The biggest threat to income in retirement, yet one that is largely misunderstood, according to Cass Business School asset management Professor Andrew Clare, is sequence risk.
This concerns the sequence in which returns are generated, rather than the average return over time, explained Clare and is one of the biggest challenges to those looking to generate income in retirement.
In the worst case scenario, he said, it could cause an investor to experience a large drawdown while they are still trying to draw income. “Losing 20% of your money – even temporarily – while you are drawing money from that pot, is potentially fatal,” he added.
Clare conducted research into reducing sequence risk, which has been used as the basis for the WM Capital Global Momentum Fund. This found it could produce what he described as “very decent” risk-adjusted results that reduced drawdown “quite dramatically” to between 10% and 12% on an equity fund.
“It is not ideal but, if you are investing in riskier assets, you have to expect some downside,” he said. “The problem is, if you experience a 40% drawdown on your equity fund, it could reduce the amount of money you can draw from that fund by five or 10 years – and, if you end up living to 100, that is not a good situation.”
Momentum Global Investors head of investment management James Klempster said one cost-effective way to safeguard against this risk is diversification. “It’s the closest thing to a free lunch in this game,” he added.
According to Klempster, factoring in drawdown is now key in creating outcome-based investments. “Going forward, we believe people care about outcomes as opposed to benchmarks, say, or ‘inflation plus x’,” he said. “We also think about making that investment journey as palatable as possible.”
Using strategic asset allocation and diversification, as well as considering risks such as drawdown, will offer the best probability of achieving an investment outcome, he argued, concluding: “If you can get this lined up well and manage people’s expectations at the outset, they are much more likely to stay with you for the journey.”
‘Don’t Follow The Herd’Investors can also minimise drawdown risk by not giving into the temptation to “follow the herd” when selecting equities, argued Hempshill Hall Asset Management founder Felicity Smith, as this can help ensure greater diversification,.
“There is a huge drawdown risk in the index,” she said. “But the big household investment names are forced to look like the index because, the bigger they get, the more they can only invest in bigger companies.”
Smith said investors and their advisers should look to strike a balance between buying businesses that can pay income now but also have the potential to grow over time.
All three speakers were guests on a live webinar on the risks to income in retirement, run in association with Retirement Planner‘s sister titles Professional Adviser and Investment Week. You can watch a recording of the webinar here
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