Investing in the decumulation phase

Philip Mowbray highlights the importance of taking a different approach to investment during the decumulation phase.

Since the 1960s, the design of investment solutions for ­investors seeking to ­accumulate assets has focused on finding diversified asset allocation strategies which ­maximise growth for some defined level of risk.

In contrast to accumulation, the retirement ‘decumulation’ ­investor is primarily concerned with ­generating a series of ­retirement cash flows over a term of up to at least 30 years. This cash flow ­requirement could be made up of different components: a ­minimum required lifetime income, a higher ‘lifestyle’ income early in ­retirement, additional expenses such as care costs, and the desire to leave a bequest to dependents.

In summary, while the focus for the 30 to 40-year-old accumulation investor may be the investment ­return, the focus for the decumulation customer is the cash flow.
Traditional accumulation ­investment approaches, such as mean-variance portfolio ­optimisation, use time-weighted measures of risk such as ­volatility.

These assume that risk is ­distributed evenly over the entire investment term. Importantly, this approach ignores the path of ­returns: the fact that a 5% per annum return over ten years could include periods where the return is higher or lower.

While the path of returns may be less important to the ­customer ­concerned only with the ­accumulated value at the end of the investment term, this approach cannot account for cash flows, such as additional contributions or ­withdrawals. Since we have seen that the primary objective in ­decumulation is to generate a ­cash flow, these traditional tools are not an effective basis for ­measuring risk or designing investment solutions.

Critical yield, critical mass?

The critical yield has become ubiquitous within the retirement investment process in the UK and is used to support or validate the recommendation of USP products. While there are different types, the critical yield is a measure of the rate of return required to generate a known income cashflow in retirement, assuming that the fund is then annuitised at some future date.

Take, for instance, a male ­investor aged 60, ­approaching retirement with a fund of £100,000 in May 2008. The ­market annuity rate was about 7.5% equivalent to a fixed lifetime income of £7,500 per annum. The Type-A Critical Yield, the rate of return required to provide and maintain a level of income equivalent to the immediate annuity, would have been about 6%.

Since this critical yield was below the intermediate return for ­pensions illustrations, our investor may have been comfortable that this return was sustainable and that risk was aligned with his ‘Balanced’ risk profile.

Of course, no investment ­produces a fixed return of exactly 6% every year. What is important to our ­retirement customer is not the return, but the sustainability of his income. If we ignore GAD limits and draw exactly £7,500 per annum, then applying this return scenario to the underlying fund, the ­investor would be left with £63,000 at age 75 – by then, it would buy a lifetime annuity of £7,100 per annum.

Alternatively, if the £7,500 ­withdrawals continued beyond age 75 without the application of any limits, then the investor would reach age 87 before the fund ran out and the income stopped.

Is the real world this risky?

Consider what has ­happened to this investor’s ­retirement account over the first three years of retirement, based on actual returns from May 2008 and May 2011.

Having selected the drawdown option and set the income level to £7,500 per annum, the value of this investor’s fund would have fallen from £100,000 to around £69,000 by May 2010.

Had he chosen to review his retirement income at that stage, at age 63, he would have found that the amount of annuity he could buy with his remaining funds had fallen by 40% to around £4,500.

In the context of a 25 to 30-year retirement term, the distressing ­sequence of returns experienced during 2008 and 2009 is not ­uncommon – an investor might expect to experience at least one such event during the course of retirement.

Philip Mowbray is head of retail product and consulting at Barrie & Hibbert