Robin Powell, editorial consultant to Sparrows Capital

 

Low-cost, evidence-based investment solutions have severely disrupted the traditional DFM market and are greatly improving outcomes for clients in the accumulation phase. But, says ROBIN POWELL, it’s in decumulation that product innovation is really needed now. The good news is that better and more personalised offerings are on the way.

 

It’s hard to overstate the transformation of accumulation-phase investment solutions available to advisers over the last ten years. A decade ago the market was dominated by traditional DFMs. 

Overwhelmingly, their model portfolios were actively managed and very expensive, which meant that most clients, whether they realised it or not, were underperforming the broad market. Today advisers have a range of low-cost, evidence-based solutions at their disposal, like Sparrows Capital’s SCore mps and, increasingly, that’s what they’re moving over to.

But although, from the adviser’s point of view, wealth accumulation is a solved problem, there’s still plenty of room for improvement in outcomes for clients in decumulation. 

Changing demographics make this a pressing challenge. The latest projections suggest that all age groups over the age of 60 are expected to increase substantially in number in the UK between now and 2050. The biggest growth, it’s predicted, will be in the number of those aged 80 and older.

A recent survey of more than 200 advice professionals by Just and NextWealth showed there is concern among advisers about the approaches and tools they currently have available for managing risk in decumulation. The vast majority of those surveyed said they were only “somewhat confident” of managing a range of risks including capital erosion and longevity risk. Almost one in ten said they were “not confident at all” of being able to manage sequence of returns risk.

Interestingly, 59% of advisers surveyed said they use the same DFM for clients in accumulation and decumulation. Three quarters of advisers said they don’t change the process for managing investment portfolios for those in retirement, or review their situation more frequently, despite the additional complexities that decumulation entails.

 

Three traditional approaches to decumulation

Traditionally, there’ve been three main ways to provide clients with an income in decumulation. The first is to carry on investing in a combination of equities and bonds. The Just/ NextWealth survey shows that continuing to invest, either in a multi-asset or multi-manager fund or by using a discretionary MPS, is the most popular solution with UK advisers

The second approach is to use an annuity or guaranteed income solution; 27% of advisers surveyed said they were doing so.

The third approach is smoothed market exposure, or setting aside some of the returns in good years to bolster returns in less favourable years.

All three strategies have their merits, but also their drawbacks. The biggest problem with continuing to invest is the risk that falling markets will deplete clients’ capital so severely that they eventually run out of money. This is a particular danger when advisers deal with inadequate pension provision by increasing equity risk to bridge the expected shortfall. 

Now that interest rates have risen, annuities can be attractive to clients with smaller retirement pots. But, crucially, they don’t produce any legacy value. The annuity is extinguished when the client dies, regardless of how early that is. If markets perform well, the client forgoes the opportunity to build a legacy for his or her dependants. 

Smoothed funds may also appeal to those with smaller pots, or those with a low risk tolerance. But they often lack transparency, and they also tend to be complex and expensive as well. Smoothing involves hidden arbitrage costs as well.

 

More and better products are needed

The good news is that there is, at long last, a high level of innovation in the market for decumulation products. The number of tools available to advisers has also risen, largely as a result of the normalisation of interest rates over the past two years. Mark Northway, investment Director at Sparrows Capital, nevertheless believes there’s still plenty of work to do.

“There is an urgent need for savers to be able to consolidate multiple pots in a simple and cost-efficient manner,” he says, “and to access cost-effective pre-retirement and in-retirement advice and products relevant to their situation and relevant to the market environment.”

One of Northway’s main concerns is the need to address inflation risk. “The adviser community has de-emphasised real outcomes in decumulation in recent years,” he says, “largely because we have been in a zero-inflation environment. It is important to consider whether, and how, a retirement plan will address real-world inflation.

“The UK’s breakeven inflation rate is approximately 2.25% per annum. Work by Dimson, Marsh and Staunton suggests long-term real equity returns in the region of 3% per annum and marginally negative real bond returns. 

“Many retirement strategies rely on expected real equity returns to provide protection against rising costs. This is a logical approach, but it can be painful and scary over the short term as equity markets initially respond to inflationary change.”

Tom Lovett from the structured investments platform FNZ Q-Hub agrees that many existing products fail to address inflation adequately.  “It’s possible,” Lovett says, “to allocate clients towards investments that may outperform in periods of high inflation — for example, commodities, property or inflation-linked bonds) — but there is no guarantee this approach will work, and the investor may take a lot of risk in the process.

“The challenge with index-linked annuities is that the pricing becomes even more expensive than a traditional annuity, and the customer has to be confident that whatever reference index is used, will fairly reflect their personal spending habits throughout retirement.”

 

Blended solutions offer a ‘free lunch”

Lovett does, however, see an increasing role for solutions that blend features of drawdown and annuity together in an intelligent and dynamic way. “Much like the basic principles of portfolio diversification,” he says, “blending can offer a ‘free lunch’ in some circumstances from a risk- return standpoint.”

 

Northway agrees that blended solutions offer huge potential. “Combining a growth portfolio with guaranteed income,” he says, “provides an efficient way of reducing longevity risk and sequence of return risk simultaneously. This strategy maintains the exposure to growth assets, which produces attractive expected portfolio values and provides some degree of expected inflation protection.”

 

“Help is on the way”

Encouragingly, Tom Lovett reports a “marked change” in attitude towards decumulation among platforms in recent months, with a growing emphasis on improving functionality.

“FNZ recently conducted research with advisers around their approach to decumulation,” says Lovett, “and there was a strong consensus that more could be done in the area of secure income products on-platform. 

“Consumer Duty places a direct responsibility on firms to help customers avoid foreseeable harm, as well as help customers realise their financial objectives. Advisers are rightly turning to the market to ask ‘what tools and products can you give me to meet these requirements?’

‘These new platform features may take a few more months to filter through to advisers, but help is on the way.”

 

A chance for advisers to shine

As well as improvements in on-platform functionality Mark Northway wants to see the introduction of holistic approaches to decumulation that can be implemented within a SIPP. He also wants better cashflow modelling, with an increased focus on tail risk. But he fully expects advisers to rise to the challenge.

“The point of retirement, and arguably the years immediately before retirement, is where an adviser can really shine,” he recently told UK Adviser. “Choices, costs and tax implications can be bewildering for clients, and mistakes at this point can be extremely costly. Explanation, looking at potential future scenarios and mentoring are all part of the adviser toolkit at this stage.”

Tom Lovett agrees that advisers have a vital role to play. Alongside innovative product development, he expects to see a greater emphasis on the emotional needs of investors in retirement, instead of seeing it as a purely financial problem to solve.

“It’s not just the outcome that matters, it’s the journey too,” he says. “We expect that the future approach to decumulation will not only solve the conundrum of how to provide both market exposure and income guarantees in one package, it will also need to offer ways to deliver this outcome in a smoother way for clients.”