How to help clients choose the right income fund for retirement

06 November 2018

Patrick Norwood discusses how advisers can help clients choose the right income fund for retirement.

This article first appeared on the FT Adviser website on 9th October 2018

Patrick Norwood - Insight Analyst (Funds and DFM)

The pension freedom reforms, which relaxed the compulsion on retirees to purchase an annuity when accessing their pension pots, were announced by the government in 2014 and introduced a year later.

In parallel with this there has been a continuing shift in demographics towards an older population.

As a result, the demand for income funds has increased significantly, with the fund industry responding to this.

Advisers can help to make sure that the client has the most suitable income fund for their retirement needs.

As the name suggests, income funds pay out an income to the investor on a regular basis (e.g. monthly, quarterly or half yearly), with the amount depending on the mandate and performance of the fund.

To do this, income funds will invest in one or more of the following: equities paying dividends; bonds; property; and possibly other income-producing asset classes, either directly or through other funds.

More income funds now hold ‘alternative’ or ‘non-traditional’ assets, such as emerging market debt, high yield bonds and infrastructure in order to try and gain extra yield and diversification of income, although this can equate to greater risk.

Based on Defaqto's latest data for the UK market, the following numbers for the income fund sector are:

Although multi-asset is the smallest of the three groups, it is currently experiencing by far the largest growth in assets under management (AUM).

Also, in line with the rest of the fund industry, charges across all these groups of income funds have been on a downward trend in recent years.

Return and risk

Investors in the decumulation phase will usually have the following requirements, but to different degrees in each individual case:

  • Minimise volatility.
  • Generate a regular and stable income, to cover everyday living.
  • Maintain flexibility e.g. for any large one-off payments.
  • Preserve capital, to provide an estate value.

For example, some people might want a high, and possibly growing, income but would accept the possibility of capital being reduced to zero before the end of their life, while others may require less of an income but would want to have more chance of leaving some capital to their family after their death.

Different income funds need to be used for these varying aims.

Defaqto has developed a methodology for assessing the suitability of income funds for different client needs.

Most people are familiar with the risk rating of funds for the accumulation phase, where an independent firm will consider the overall volatility of a fund and/or similar measures, before placing the fund somewhere on its risk scale, typically one to 10, where one is the least risky and 10 is the most risky.

Defaqto has done the same for decumulation. As is the case with the accumulation investor, there is a questionnaire based on client requirements and attitude to risk for decumulation.

The results of this questionnaire put each client into one of four different suitability categories. Similar to Defaqto's accumulation ‘workflow’, there will be lists of funds ‘mapped’ to these different profiles that the adviser can then choose from for their client (see below).

The types of investor in each of these categories are likely to be as follows:

Low Income Volatility - The client has a greater need for a consistent level of income from their investment and a need to safeguard their initial investment against market downfalls. The client will have a low capacity for loss and may require investment income for non-discretionary spending.

Medium Income Volatility - The client will be able to accept a short-term fall in their investment, with the expectation that this risk would be rewarded with greater income and capital gains in the long-term. The client has a need for level or growing income over the long-term but will accept short-term fluctuations.

High Income Volatility - The client will be able to tolerate falls in investment with the expectation that this risk is rewarded with level or rising incomes in the long-term. The client will have higher capacity for loss and is likely to require investment income for non-discretionary spending.

Capital Preservation - The client has a need to safeguard their initial investment and has a low capacity for loss. They have a high income risk tolerance and would be willing to tolerate fluctuating dividend payments. They are likely to use income for discretionary spending purposes only.

As with all investments there will be a trade-off between return and risk.

Defaqto's process for deciding which of the above four categories an income fund should fall into relies on the principle alluded to above that the total return for any fund can be broken down into the income part of the return and the capital gain or loss, and that these income and capital gain/loss components, as well as the total return, will each have an associated volatility or risk.

Therefore, there is a trade-off between income and capital as well as return and risk.

Defaqto's methodology for deciding which of the four income risk ratings an income fund should receive is based on:

  • The fund’s historic capital and income volatilities
  • The maximum capital drawdown that the fund has seen
  • The consistency of the fund’s annual income payments
  • The fund’s asset allocation
  • The name and mandate of the fund
  • Discussion(s) with the fund manager.

This analysis will be reviewed every year for each fund that Defaqto rates with the latest numbers and information to ensure that the rating given to the fund is still accurate on an ongoing basis. If it is no longer accurate, Defaqto would look to change the rating.


As well as rating income funds from a suitability point of view, Defaqto also produces ‘Diamond Ratings’ based on the perceived quality of the income fund.

So that Defaqto is comparing like for like when producing its ratings, it has divided income funds into the following categories of equity income funds, bond income funds and multi-asset income funds.

It then ranks the funds in each of these three sub-universes on the basis of:

  • Capital batting average - how often the value of the fund has been at or above its initial value.
  • Conditional Sharpe and Calmar ratio - these are two different measures of risk-adjusted performance.
  • Delivered yield.
  • Income volatility.
  • Rolling conditional Sharpe and Calmar ratios - measures of how consistent the above risk-adjusted performance has been.
  • Average rolling batting average and forward yield.
  • Dividend payment delay, where those funds taking more than the regulatory limit (four months) to deliver dividends to the investor are penalised.
  • Fund manager tenure - a feature of many successful offerings is longevity of people and resource.
  • Ongoing charges.
  • Size of fund - it is generally accepted that most funds are not particularly profitable or comfortably sustainable until they reach a certain size; while funds that are too large will find their size impacts on investor returns due to liquidity and market impact issues.
  • Overall size of the underlying fund management group.

Ucits compliance - a key plus for any fund today is having Ucits status as it gives investors some assurance that certain regulatory and investor protection requirements have been met.

Domicile - funds registered within Britain will enable investors to access the Financial Services Compensation Scheme (FSCS) if necessary.

The fund receives a score for each of these criteria on the basis of how it compares to peers for that measure. These scores are weighted by how important Defaqto believes each of these criteria are and then added up to give an overall score, which translates into a Diamond Rating, with 5 Diamond indicating best in its class and 1 Diamond being the worst.

More solutions bring greater risks for investors

The changes announced in the 2014 Budget have sought to give more responsibility to the individual in terms of retirement provision.

As a result of this legislation, the fund industry is now offering more solutions for post-retirement as opposed to just pre-retirement and income funds are figuring highly in this new growth, with the income fund market in the UK now more than £1trn in AUM.

However, while these changes give greater freedom to investors, they also mean greater risks.

In particular there is a danger that people could spend too much too soon, or invest badly, leading to longevity risk, where the individual outlives the money set aside for their retirement.

Investors at or in retirement therefore need suitable advice.

Ratings enable the adviser and their client to select the best income fund on the basis of several attributes, including risk-adjusted performance, stability of the fund management team and charges.

Engage Core

The decumulation workflow within Engage Core is designed to help you make recommendations for clients who are retired or semi-retired and looking to withdraw an income from their investments. The workflow has a retirement modelling tool which allows you to model how your clients' income can meet their needs, then seamlessly go onto research solutions to provide the required income whilst ensuring suitability through integrated profiling.

You can read more about the decumulation workflow here.

You can learn more about our end-to-end financial planning tool or request a free trial here.

You might be also interested in our other Insight articles.

Disclaimer: The Defaqto risk scheme, asset allocations and Diamond Ratings are subject to change, due to regular ongoing reviews.

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