Henry Cobbe looks at how advisers running
decumulation portfolios can judge and balance the four main drivers
behind the risk that a client will run out of money during their
retirement.
Advisers running decumulation portfolios have to consider the key
retirement risk known as ‘shortfall risk’ – essentially the possibility a
client will run out of money in retirement.
Shortfall risk has four main drivers:
Sequencing risk: Risk and return expectations vary
depending upon different time horizons. This can be mitigated by
ensuring the asset allocation is appropriate for the time horizon.
Longevity risk: This is the risk that clients
outlive their assets and it can be mitigated by applying a matching
‘safe withdrawal rate’ for a given time horizon, based on life
expectancy. Advisers can thereby get statistical confidence the
retirement pot will last the course. Briefly, the safe withdrawal rate
is a commonly used term to define the percentage of the initial
investment that can be withdrawn each year for a given investment term
and not lead to portfolio failure to a given level of statistical
confidence.
Interest rate risk: Also known as duration risk,
this is the sensitivity of a retirement plan to interest rates. As a
retirement portfolio is trying to match a future stream of withdrawals
over time – a bit like a bond in reverse – it is highly sensitive to
interest rates. This requires a targeted approach to duration management
that is appropriate to the time horizon of the portfolio.
Inflation risk: Portfolios should be well diversified with an income bias to preserve value in real terms while sustaining regular withdrawals.
Why is asset allocation different for different time horizons?
Clients with the same risk profile but different time horizons should
have different asset allocations. This is because the risk, return and
correlation assumptions that are used to create portfolios differ for
different time horizons, so it is wrong to use long-term assumptions for
a short-term or medium-term portfolio.
In the world of accumulation, it is all right to assume very
long-term estimates of risk and return – at least to start with. In
decumulation, however, it can be inappropriate. Risk and return
estimates should match the client’s time horizon.
What retirement portfolio should look like?
Only advisers know, or can estimate, the inputs into a client’s
retirement maths. To help advisers offer decumulation strategies that
are fit for purpose, retirement portfolios should offer a range of
risk-return levels to suit a client’s risk profile. But they should also
consider time horizon to suit a client’s life expectancy, and the safe
withdrawal rate that matches that asset allocation.
Putting it all together
At Copia we want to help advisers create a compliant investment
solution for clients in decumulation. Decumulation is different. And
getting it right – both from an investment and a compliance perspective –
is not easy. That is why we recently launched the Retirement Income
range of portfolios – labelled by risk level and time horizon – and we
also offer advisers with a safe withdrawal rate table matched to each
asset allocations and for each time horizon.
In addition, because of a lack of risk-profiling tools that can
properly assess suitability for decumulation, we have asked an
independent actuarial consultant to develop one specific to our
portfolios.
Retirement investing is different, but with the right tools and
options, advisers can aim to get the best outcome for their client given
their client needs and circumstances.
Henry Cobbe is head of Copia Capital Management
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