Insights A new toolbox for retirement planning Part 1: Risk measurement: an essential tool for retirement income planning This is an updated version of a report first presented at Barrie & Hibbert s Retirement Breakfast Briefing, September 2011. Philip Mowbray Philip.Mowbray@barrhibb.com Drawdown Income: UK Market Experience 2006-2011 To understand the practical challenges facing advisors and investors in relation to retirement planning, we can consider the outcome experienced by UK-based Drawdown clients who took out policies in July 2006. These clients would have faced their first formal drawdown income reviews at the end of June 2011. The following table shows how different income and investment choices would have determined the outcome for a male who took out a policy in June 2006, aged 60, based on an initial retirement fund of 500,000: Based on our engagement with a broad range of UK advisory firms, it is clear that many advisors face large numbers of drawdown clients in the amber or red zones, and many difficult conversations with valued clients. This shows that anyone who chose to draw close to 100% GAD will have seen their income fall significantly. While investment choice has certainly impacted the outcome, with equity investors suffering most, the choice of initial income level has been the most critical factor in determining the new income limit. Focusing on client outcomes The case highlighted in blue could be regarded as representative of many USP drawdown policyholders. This Balanced customer chose to draw income at 100% GAD and invest in a Balanced fund (60% UK Equity / 40% UK Gilts). The critical yield target of 6.5% sits below the FSA central pension projection rate of 7% pa. When the income limit was re-assessed at end-june 2011, the value of the client s retirement fund was 397,000 and the client would have been forced to reduce their annual income by at least 21% (from 32,000 to 25,000). If this drawdown plan made up a substantial element of the client s retirement income, this would have had a significant impact on lifestyle the key outcome measure for many retirement customers.
To make matters worse, this analysis ignores the impact of inflation. Taking this into account, the real buying power of this client s income is likely to have fallen by a further 15% or more. How did we get here? The equity investment within this customer s portfolio (tracking the FTSE 350 Index) grew by over 20% between June 2006 and June 2011. Not great, but far from an historic extreme. Drawdown clients might wonder why there has been such significant reductions in income, even for apparently moderate risk portfolios? In this table, we un-bundle the different factors that have determined the new income limit for our Balanced client. This shows that the total equity market return accounts for only around 8% of the 21% reduction in income. Risk Factor Change from 2006 to June 2011 Impact on Income Market Return Market Volatility (Sequence of Returns) Falling interest rates The annualised return on the client s investments over the five-year period was 4.9% pa, compared with the target of 6.5%. While the average return over the fiveyear period was 4.9% pa, significant market falls in 2008 meant fixed withdrawals began to erode capital more rapidly. GAD reference rate of 4.5% in 2006, fell to 3.75% in June 2011. (By September 2011 this had fallen another 0.5% to 3.25%!) 8% Reduction 3% Reduction 6% Reduction Increasing life expectancy Based on the June 2011 reference rate of 3.75%, the GAD basis amount for a 65 year old male has fallen from 67 income per 1000 fund, to 64 per 1000. USP rule changes From June 2011, income is limited to 100% GAD (rather than 120%). Only impacts clients drawing income at 120% GAD. 4% Reduction No impact. Total Income Reduction -21% This simple analysis of the last few years highlights the various risk factors which have had an impact on the outcome from a retirement income or drawdown plan. Unfortunately, the typical approach used to illustrate risk in drawdown has focused on the first of these risk factors the likely range of investment returns over the term of the drawdown policy at the expense of the others; in practice, ignoring over half of the risk to this customer. Market return v volatility: the importance of sequence of returns Traditionally, tools used to measure risk in an investment portfolio have focused on the typical range of returns over the investment term. The most common metric used being asset return volatility. In UK retail investment markets like drawdown, this is often presented as an illustration based on different rates of return (e.g. 5%, 7%, 9%). However, the outcome for retirement investors is affected not only by the total return experienced over the investment term, but by the path markets have taken to achieve that total return the sequence of returns. For a retirement customer making fixed withdrawals, an annual return sequence of +5%, +5%, + 5% will give a very different outcome than -10%, +5%, +20%, even although the total return or average return over the three years is the same. Another way to look at this is to consider what would have happened in the case of our Balanced drawdown client, had we increased the historic portfolio returns by 1.6% in each year, such that the total return over the five year period equalled the target Critical Yield of 6.5% pa. Importantly, by making this adjustment, we retain the historic sequence of returns, as show in Exhibit 1:
Exhibit 1: Adjusting returns to match critical yield target Under this adjusted return scenario in Exhibit 1, the total return on the portfolio matches the critical yield of 6.5% pa, but the client would still have experienced a 13% reduction in income at the June 2011 review. Clearly the total market return explains only a fraction of the total reduction in income. In this case, the sequence of returns has done additional damage, in particular during the period of increased volatility of 2008. Making matters worse, falling UK government bond yields continue to hurt drawdown customers: indeed, since the end of June, the GAD reference rate has fallen even lower, representing further reduction in the GAD income limit. Asset performance is just one of a number of complex and interrelated risk factors facing retirement investors. Falling interest rates, coupled with a weak economy and volatile stockmarkets are all inter-related economic factors that will lead to poor outcomes for retirement drawdown investors. Critical yield: a game of retirement roulette Unfortunately, traditional techniques used to support drawdown income planning are not designed to quantify the size of the various risks facing the investor. Advisors and clients have had very little information which allowed them to measure the potential for significant reduction in income level, or the long-term and irrevocable impact this would have on their lifestyle in retirement. In effect, by relying on fixed growth assumptions and Critical Yield illustrations, advisors have used their clients retirement savings in a game of retirement roulette. Instead of ensuring investors understood and accepted the potential scale of income losses, or explaining the options available to mitigate these risks, the primary decision has most often concerned the type of investment required to achieve a target return. While these traditional retirement planning processes have focused on returns, for many investors who took out drawdown policies in 2006, and who are now coming up to their five-year income reviews, it will be very clear that investment return is only one of a number of risk factors that determines the success or failure of an individual s own retirement income plan.
Financial planning solutions: accumulation v decumulation Many of the techniques used to support retirement income planning have simply been rebranded accumulation tools. This approach had the benefit of familiarity for many advisors and investors. Unfortunately, the investment approach required to achieve desired outcomes for decumulation clients - those seeking to draw a stable level of income from a fixed initial pot of accumulated assets - is fundamentally different to that required for accumulation: Accumulation clients are focused on investment returns, seeking to deliver a return above inflation in order to grow the value of their wealth over the long term, subject to some level of risk. Investment choices are often compared using measures such as expected growth (return) and volatility. The critical assumption is that tough years can be recovered because investments generate returns over the long term, and because human capital can offset losses in financial capital. Decumulation clients are focused on sustaining some income cash flow required in retirement, based on a fixed initial level of wealth. Explicit or implicit within this cash flow is some minimum Lifetime Income Floor. Human capital is severely diminished, so the risk of falling below this income floor must be small, and the potential size of any reduction in income below this floor must be small. Only once this income floor is secured to an acceptable degree, can growth or upside be managed to deliver higher discretionary spending or a bequest. Retirement investment (drawdown) will continue to be an important part of many individual retirement plans. Advisors must build advice services which focus on the specific planning needs of decumulation client. In the language of the FSA s recent guidance on Assessing Investment Suitability, this should mean measuring and managing the risk in terms of the potential reduction in lifetime income, such that this remains aligned with the client s capacity for loss. Retirement Risk Dahsboard: a new framework for assessing suitability In decumulation, we need to measure risk in relation to the key objectives of the retirement customer namely the income cash flow (or lifetime income floor) and the need to retain access to capital. With this in mind, we will use three different measures to assess the risk and return in any retirement plan, which reflect the financial needs of the retirement customer: Note. These metrics all rely on a table of mortality assumptions, which will reflect actuaries assumptions about the mortality experience across a defined population. For clients who would prefer to rely on their own assessment of longevity, these same numbers can all be calculated assuming a specific age (e.g. 90). Exhibit 2: Defining appropriate risk measures for retirement Retirement Risk Metric Retirement Income Sustainability, RIS (%) Income Comfort Zone ( pa) Upper Limit (RIS=75%) Lower Limit (RIS=90%) Definition The probability that the income generated from the retirement plan will remain above the customer s stated Lifetime Income Floor, for the rest of their life. The level of income that the retirement plan will sustain for life, with a probability of between 75% and 90%. The income sustainability range given by the Income Comfort Zone should reflect a client s risk profile and capacity for loss. Expected Bequest Value, EBV ( ) (Death Benefit) The expected death benefit is residual capital value in year T of retirement weighted by the probability of dying in year T, summed across all years T:
This Risk Dashboard can be illustrated in simple graphical form, as shown in the example below: This shows how the Income Sustainability of the client s retirement plan can be classified into one of three status zones: At Risk: Retirement Income Sustainability less than 75% Comfort Zone: Retirement Income Sustainability between 75% and 90% Secure: Retirement Income Sustainability greater than 90% While these zones (probability regions) and the associated descriptive labels can be defined according to specific needs, the example given above would seem appropriate in many cases, and would result in significantly more prudent decisions and advice than would be typical when using fixed rate illustrations and critical yield calculations. Practical example: mitigating income loss at drawdown review As an example of how this Retirement Risk Dashboard framework can be applied in practice, we will consider our Balanced drawdown customer, whose initial income was set to 32,000 in June 2006, but who now faces a reduction in this GAD limit to 24,500 pa. Step 1: review the sustainability of the current retirement plan As a first step, we can use this Retirement Risk Dashboard to understand the true sustainability of this new GAD income level of 24,500 pa, based on the current Balanced investment strategy, and compare this to some other risk-graded drawdown options. To add some further context when measuring risk, it is useful to consider the natural low-risk benchmark. In the case of retirement decumulation, the most natural low-risk income benchmark is an immediate fixed payment annuity. This represents the maximum income that retirees can secure with no exposure to market or longevity risk, where they are willing to give up all their capital. Where customers are concerned with inflation, they can purchase an RPI-linked annuity, or an annuity with fixed payment escalation.
Under the current Balanced drawdown strategy, the client has a 50% chance of sustaining an income equal to the current GAD limit ( 25,400 pa). The Income Comfort Zone for the different Under the current Balanced drawdown strategy, the client has a 50% chance of sustaining an income equal to the current GAD limit ( 25,400 pa). The Income Comfort Zone for the different options suggests that the highest sustainable level of income is around 21,000 pa (i.e. 85% of the new GAD income limit). At this level of income, moving to a more Cautious asset allocation does not increase the RIS(%). Reducing equity allocation will only increase income sustainability where the client is willing to accept a significantly reduced level of income around 18,000 pa. This reflects the experience of the last few years: taking income close to the GAD limit exposes drawdown customers to substantial risk of future reduction in income, regardless of the chosen investment option. Assessing income sustainability: don t rely on the GAD limit The most important take-away from this analysis is that the GAD limit is a poor guide to setting a sustainable Lifetime Income Floor. While the GAD limit stops drawdown customers running out of money, when the Lifetime Income Floor is close to the GAD limit, even moderately poor investment returns or volatility are very likely to result in some reduction in the GAD limit, and the Lifetime Income Floor will become unsustainable. This is reflected in the shape of the line in Exhibit 3 below, which illustrates how Retirement Income Sustainability falls as the chosen income level increases toward the GAD limit, based on the Balanced investment option. Once the income level exceeds around 75%-80% of the GAD limit, income sustainability drops off rapidly. Reflecting the analysis above, the top end of our Income Comfort Zone sits at around 85% of the GAD limit. Exhibit 3: Income sustainability drops significantly as income approaches the GAD limit While this review of drawdown investment options is unlikely to make comfortable reading for many existing drawdown clients with existing income levels close to GAD limits, we can consider a number of practical steps advisors can take to mitigate the risk of further income shortfall in future. Step 2: assessing options to enhance sustainable retirement income We have shown that drawdown clients taking income close to the GAD limit are exposed to a significant risk of future income reduction. However, having already suffered a significant reduction in income and the consequent re-alignment of retirement expectations, the last thing most customers will want to be told is that the new reduced income limit is itself likely to be unsustainable! The question is how do advisors enhance this new income level to mitigate the loss already experienced, and more importantly, how can this be achieved on a basis that is sustainable going forward?
In this section, we consider a simple but effective option for increasing income levels and sustainability. This illustrates how the Retirement Risk Dashboard can be used to assess alternative retirement planning options in relation to a client s specific retirement needs and capacity for loss. In a second paper in this series (A New Toolbox for Retirement Planning - Part II: Risk Management Solutions), we will extend this analysis to consider some alternative retirement risk management solutions. Combining investment with insurance: partial annuitisation The previous analysis showed that the client would need to reduce their income to below 21,000 pa to ensure a reasonable level of sustainability. However, we also saw that the immediate annuity income available to this client ( 25,600 pa) is above the required Lifetime Income Floor ( 25,400 pa). By annuitising part of their Retirement fund, is it possible for our client to increase the sustainable income level? In the following table, we use the Retirement Risk Dashboard to compare a range of combinations of Balanced Drawdown (60% Equity) and Immediate Annuity, to understand how this can help the client sustain an acceptable level of income in retirement: Note: This analysis is for illustration only. We have not attempted to use actual market annuity quotes. The annuity rates used are based on current government bond yields and use representative mortality and expense assumptions to reflect typical current lifetime annuity rates. The rates assumed here will not reflect actual market annuity quotes. Where advisors are using this type of analysis to support advice or recommendations, actual annuity quotes should be applied. One notable take-away from these results is that annuitising more of the fund has almost no impact on Retirement Income Sustainability, i.e. the probability of sustaining the GAD income limit of 25,400 pa. With an income level so close to the annuity rate/gad Limit, any loss in fund value will result in a reduction in the GAD limit and a reduction in the total income level. However, more importantly, annuitising some of the fund will reduce the size of the potential loss in income below the GAD limit. The true level of sustainable income the Income Comfort Zone will increase with the proportion of the fund annuitised. This relationship between the proportion of fund annuitized, sustainable income level (Income Comfort Zone) and Expected Bequest Value is shown clearly in Exhibit 4 below:
Exhibit 4: Partial annuitisation: combining insurance and investment to improve retirement outcomes For comparison purposes, Exhibit 4 also includes the 100% Cautious drawdown strategy (40% Equity). This comparison shows that a retirement plan comprising a 60% allocation to a Balanced investment strategy and 40% allocation to annuity is likely to be a better solution than the 100% allocation to the Cautious drawdown strategy. With the combination of investment and annuity (insurance), the customer can achieve a higher level of sustainable income, while maintaining a broadly equivalent level of Expected Bequest, or residual capital. In Exhibit 4 the trade-off between income sustainability and bequest across the different options is completely explicit. The advisor and customer can see how much bequest they will have to give up in order to secure a higher level of sustainable income. It is also useful to note that even small amounts of annuitisation (e.g. 10% to 20% of the retirement fund) can increase the sustainable income level by around 10%. If the client wants to get into the Income Comfort Zone without giving up more income than necessary, one option may be to annuitize a modest portion of their remaining fund. Step 3: prioritisation of needs, recommendation, reporting While this analysis has considered a relatively simple set of retirement options, the advisor and client are now in a position where they can have an objective and informed discussion about the different options, and the associated trade-off between sustainable income and bequest, or access to capital: Even if the client is willing to reduce his income level to the new GAD Limit ( 25,400 pa), the sustainability of this is only 50% (an evens bet), based on the Balanced investment option. A more Cautious investment strategy does not help, and substantially reduces the Bequest. By annuitising part of the remaining retirement fund, the client can significantly increase the sustainability of the retirement plan, substantially mitigating the reduction in income. The trade-off between income sustainability and bequest is completely explicit. The advisor and client can see how much bequest they must give up in order to secure the required income floor, or to increase the income to an acceptable level. This Insight Note has considered a relatively simple set of retirement risk management options, in order to demonstrate that any retirement option can be assessed using the three risk metrics defined within our Retirement Risk Dashboard. This Dashboard enables advisors and customers to understand the trade-off between the sustainable income level and the expected bequest.
Drawdown Review Analyser The Drawdown Review Analyser allows advisors to evaluate the Retirement Risk Dashboard for their client s existing drawdown plans and to suggest options to mitigate income losses and manage retirement income risk on a sustainable basis A demonstration version of the Drawdown Review Analyser is available at: http:/// drawdown_review_analyser/ Delivering an enhanced drawdown review service: a practical guide With many clients falling in the red and amber zones, we might ask if the horse has already bolted? How can advisors use this Retirement Risk Dashboard and the associated Drawdown Review Analyser to help manage clients facing painful reductions in income at their drawdown review? Unfortunately, for some clients (very high income, high equity exposure) there is no doubt that some reduction in income will be the inevitable consequence. However, a clear retirement planning framework based on these risk measures can enable advisors and their clients to better understand the key retirement trade-offs, find optimal retirement solutions which minimise the loss, and ensure the plan is sustainable in future. While different advisors will need to build processes which fit with their own business proposition and processes, the generic Drawdown Review process flow illustrated overleaf can be used as a useful starting point.
In the post-rdr world of advisor charging, advisors will need to be able to present and explain this process to clients, highlighting the value being added through a regular drawdown review service.
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