Considering income streams during a client's retirement
09 October 2014
In the most recent Budget announcement in May 2014, Chancellor George Osborne announced sweeping changes in government regulation of the annuity market.
As a result, UK clients are now free to use their pension fund assets as they see fit to fund their retirement, a step change from the previous requirement to purchase an annuity. Given these changes, the importance of portfolio construction during the decumulation phase is gaining more prominence.
Characteristics of decumulation
For a typical investor, the main focus for much of their working life is saving for retirement and growing assets. Upon retirement and switching to decumulation, the goals change from asset growth to providing income.
There are a few key factors to consider during decumulation:
Longevity risk: the risk of out-living your assets.
Investment risk: the risk of suffering negative returns that are significant enough to irrecoverably deplete your savings.
Bequests and estate planning: any desire to leave assets behind for family, charities or other causes, and any other one-off payments.
Addressing the key factors during decumulation
Traditionally, annuities were the instrument of choice for retirement. In one sense they are perfect as they insure completely against longevity risk, and investment risk is removed from the client.
However, in the current environment of very low interest rates, the income annuities can provide has dropped significantly, making the initial price of the annuity increasingly expensive. This has been the major factor in the push for an update in regulations to allow other options.
While annuities can still be considered, for example a deferred annuity, it is likely that this will be a fertile area for product development in the coming couple of years. Product providers still need time to figure out a way to adequately meet retirement needs in a low interest rate environment – watch this space!
As the underlying portfolio is now required for day-to-day living costs, risk appetite becomes much lower. Any large drawdown in assets due to poorly performing markets will be hard to recover from as withdrawals will still need to be made for retirement income. Consequently, the bulk of an investor’s portfolio during decumulation should be in low risk, fixed income assets. These can involve low risk bonds as well as inflation protected bonds.
In recent years, another impact of low interest rates has been to include a small exposure (<10% of total investments) to higher risk assets. In theory, a small, diversified exposure to emerging market debt, property and/or equities may be used to provide further inflation protection, diversification and an element of real growth.
Bequests and estate planning
Depending on the size of any bequest, there will likely be some tax planning required which will guide the choice of the type of investment used.
Notably, while bequests can be handled in a similar way to growing assets during the accumulation phase, that is the use of equity and other higher risk investments, the use of life insurance is usually most appropriate. Most insurers can provide an insurance-type payout in combination with an annuity product.
Compiling flexible solutions
Recent regulatory changes have unlocked new options for investors to provide for their retirement income. While product developments are in the pipeline, there is a renewed focus on creating income via a portfolio. A combination of life insurance, multi-asset investment portfolios and a variety of annuity products can be used to address most client needs.
However, the challenge of low interest rates remains significant. While the increased flexibility of retirement options has been welcomed, advisers should remember that there is no such thing as a 'free lunch'. For those clients with insufficient retirement savings, expectations of a plush retirement lifestyle will need to be reduced – or they may possibly just need to work a few years longer.