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Selecting a retirement strategy: Risk conundrums

Rubik's cube to represent the multiple routes to a solution, paralleling the risk conundrums that come with retirement planning
Photo by Daniele Franchi on Unsplash

For financial professionals only

The short story when it comes to choosing a retirement strategy is that you pay your money and you take your chances. The longer version is that you’ll never know if you made the perfect decision. And if you decide to change horses along the way, it becomes a lot harder.

Suitability can never depend on what happens in the future – the actual outcome of a well-chosen investment strategy. It’s a judgment made in the present.

It depends heavily on the soft facts around personal temperament, your client’s ability and willingness to accept and understand risk, and capacity for loss. And ongoing suitability depends on being alert to changes in personal circumstances and financial capability.

So, if we know that there’s no silver bullet, how do we differentiate between choices and make a clear, decisive retirement recommendation?

Robust modelling

Almost every conceivable investment strategy could be perfect given ideal future conditions, but even the best laid plans can go wrong if the unexpected happens. A great defence against the unfair test of hindsight is the application of independent, well researched assumptions when framing advice. They support modelling with calculated probabilities of strategy success and failure.

That’s why we offer the Income Manager Tool (IMT) to financial advisers using our DFM solutions and why we’ve partnered with a firm of actuaries to maintain this modelling – so it can be truly independent of our own thinking and expectations.

So, with that in mind, let’s discuss some of the dilemmas.

Choosing a core risk level for drawdown

A client with no sensitivity to investment risk and a high capacity for loss would want a drawdown portfolio recommended to them based on the adviser’s assessment of its merits, relative to the risks being taken. The indifference of the investor would mean there were no limiting factors.

Our IMT can clarify this research challenge by offering a probability of success at all different levels of risk. Let’s take a look at such a client, aged 65 with a £100,000 Guardian portfolio. Imagine their income requirement was £4,000 or 4% in real terms, for the rest of their life.

Here’s the IMT’s appraisal of this retirement strategy.

Portfolio risk grade Viability % chance of strategy success Age, at median investment outcome, when capital exhausted Age capital exhausted, at 10th percentile (worst) investment outcomes
1 39% 84 years 82 years
2 41% 84 years 82 years
3 45% 85 years 82 years
4 53% 87 years 82 years
5 59% 88 years 82 years
6 64% 89 years 82 years
7 67% 91 years 81 years
8 69% 92 years 81 years
9 70% 93 years 80 years
10 70% 94 years 80 years

This analysis shows some of the risk conundrums.

First, your chance of success increases with almost every increased level of portfolio risk. However, these increases aren’t uniform and they are negligible at the highest risk levels, which raises the question, how great a need is there to take additional risk in the higher risk grades. The sweet spot seems to be somewhere between Risk Grades 5, 6 and 7, where there is a good level of equity exposure in the portfolio, but diversified with cash, bonds and some property.

More portfolio risk, less risk of failure

Second, at the very lowest levels of risk, where bonds predominate, the strategy is more likely to fail than to succeed. Viability scores are below 50% at risk grades 1 to 3. It’s only at RG 5 that the chances of success are well in excess of 50/50 – which is a coin toss, and not really an advisable approach for anyone. You can improve the probabilities by taking out less money, or by investing more, but few people can readily just “be richer” and/or want to live much more frugally.

What if?

Next, when it comes to examining the downside, there’s a broad similarity in how quickly the money runs out if really bad investment outcomes are experienced. At each risk grade in our case study, the capital is exhausted between ages 80 and 82, modelling the worst 10% of investment outcomes. Note that the higher risk portfolios are exhausted slightly faster.

Finally, if on your journey through retirement you experience good markets and therefore achieve above median expected returns, it will pay to have taken that extra risk. That aspect is not illustrated in our table. It could too easily be mistaken for a prediction. However, this possibility of outright success may be one reason drawdown could be suitable for a client who is willing and able to take risk and confident they can do so with adequate downside cover, or capacity for loss.

Other strategies

That said, drawdown portfolios are rarely used alone – and are often recommended in combination with other strategies. For example, high cash reserves, risk tapering, partial annuitisation, and asset cascades or burn down strategies. We’ll be looking at some of these permutations in our forthcoming webinar and examining which can be bench tested using the IMT.

Our final thought is that it’s important to remember that no one can get a better outcome simply by worrying about the future and money. Whatever else you do in retirement, planning to enjoy life and experience wellbeing is more important than gazing into your crystal ball, even if you have one of the best available.

Hear what the experts think in Episode 5 of our Let’s talk retirement series

Thu, Jul 30, 2020 11:00 AM

In episode 5, I chat with Richard Allen, Head of Propositions, Investment Services at Hymans Robertson and our very own Tim Willis, Investment Director, PIM.

They give their views on how risk levels should be tackled for different planning goals – and the different strategies that could appeal to investors when looking for additional confidence in retirement.

Watch the replay ➜



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