Decumulation in DFM
25 July 2016
It’s been over 2 years since the pension freedoms regulation was announced and DFM offerings are gradually developing their offerings to serve this decumulation market.
The drivers of pension freedoms were twofold – quantitative easing, low interest rates and high asset returns since 2008 meant investors were impracticably locked into low yields and unable to unlock capital gains due to the annuity purchase requirement; and investors living for longer beyond retirement age, combined with limited state assistance, means they need to take some responsibility for funding their retirement.
The response from DFMs has been slow, but only because the problem of meeting the decumulation objectives are so complex. By implementing pension freedoms, investors can now use several sources to fund their retirement, and individual investor circumstances can vary greatly.
While this has meant using a single type of solution has not been possible, we have noticed there are a couple of areas that are critical in any decumulation solution. As a first step, decumulation investors need to have their Attitude-To-Risk (ATR) assessed from a different perspective than that used in the accumulation phase. This is due to the ‘pound cost ravaging’ or sequencing risk in decumulation. Hence questions to the client should focus on volatility of income, liquidity and risk of income shortfall vs. the accumulation approach of focus on total return and capital volatility. At Defaqto, we are unaware of any specific decumulation ATR questionnaires in use and it appears that most IFAs attempt to adapt their existing accumulation questionnaires for decumulation use. (By the way, Defaqto is currently developing a decumulation questionnaire.)
There are also the other significant risks facing a decumulating client, namely investment risk, and longevity risk.
- Investment risk is easy to explain, but hard to solve. Essentially any period of sub-par returns can permanently impact the pension pot and necessitates any future withdrawals be made at a permanently lower level.
- Longevity risk is defined by potentially outliving the funds in your portfolio, and also includes not having enough money for bequests or estate planning. Traditionally annuities were used to address longevity risk, but it would appear the insurance market is still under developed in this area. Many clients baulk at the idea of paying out funds up front for an income that they may never use that is far off in the future.
Some DFMs have attempted to address these risks by using stochastic modelling and scenario analysis to explain the options open to individual clients. The other advantage of DFMs is that they can provide a one-stop shop in order to tie in tax and inheritance planning, thereby enabling the above investment and longevity risks to be addressed in a tax efficient manner.
While we are 2 years into pension freedoms, we still see room for development of more sophisticated and suitable solutions that can address decumulating investor needs. We don’t consider any DFM to have a full solution yet, although it is good to see some progress being made. Notably, and amazingly enough, at the other end of the financial advice market, the National Employment Savings Trust (NEST) is in the final stages of consultation for a post-retirement strategy involving deferred annuities.