Adrian Boulding: Strategies to avoid income ‘over-drawdown’

A total of 345,265 pots have been used to buy income drawdown policies while 152,843 moved into annuities. Scarily, 620,150 pots were cashed out completely since October 2015.

Triple whammy effect

The growing army of ‘drawdowners’ must be wary of potential traps including ‘pound cost ravaging’.

This triple whammy effect happens when markets fall steeply. Retirees then suffer falling capital value of the fund, further depletion due to the income they are taking by selling assets at rock-bottom prices, and a drop in future income going forward as dividends follow asset values downwards.

This poses a problem every time markets take a tumble but is especially dangerous near the start of retirement because investors can rack up big losses and never make them up again if they are not careful.

One recent lurid headline suggested that, as a result of this triple whammy effect, some drawdown-based incomes could be cut in half in short order.

So what tools and techniques are now available to help this majority who are either cashing out in full or purchasing an income drawdown policy in retirement? There is already lots of guidance available in this area.

You can read about safe drawdown levels sitting at somewhere between 2% and 5.8% of the total value of assets held in a policy. Some prefer to peg the drawdown level at close to average annuity rates, which currently sit around 4.8%.

But surely it depends hugely on the performance of the assets the policy is investing in, the size of the overall fund at the start of drawdown, the position on the economic cycle and much else besides?

There are well-trodden strategies for preserving drawdown funds during market downturns by building up three to five years’ worth of cash reserves, which can be used for drawdown payments so you are not selling assets into falling markets, thereby crystallising losses in bad times such as the aftermath of the global financial crisis.

On the other hand, holding five years of cash – maybe 20% of the portfolio – at today’s nugatory interest rates feels like standing in the rain waiting for a delayed bus …

Others prefer to choose emerging hybrid products that offer to lock in part of a retirement pot to secure a guaranteed income. Such lock-ins can be judiciously upped over time – perhaps by taking profits from the drawdown portfolio in good times. There is a win-win element to this strategy.

Having a bedrock of secure income enables the adviser to increase the equity proportion of the remaining drawdown portfolio, so it is quite likely there will be periods of future gains to harvest.

You might also re-align your portfolio, perhaps selling some funds that are still on an upward curve, and draw down the proceeds from these sales only. Alternatively, you might buy more stocks that have a strong and stable track record of dividend pay-outs.

Turning to tech

Advisers can run the slide-rule over many of these drawdown fund-preserving techniques for clients. They are also, however, increasingly turning to technology to determine safe withdrawal rates for clients.

One such tool that has already gained a healthy following is Finalytiq’s Timeline app. It bases its calculations on historical monthly returns for all global asset classes since 1900 – a very large data set indeed. Advisers input the customers portfolio and current income withdrawal rate and then the app calculates what would have happened to those funds if it had been started in all months since 1900.

All this number-crunching tells you what proportion of ‘starter’ customers would have succeeded in not running out of money prior to death. If your chance of successfully not running out of money is above 85% (based on those past numbers) then the client may feel happy to leave withdrawal rates as they are.

Vanguard will shortly publish its own research on the ‘cap and collar’ withdrawal model. This approach, easily understood by clients, increases the drawdown income each year in line with the investment performance of the drawdown portfolio, but subject to a pre-determined cap and collar.

So, with help from their adviser, a client may have decided to cap annual increases at 5% and to limit annual reductions – when investment performance is negative – to 2.5%.

The logic behind this approach is that holding back some of the gains in the good years will protect against losses in harder times. Bible students might recognise the same advice given by Joseph to the Egyptian Pharaoh to lay up the surplus harvest from good times for lean times to come.

The adviser can choose to use these types of tools to set up automated alerts that could drive interventions if the policy has been pushed off-course by extraordinary market events, such as three years of poor equity returns, for example, or overall fund growth falling below 4%.

If these pre-set thresholds are reached, advisers could seek – or be given in advance – clearance from the customer to adjust portfolios to take more defensive positions and/or reduce amounts being withdrawn.

Providing a plethora of powerful tools can be dangerous, however – especially if they are in the hands of the inexperienced. One simple truism is that it is safer not to touch a tool at all until you have a clear sense of purpose as to the objective you seek to achieve with it.

Three goals

Advisers are well-placed to help clients take a step back and write down their at-retirement objectives. A process that can help here is to focus on three goals: building ‘essential income’ for unavoidable monthly bills, ‘lifestyle income’ for the things the retiree would like to do, and finally a ‘legacy target’ to leave funds either to a spouse or the next generation.

Given the increasing number of baby-boomers moving their retirement funds into drawdown, it is clear there is a growing demand for more decumulation planning tools to assist advisers and guide consumers direct.

Many of these tools will be finding their way onto platforms. Others will be integrated into existing adviser planning and illustrations suites in the coming years. Who knows – they may even be deployed on the pension dashboard in a couple of years.

Adrian Boulding is director of retirement strategy at Dunstan Thomas