Following on from the announcement by The Pensions Regulator (TPR) in late 2023 that the watchdog plans to share interim guidance on decumulation in 2024, Mark Northway, Investment Manager at Sparrows Capital has been actively discussing with us the key things he believes that advisers need to bear in mind about the decumulation market in this exclusive Q&A.
IFA Magazine: What do you think the TPR’s interim guidance on decumulation should feature?
MN: Regrettably, the TPR’s five principles are nebulous and vague, promising little more than an increasingly complex interplay between multiple regulators.
There is an urgent need for savers to be able to consolidate multiple pots in a simple and cost-efficient manner, and to be able to access cost effective pre-retirement and in-retirement advice and products relevant to their situation and relevant to the market environment.
Schemes should be able to identify the different options available to savers during the accumulation, pre-retirement, decumulation and increased dependency stages, and should have access to scheme-paid or flat-fee panel advisers to provide advice and guidance where required.
All options should be as transparent as possible about costs. Where insurance products are involved, the scheme should be responsible for a value assessment process to identify the frictional costs associated with products.
Savers should have the option to make unadvised decumulation choices. We look to the FCA to ensure in its current policy review that the line between guidance and advice is clarified in such a way that this is possible.
IFA Magazine: Is there a lack of options in the market for clients in decumulation?
MN: Definitely not! The range of solutions available to savers has become far more attractive following the ‘normalisation’ of interest rates in 2022 and 2023.
Decumulation strategies broadly fall into three approaches: annuity, market exposure and smoothed market exposure.
In recent years the traditional annuity has looked prohibitively expensive, but that has now changed, at least in nominal terms. Advisers have tended to focus on smoothed funds or have simply relied on the accumulation growth portfolio, perhaps with the addition of a cash pot to address sequence of return risk.
Modelling suggests that a combination of income and growth products can, in most instances, reduce longevity risk while still providing attractive expected legacy values, this is particularly the case where mortality pooling guaranteed income instruments are used.
IFA Magazine: Are there particular issues you think advisers should bear in mind which can arise from steering clients into smoothed funds and annuities?
MN: Smoothed funds can be a useful mechanism, particularly for clients with smaller pension pots and / or low risk tolerance. Depending on the smoothing mechanism (withholding returns versus expected growth rates versus historical moving average), they can be particularly relevant in the years leading up to retirement.
The downsides are primarily cost and lack of transparency. The processes involved in running a traditional smoothed fund are complex, and this complexity must be paid for through the investment charge and through the fund’s expenses.
There are also hidden arbitrage costs. Genuine price smoothing relies largely on economically irrational behaviour by investors: investing and remaining in the fund when the unit price exceeds the NAV, and withdrawing when the converse is the case. Inevitably some participants will adjust their behaviour considering NAV fluctuations, creating a frictional drag on fund returns.
Annuities can also be interesting for clients with smaller pots now that interest rates have risen. The product is transparent as to the return offered, although it is difficult to assess whether that return represents fair value for the saver.
The principal drawback is that a retirement strategy using annuities alone won’t produce any legacy value. If the saver dies early the annuity is extinguished, and if markets are strong the saver foregoes the opportunity to build a legacy for his / her dependents.
IFA Magazine: How do you think advisers and their clients should deal with the danger that the timing of withdrawals from a retirement account can have a negative impact on the overall rate of return available to the investor – ie sequencing risk?
MN: Sequence of returns risk is a very real problem. Our modelling suggests that traditional growth portfolios are surprisingly prone to sequencing risk. We have estimated, for example, that a 100% global equity portfolio with a traditional 4% nominal withdrawal rate, carries a 1:14 chance of depletion after 20 years, rising to to 1:7 at a 5% withdrawal rate.
Combining a growth portfolio with guaranteed income provides an effective 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 also provides some degree of expected inflation protection.
IFA Magazine: When is the right time to reassess the risk of the portfolio when clients are heading into or throughout the decumulation phase?
MN: Sensitivity to market falls peaks in the years immediately prior to retirement and, depending on the retirement solution selected, in the years immediately post-retirement.
It makes sense to reassess risk at least five years prior to intended retirement and, depending on the size of overall wealth and living costs, to consider reducing the sensitivity to markets.
Traditionally, this has been achieved by feeding increasing amounts of fixed income or alternatives into the portfolio, although that strategy fared badly as interest rates rose in 2022 and 2023.
There are now principal protected strategies available to limit equity downside. These inevitably dilute any positive market performance but can provide useful protection during the critical phase between accumulation and decumulation.
IFA Magazine: How should advisers work with clients worried about running out of money in the decumulation phase? What tools are available to help clients?
MN: Running out of money in retirement is a catastrophic outcome. The adviser has a major role to play in assessing whether a client’s total wealth is sufficient to maintain his / her intended lifestyle, and to recommend any actions and /or lifestyle changes needed to avoid a shortfall.
Cashflow modelling tools are helpful in illustrating potential outcomes, but relatively few clients can really appreciate the tail risks without assistance and explanation.
A retirement plan needs to be reassessed frequently to ensure that it is behaving as intended, and to take account of changing circumstances.
Explanation, looking at potential future scenarios and mentoring are all part of the adviser toolkit at this stage.
IFA Magazine: How will the FCA’s Retirement Income Review impact the future of the decumulation market and decumulation process?
MN: We expect the review to underline the need for demonstrable planning and action in the run-up to retirement, at the point of retirement, and throughout the decumulation phase.
This, combined with a focus on outcomes, will act as a catalyst in ensuring that retirement plans are properly personalised and fit for their specific purpose.
