time to be taking a foot off the risk pedal.

 

 

The evidence

One of the most important pieces of research in this area was conducted by Robert Arnott, chief executive of Research Affiliates in California.

In his landmark 2012 paper, The Glidepath Illusion, Mr Arnott simulated the performance of three distinct retirement strategies on the basis of more than 140 years of historical returns.

He offered three characters on the ‘glidepath’ to retirement – Prudent Poly, whose stock- bond allocation progressively moves from 80-20 to 20-80; Balanced Burt, whose stock-bond allocation is rebalanced annually to a static 50-50; and Contrary Connie, whose stock-bond allocation progressively moves from 20-80 to 80-20.

According to Mr Arnott, assuming an annual investment of $1,000 (£784.70) over 40 years, on average, Polly could expect to enter retirement with around $124,000, Burt with $138,000 and Connie with $152,000.

Crucially, the worst case scenarios showed a similar pattern. In the worst outcomes experienced over 140 years of historic returns Polly would end her working life with just $50,000, Burt with $52,000 and Connie with $53,000.

Many others have corroborated this research. In 2017, I carried out a similar study to explore how far retirement savings might last in a range of scenarios.

In this study, two investors (and admittedly this is not a hard luck tale – these would be high-net-worth individuals) save an average of £20,000 a year from the age of 30 to 60, retire and then set about withdrawing an annual pension of £60,000 a year.

But having also modelled much more modest scenarios, the conclusions drawn below in terms of the risk reward trade-off are consistent whether you save £20,000 or £2,000, and draw £60,000 or £6,000.

One invests throughout in a moderately cautious portfolio generating 4 per cent per annum on average (after advisory fees and miscellaneous costs), the second targets 5 per cent per annum through a balanced portfolio.

The cautious investor runs out of money at nearly 86, by which point the balanced investor still has £800,000 in savings.

The comforting conclusion is that it only takes a modest increase in risk to generate significantly better returns.

This was a simple model – it assumed the portfolios were kicking out exactly 4 per cent and 5 per cent a year.

Not very realistic, you might argue.

Subjecting them to the vicissitudes of normal markets using real-life market data that included the market crash of 2008 to 2009 aimed to address that issue.

Taking a ‘bad’ scenario (on a scale of one to 100 of outcomes, where one was the best and 100 was the worst, this was number 80 on the scale), the cautious investor ran out of cash at around 80; the balanced investor ran out of money at 84.

Caution still did not pay.

We dialled up the gloom even further, this time assuming both investors had been taking the same levels of risk all their lives, so they started out with the same pot of money at 60.

Then we plugged in the 90th centile – ‘really bad’ – market data. Both investors ran out of money at roughly the same time – when they were 80.

 

No need to be reckless

The comforting conclusion is that it only takes a modest increase in risk to generate significantly better returns – in our research it was one step up the risk ladder, from moderately cautious to balanced.

This is helpful because an adviser may have to nurse a client to an uncomfortable conclusion – they may be inclined towards caution, but cannot afford it.

There are several drivers of this caution. The obvious one is that it is not as easy in retirement to go back to work to make up investment losses.

But we must also contend with what you might call ill-informed optimism and misguided pessimism.

Firstly, the optimism. Seven Investment Management's annual survey research consistently shows that investors looking at the size of their pension pot overestimate by about 100 per cent how much income it will generate, or how long it will last.

 

 

Battling instinct

As for the pessimism, that is human instinct according to Nobel Prize winners Daniel Kahneman and Amos Tversky, who developed the concept of ‘prospect theory’.

Supported by an array of studies in the fields of psychology and experimental economics, the concept posits that we place more emphasis on avoiding losses than on acquiring gains – losses hurt roughly twice as much as gains feel good.

This leads to another dangerous tendency.

Rather than evaluate the expected range of returns for a lower risk portfolio alongside those of a higher risk portfolio, our natural loss aversion leads us to instinctively contemplate what the likely return from a lower risk portfolio might be and then contrast it to what we could face if something utterly terrible were to happen with a higher risk portfolio.

 

 

FCA findings

This perhaps explains why the FCA found so many consumers ending up with investments that were not right for them, including in cash – and why those who struggled most with this were those without the benefit of professional advisers.

Overall, 33 per cent of non-advised drawdown consumers are wholly holding cash, according to the FCA Retirement Outcome Review Final Report, which took the view that “holding funds in cash may be suited to consumers planning to draw down their entire pot over a short period".

The FCA continued: "But it is highly unlikely to be suited for someone planning to draw down their pot over a longer period. We estimate that over half of these consumers are likely to be losing out on income in retirement by holding cash.”

The FCA report draws the conclusion that someone who wants to draw down their pot over a 20-year period could increase their expected annual income by 37 per cent by investing in a mix of assets rather than just cash.

Arguably, this is the clearest signal yet from the FCA that it does not assume investors should necessarily reduce risk at retirement.

That, coupled with the growing body of research on investment outcomes, should give advisers further discussion points with inherently very cautious clients on the risk/reward trade-off.

 

 

Risk and the advice process

So how does an adviser deal with the client who is too cautious for their own good?

A simple step might be to ensure your advice process is not primarily focused on investment risk.

If the process begins by you asking about the client’s tolerance to investment risk, this is likely to drive the shape and tone of the conversation, potentially closing down opportunities to explore beneficial alternatives.

Here the primary focus is on the client’s goals – what they want to achieve and when. This determines the investment return they need, which in turn determines how much investment risk they need to take to achieve that.

Only at this point does the adviser consider the client’s investment risk tolerance versus how much risk they need to take to achieve their financial goals.

If the client is not comfortable with the required level of risk then the adviser can take them through the options – for instance, save harder, work longer or reduce aspirations.

Alternatively, they may opt to take up risk just a notch, supported by a combination of these other options.

It might not be natural instinct to many investors, but in the vast majority of circumstances investors would be better off leaving more of their portfolios in equities at and into retirement than they have done traditionally.

That doesn’t mean investors should necessarily take more investment risk than they are comfortable with, but they need to understand that by choosing lower-risk investment options they may be increasing the danger of running out of money in retirement.

And they certainly shouldn’t do it automatically without thinking the issue through. This is something the FCA paper makes loud and clear, and it is very encouraging to see this creeping up the national agenda.

Ultimately, however, investment risk is not the only lever to pull when making investment decisions.

Investors should frame their plans in the context of balancing all the risks they face, not just investment risk.

This includes the risk they can’t save as much as they plan to, that they live longer than expected and that other events happen which knock their plan off course. This is something the FCA paper alludes to.

Advisers have a really important role to play in informing this debate, given this is one of the most important issues for the profession.

It will provide a great opportunity for clients to recognise the real value of planning and, above all, their adviser.

 

 

Matthew Yeates is an investment manager at Seven Investment Management



 

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