Preparing for a Life Beyond Work
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The tension between client needs and their financial capacity to support them is at the heart of retirement planning and investment.
Retirement – it's a risky business
It has become a cliché to label baby boomers as a charmed generation, but their retirement fortunes are certainly more straightforward, than the generation that succeeds them.
The retirement landscape: boomers versus Gen X
Retirement has evolved: it is no longer about stopping work at a fixed age; instead, more people are embracing the golden decades of retirement, continuing to work and live as actively as before.
retirement is changing
how CAN advisers keep up?
Exploring the retirement strategies advisers need to focus on over the next decade as a new era of retirement beckons
As the population ages, individuals are living longer and for some this means a longer retirement. How can advisers help them prepare?
What are the new ideas and technology developments helping retirees and advisers plan a better future?
Future retirement advice models
Rethinking retirement investing
Advisers are under more pressure than ever before to deliver advice in a concise, structured and measurable manner.
Clients seeking retirement income are different from those accumulating wealth and we need to recognise these differences when building and recommending solutions for them.
What really drives sequence of returns risk and what strategies are most useful in managing this?
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DISCOVER MORE
Learn more about BNY Investments
A closer look at sequence of returns
What makes retirement clients different?
The regulatory catalysts challenging advisers
Four lifestyle changes shaping retirement advice
How advisers can adapt their investment approaches to address changing retirement risks.
Header: 70/70 > 80/80 Subheads/Body: 18/27 > 30/41 PQ's: 30/36 > 40/46 Source: 16/25 > 24/35
The role of financial personality in retirement decision making can often be just as important as investing in the right way, Oxford Risk's head of behavioural finance, Dr Greg Davies, explains.
Creating economically and emotionally comfortable retirements
The demand for retirement advice outstrips supply – which has created an ‘advice gap’ that poses challenges for policymakers. But what role do advisers have in solving this problem?
Gap analysis: evolving retirement advice
As the complexity of retirement planning increases, the role of technology in enhancing financial advice grows ever more significant.
How can technology enhance retirement advice?
Done properly, cashflow modelling offers clients information they need to understand Investment product and risks – but there are also limitations that advisers must be aware of.
The ins and outs of appropriate cashflow modelling
Retirement income clients face different risks from those growing their wealth – and strategies must match these needs too.
Managing income for a better retirement outcome
The FCA’s review of retirement income advice means clients and advisers must think differently about risk in retirement. What are the options?
Rethinking retirement investment for the outcomes clients want
Many of the baby boomers (those born between 1946 and 1964) are now settled into a comfortable retirement. It has become a cliché to label them a charmed generation, but their retirement fortunes are certainly better, and more straightforward, than the generation that succeeds them. Generation X (born between 1965 and 1980) starts to hit 60 next year and has a more complex path to a prosperous retirement. Demographics is not an exact science: older Gen-Xers may retain some of the privileges of the boomers, while younger boomers may face some of the challenges of Gen X. However, there are clear trends in how retirement paths have evolved across generations, shaped by new working patterns, changing family dynamics and shifting patterns of wealth.
Working life
Baby boomers tend to have had more stable working lives. For much of their career, ‘jobs for life’ were still available, usually with the security of a defined benefit pension. Gen X’s careers have been more wandering in nature. They have more jobs in their lifetime , and are more likely to have periods of self-employment, entrepreneurship, education and employment. Nearly half of all self-employed people in the UK are over 50. Gen X are also likely to work longer. The Institute for Fiscal Studies (IFS) has found that patterns of employment among people in their 50s and 60s are dramatically different to those seen a few decades ago. This is both preference and necessity. The state pension will kick in far later for Generation X. A woman born in 1946 would have been able to claim her state pension at 60; a woman born in 1978 will have to wait until she is 68. For those currently considering retirement, this situation has been exacerbated further. In BNY Mellon Investment Management’s 2023 research report, Life Beyond Work: The changing face of retirement, 67% of advisers surveyed said that the current challenging economic environment means that clients will have to work longer. In addition, 15% of respondents felt current economic pressures could mean some of their retirement advice clients having to go back to work. While some clients may have jumped the gun by deciding to retire after the upheaval of the pandemic, that any advised client might have to return to work must be a concern.
While boomers often have healthy workplace pensions, and the fall-back position of property wealth, Gen X are likely to have more disparate sources of income, including property, ISAs, workplace and personal pensions
Commitments
Boomers were often free to enjoy their wealth: their children did not need the same support on education costs, and their parents often didn’t live long enough to require expensive care. The next generation of retirees may have had children later, and have had to pay tuition and maintenance fees. They are likely to inherit later, as their parents live longer, and may be on the hook for care costs for their elderly parents. In our survey, 27% of advisers said the cost of supporting family is an important consideration for their clients. The problem is becoming more acute, as inflation pushes up the cost of supporting both elderly relatives and ‘boomerang’ children - 29% of advisers said this concern is rising for their clients. Gen-Xers may also have more debt. Having bought their homes later and at higher cost, they may still be paying down a mortgage in retirement.
Disparate wealth
While boomers often have healthy workplace pensions, and the fall-back position of property wealth, Gen X are likely to have more disparate sources of income, including property, ISAs, workplace and personal pensions. Many of this generation entered the workplace just as companies realised they could no longer afford generous final salary schemes. However, neither did they benefit from auto-enrolment in the same way as Millennials. Auto-enrolment started in 2012, so it came relatively late into most Gen-Xers’ careers. Caught between two regimes, many do not have the same generous pension provision as those either side of them and the balance of their wealth may be different. Yet many Gen-Xers will still have been able to get on the property ladder and participate in housing market growth. For example, a Gen-Xer who bought a house for £200,000 in 2000, would have seen an average gain of 226%, raising their house price to £652,72. They may have higher mortgages at retirement than the previous generation, but are likely to still have a lot of capital tied up in their homes. The result of these disparate sources of wealth is a retirement pot that can be difficult to manage. Advisers may find themselves trying to impose order on multiple pots of capital, managed in different ways.
Changing family structures
While boomers are more socially progressive than the generations that went before, the model of a single breadwinner with a large workplace pension is still the norm for this generation. This is far less likely to be the case for Generation X. Female participation in the workforce has notably expanded, with the female employment rate rising from 54% in 1983, when the first Gen-Xers started to hit the workplace, to over 71.9% today. Households are far more likely to have two people working and contributing to a pension. The latest data from 2021 shows 74% of families had both parents working with 50% of families having both working full time, up from 42% just 9 years earlier. This means many households will have two pots of wealth to draw on for retirement. Also, the family unit is more fluid for Generation X. Back in 1965, 1 in 10 couples who married that year were divorced by their 10th anniversary. This increased to 1 in 4 couples for those married in 1995 though it has now fallen back to 1 in 5 for those married in 2012. This creates complexity – step-families, divorce settlements, multiple properties – with added challenges around inheritance. It is clear that Generation X is likely to need more help, perhaps at an earlier stage, to knit together its various income sources and build a coherent plan for retirement. The need to plan holistically and imaginatively to ensure assets are utilised in the most effective and efficient way will only grow. It represents a golden opportunity for advisers.
1. uk.finance.yahoo.com 2. restless.co.uk 3. ifs.org.uk 4. Research conducted by NMG Consulting for BNY Mellon Investment Management between June and July 2023, based on responses to an online survey with 202 retirement-focused financial advisers. 5. nationwide.co.uk 6. ons.gov.uk 7. ons.gov.uk
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This evolution is not just a trend but reflects a broader shift in how society views retirement. Importantly, advisers recognize that traditional retirement strategies may no longer be suitable for individuals. Here are four lifestyle changes that are reshaping retirement financial advice and necessitating a fresh approach to ensure financial security in the golden years.
Longer lifespans due to improved healthcare and access to medical technologies and innovations have seen the average life expectancy increase from around 69 years in 1950 to around 82 years in 2024. With this increased longevity, the need for more comprehensive financial planning has become essential, particularly as the amount of money needed during the early phases of retirement can differ significantly from that needed in later years. “The idea that people need an ever-increasing income in retirement is not always true,” explains Richard Parkin, Head of Retirement at BNY Investments. “In reality, individuals often need more money in the first decade of retirement as they seek to make the most of their free time, and then income requirements go down as activity slows.” This contrasts with how the retirement market is currently structured, particularly regarding defined benefit pensions and the state pension, which pay a fixed amount that increases over time. While annuities have a very useful role to play in retirement, securing even more guaranteed income may not match clients’ spending needs. “These setups do not align with the true shape of retirement, and there is a good opportunity for advisers to add value by exploring the income clients actually need and by looking at how other investments can fill any gaps,” says Parkin.
For clients who cannot work beyond 60, for example due to ill health, retirement savings will be needed sooner to bridge the gap until state pension payments begin
The problem with pension freedoms
When pension freedoms were introduced in 2015, the aim was to give those approaching retirement and those already retired more flexibility regarding when they could access their defined contribution pension. Initially available to pension savers from the age of 55, this age will rise to 57 in April 2028. However, nearly a decade on, the change in consumer behaviour resulting from pension freedoms has shown that individuals are not always equipped to make sound decisions when left to their own devices. Often, it can be the first time individuals have had to manage large sums of money, highlighting the need for financial advice in retirement planning. “In reality, most people cannot afford to retire at 55 but are attracted to the fact that they can take out a lump sum tax-free. However, just because they can do this doesn’t mean they should when planning for the long term,” says Parkin. For example, the fact that pension freedoms are available at 55 may lead some to believe they should access their pension early—even if they have no plans to stop working for another decade. Some individuals might use the lump sum to invest, but without any financial guidance there is a danger that clients are attracted to high-risk, unregulated assets. The introduction of pension freedoms has also led to an increase in scams. “Financial advice can make the difference between people making mistakes with their retirement funds and having a comfortable amount of savings to depend on,” adds Parkin.
Working beyond 55
ONS data revealed a 26% increase in the number of people over 50 working part-time in the last decade. The figures, from 2023, represent a record high and a 12% increase since 2021, suggesting that the days of a ‘linear’ career path ending at 60 are no longer a reality. Parkin notes that this trend has become more prevalent for various reasons: “Some of the increase in people working is out of necessity—individuals realize they need to bridge the gap between age 60 and when they start receiving the state pension. That’s the reality of the pension age increasing. In other cases, it’s a lifestyle choice. People no longer want to walk away from the workplace at 60. They want to remain in work, whether that’s moving to part-time in their current role, taking on governance or consulting roles or even starting their own businesses.” For other clients who cannot work beyond 60, for example due to ill health, retirement savings will be needed sooner to bridge the gap until state pension payments begin at age 66 or later. “The need for flexibility in retirement and the ability to mix retirement savings with earned income has become essential,” adds Parkin.
A ‘sandwiched-in’ era
The original ‘sandwich generation’ described middle-aged adults with additional financial pressures due to supporting both their children, perhaps at university, and their aging parents simultaneously. However, when today’s middle-aged adults reach retirement age, they may face even greater financial pressures. “There is a generation of young people who cannot get onto the housing ladder until much later. So, as well as having to support aging parents, individuals may have children returning home from university or choosing to live at home for much longer. The challenges are different: you have children who are less independent for longer and may need help getting on the housing ladder,” says Parkin. Additional pressures may arise from the fact that this is a generation that does not have as much pension wealth as previously thought. Data from Just Group found that more than a quarter of Gen X—those born between 1965 and 1980—are not confident they can pay off their mortgage before the age of 67. “This generation may need to work longer to pay off their mortgage or even enter retirement with some of that mortgage still outstanding. Some in this situation may want to use their pension assets to pay it off,” Parkin adds. However, it is perhaps more likely that individuals in this situation will draw on property wealth to fund retirement at some point, either by downsizing early in retirement to release capital or at least recognizing that the property is a ‘contingent asset’ for use later. For advisers, this brings added complexity to the retirement income puzzle. More people are likely to be relying on their retirement savings to provide the bulk of their retirement income making investment and withdrawal decisions even more difficult. In addition, advisers may need to develop expertise in managing housing wealth, not just investment expertise—particularly if clients need to use equity release to supplement retirement income if they live longer than originally anticipated.
Funding a golden decade-and beyond
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From pensions freedoms, RIAR, and Consumer Duty to new tax rules and political upheaval: advisers are under more pressure than ever before to deliver advice in a concise, structured and measurable manner. We analyse the regulatory and political issues challenging adviser businesses in 2024.
The UK retirement environment underwent significant changes in 2022, culminating in a perfect storm of events. Liz Truss’s brief tenure as Prime Minister saw the introduction of a controversial mini-budget, which triggered a sharp sell-off in UK assets and prompted the Bank of England to intervene to stabilize the bond market. This uncertainty came on top of rising inflation, which had already surged earlier in the year due to a combination of supply chain issues and the energy crisis stemming from the Ukraine-Russia War. This led the Bank of England to increase interest rates sharply, with 14 consecutive rate rises from December 2021. “2022 saw the market environment change markedly,” explains Richard Parkin, Head of Retirement at BNY Investments. “While we had experienced some market volatility since 2015, it was always relatively short-lived. In fact, for the past few decades, the investment environment has generally been positive, with globalisation, central bank interventions and fiscal policy creating an environment of lower inflation and declining interest rates supporting asset prices.” The combined effect of rising geopolitical risk, inflation and interest rates, heightened market volatility and made borrowing more expensive. As a result, the value of retirement savings fell, the cost of living increased, and advisers faced pressure to generate more income from fewer assets. “These challenges have been significant from a client perspective, but also extremely challenging from an adviser’s commercial standpoint,” says Parkin.
Taxing times
Adding to these challenges are recent tax changes, including amendments to capital gains tax and pension allowances, which have caused advisers to rethink their approach. “Advisers have always excelled at helping clients manage tax,” Parkin explains, “but the problem is the level of uncertainty that has surrounded fiscal policy as we change government. We may see more capital gains tax changes in the coming years, possibly changes to inheritance tax, especially concerning pensions being passed on IHT-free. If that is amended, it will have a huge impact on retirement advice.”
We may see more changes to capital gains and inheritance tax in the coming years....it could have a huge impact on retirement advice
New rules
The introduction of new Consumer Duty rules in 2023 has also put pressure on advisers to ensure that the products they recommend are suitable for their clients. Coupled with the Retirement Income Advice Review (RIAR), their advisory structures are under increased scrutiny. Many are concerned that the need for more rigorous advice processes could increase costs and affect clients who rely on this guidance to manage their retirement finances. “Client circumstances are far more complex today, and advisers need to be more thoughtful about the advice they provide,” says Parkin. “Firms are now required to demonstrate the value they offer to clients, and the standards against which that value is measured have been significantly raised. “While Consumer Duty emphasizes the need to act in the client’s best interest, RIAR reminds advisers that retirement clients are very different from those who are still accumulating wealth. As an industry, I’m not sure we’ve fully recognized that yet.”
For Professional Clients only. Any views and opinions are those of the investment manager, unless otherwise noted. This is not investment research or a research recommendation for regulatory purposes.
Important information
Brighter futures
Regulatory and legislative disruption poses challenges for advisers, particularly those looking to grow their business. However, this isn’t necessarily all bad news for advice firms. According to Parkin, these changes present an opportunity for advisers to work more closely with their clients, helping them navigate the more challenging market and economic environment and managing whatever tax changes are coming our way.
Clients seeking retirement income are different from those accumulating wealth – but how do you spot the difference?
The FCA’s review of retirement income advice is full of detail about how firms can improve the way they approach this most complex area of financial planning. But looking through this detail there is a clear message. Clients seeking retirement income are different from those accumulating wealth and we need to recognise these differences when building and recommending solutions for them. At BNY Investments, we have developed a retirement investment framework which starts with these differences and uses them to better understand how we invest successfully for clients taking retirement income.
Multiple specific objectives
For clients who are some way from retirement, their retirement objectives tend to be vague. They may have some idea of when they want to retire, and a hope that they will be able to maintain their standard of living throughout retirement, but that is probably as far as it goes. Advice tends to focus on saving as much as possible and maximising returns within acceptable risk parameters. Clients who are approaching, at, or in retirement will tend to have a much clearer idea of what they need and when they need it. This will not just relate to the level of regular income they need to generate to support their day-to-day living but what else they might need to fund their retirement bucket list. There may also be greater clarity on what they want to leave behind or gift away during their retirement. Overall, objectives will be much more specific, at least for the initial phase of retirement. This allows us to tailor investment strategy to meet those objectives and to consider risk in the context of achieving those objectives rather than just focusing on volatility. The two are linked but are not the same. As the FCA review highlighted, we need to think about a client’s capacity for loss not just in terms of their wealth but also in terms of their income. Framing this in the context of the client’s objectives is a helpful way of assessing what tolerance for risk a client can bear.
With the decline of defined benefit pensions, more clients are likely to be reliant on their retirement savings for much or all of their retirement income
Limited resilience
If I am still working and saving for retirement and I am hit by poor markets, unexpected inflation, or both, as we saw in 2022, I have options for dealing with this. I can work longer. I can save more. I may even be able to take more risk. Those who are in retirement are unlikely to have many or any of these options available to them. Their ability to tolerate losses versus their appetite for gains will change markedly. Again, we need to consider this in terms of income as well as capital. For many, there will be a level of income below which they cannot meet their essential expenses. With inflation likely to pose a greater risk to retirees than it has in recent years, we also need to consider how we handle any potential loss of purchasing power during retirement. While retirement income clients may still want and need to grow their wealth, they are likely to be most focused on limiting or avoiding capital losses, preserving the real value of their income, and making sure their retirement savings last. Of course, if my income needs are modest compared to my wealth then I will be better able to absorb capital losses and higher inflation. But with the decline of defined benefit pensions, more clients are likely to be reliant on their retirement savings for much or all of their retirement income. In the face of continued inflation and challenging markets, getting the balance of risk and reward right is likely to be important for many.
Sequence of returns risk
While sequence of returns risk affects all investors it has a particularly profound effect on those taking retirement income. The potential for losses in retirement to undermine the sustainability of future income was seen as a big issue for investment-based retirement solutions when pension freedom was first announced. In practice, markets were kind to drawdown clients and concerns about sequencing risk may have taken a back seat. The sharp rise in interest rates in 2022 saw both equity and bond markets fall sharply, something that thankfully happens very rarely. These falls were compounded by higher income needs driven by the increased cost of living. As a result, clients using investments to generate retirement income were having to get more from less. Those who had recently entered drawdown were particularly affected leaving many having to rethink their plans. Research we conducted in 2023 showed that around two-thirds of advisers expected clients would have to work longer, over half expected clients to have to reduce withdrawals, and 15% thought some clients might have to go back to work. While 2022 was an abnormal year, it did show we cannot be complacent about managing market downturns and will need to structure portfolios accordingly. Once again, we need to think about this risk in terms of income and not just capital. Successful management of sequence of returns risk involves more than just managing volatility and downside risk. In summary, we need to think about risk for retirement income clients in terms of risk to their objectives, to recognise that their ability to withstand these risks may be limited given the constraints they face, and to understand the complex way in which the profile of investment returns affects income sustainability. The industry has some work to do on adapting its approach to retirement advice and investment, but helping clients navigate these challenges is still a golden opportunity for advisers.
1. BNY Investments Life Beyond Work: Changing Face of Retiremement Research, November 2023.
Research by BNY Investments in 2023 found clients’ ability to maintain their standard of living into retirement and making their savings last as long as they need to are top priorities.
These priorities can clearly conflict. Maintaining my standard of living is an open-ended commitment funded from a finite pot of money that is constrained in the level of income it can support. This tension between client needs and their financial capacity to support them is at the heart of retirement planning and investment. Managing this tension when we had relatively low inflation and benign investment markets was hard enough. Now, with inflation likely to be a more permanent feature of the retirement landscape and with increased market uncertainty driven by a range of factors from climate change to geopolitical risk, the challenge has become even greater. Some clients will be fortunate enough to have more than sufficient assets to support their retirement income needs. But, with defined benefit pensions becoming less prevalent and State Pension Age increasing, more and more people will be relying on savings to support a greater part of their retirement income. Moreover, the replacement of defined benefit with much less generous defined contribution arrangements means many will find that the sums simply don’t add up giving advisers the near impossible job of generating more from less.
Focus on avoiding losses
Let’s look at two different illustrative investment strategies (A and B) over a 10-year period, each with £100,000 invested. For those saving for retirement, Strategy B would be expected to be most alluring as it gives a better outcome in most market scenarios. However, when we impose a requirement to achieve at least £100,000 at the end of the period, Strategy A will likely be most appealing as Strategy B can't be relied upon to deliver that amount. While Strategy B delivers higher returns in other scenarios, Strategy A is still delivering outcomes well more than the minimum needed.
In this context, it is clear we need assets to continue to work as hard as possible in retirement. This suggests a need to continue taking investment risk in the pursuit of returns. But we also need to recognise that a client’s capacity to take that risk can be much diminished. Note that we distinguish between capacity for risk and risk attitude. Some argue that a person’s attitude to risk remains relatively constant throughout life. Some people are just more comfortable taking chances than others. What does change though is people’s financial capacity to deal with the consequences of those risks. As such, basing the level of investment risk purely on someone’s attitude to risk may not be the right answer. A 20-year-old who is inherently risk averse has a low attitude to risk but their potential to generate wealth through employment and saving in the future gives them a high risk capacity. They may prefer a cautious portfolio but with many years to accumulate wealth and overcome any setbacks, they can afford to take more risk. Conversely, someone in retirement may still be willing to take some risk but if they have limited assets relative to their income needs, they have a low risk capacity. The consequence of this is that they are less able to deal with losses and need to invest accordingly. Another way of saying this is that generally younger investors should be more focused on making gains than avoiding losses whereas those in retirement may need to concentrate more on avoiding losses rather than making further significant gains.
Younger investors should be more focused on making gains than avoiding losses whereas those in retirement may need to concentrate more on avoiding losses
Of course, this is a stylised example, and retirement investors are more likely to think about ongoing income sustainability rather than aiming for a particular minimum amount. But the point remains that retirement income clients are likely to be more concerned about falling below their income needs than trying to make further gains. Achieving a durable income stream in retirement – which is arguably the aim for most people – will likely require a shift in mindset from both the adviser and the client. It’s human nature to focus on what we could have had when other choices deliver better outcomes, but we tend to be less willing to consider what we might have lost when other choices would have been worse. Focusing on what a client needs to achieve their objectives will need a different approach to managing investment risk – one that moves away from trying to maximise wealth and much more towards balancing risk and return.
Source: BNY Mellon Investment Management. For illustrative purposes only.
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Identifying risk and managing it are key to retirement outcomes – but what processes are in place to successfully navigate it?
Most advisers will be familiar with the idea of sequence of returns risk. That is, the risk that losses occur in retirement and reduce the sustainability of future income. But where does this risk come from and how do we measure and manage it? At BNY Investments, we’ve been investigating this and have come to some conclusions that may be surprising. Volatility is the usual measure of investment risk and measures how much individual period returns deviate from the average return. It feels like this could be useful in describing the riskiness of a fund for retirement income. Indeed, many assume that clients entering retirement should automatically be reducing volatility. That may be a sensible thing to do, but volatility doesn’t really capture the detail of how investment returns occur. Given sequence of returns risk is about investment losses, risk metrics that measure these such as maximum drawdown and Value at Risk may also be useful. But again, knowing how much something might fall doesn’t give us the full picture. To understand what really drives sequence of returns risk we need to think about patterns of returns, not just the level of returns.
Both investors earned an average return of 6% over the 20 years, both experienced the same volatility of 10%, and both experienced the same maximum loss of 20%. Despite this, the outcomes were very different. The key point is that a big loss may not be an issue if we recover from it quickly. The quicker we recover losses, the fewer income withdrawals have to be made at depressed asset prices. Investments that have lower volatility and lower downside risk may not be as useful in supporting retirement income if they don’t recover quickly. Examples of this include less liquid assets and even some smoothed funds. Their value tends not to fluctuate much day-to-day but they can, and do, fall sharply. More importantly, they can be slow to recover meaning I have to sell more of them to support income payments which will affect the sustainability of income. Many retirement clients will need to take some risk to earn the returns they need to achieve their objectives. Reducing risk to limit losses and the impact of sequencing risk may just mean we’re more certain of running out of money. The aim should be to identify investment strategies that have lower downside but also recover more quickly when they do lose value. That is, they have greater “bouncebackability”. Of course, identifying the characteristics that are desirable for limiting sequence of returns risk is easier than finding strategies that display those characteristics. Different asset classes and investment approaches can be used to achieve these. In our analysis, we have found evidence that equity income strategies that are biased towards quality and value factors can display lower volatility, lower downside and greater bouncebackability. This is not guaranteed but has some intuitive appeal since well-managed companies generating reliable dividends should be more likely to do well during times of market stress. Also, their value is better anchored to the “jam today” of a visible income stream rather than the “jam tomorrow” of future growth providing an underpin to the share price and an intrinsic value to which they can return even as market uncertainty persists. Whatever approach is followed, we’ve hopefully demonstrated that we need to look beyond simple risk measures when thinking about retirement risk. Whether taking income by regular withdrawals from a total return portfolio or through managing assets to generate income through dividend payments, we believe equity income strategies have a key role to play in retirement planning.
As a stylised but hopefully simple example, consider two clients taking the same level of income from the same starting level of savings. Let’s call them Harry and Lucy. They both take £6,000 at the end of each year from an initial investment of £100,000. Both see the value of their investments fall by 20% in the first year leaving them with £80,000 from which they take £6,000 giving them £74,000 at the end of year 1. Not a great start. The next year, they both earn 6%. This would have been enough to cover their income had they not suffered the earlier loss but, on the reduced portfolio value, only generates £4,440. Taking the £6,000 of income at the end of year 2 uses up all the return earned, and they have to top this up with £1,560 of capital, reducing their savings still further. Despite the better return of year 2, the initial loss means they are still on a downward trajectory. The more they dip into their capital, the less capital they have invested. This means they earn less on their investments and so must draw more capital to meet their income needs. But from year 3, things go differently for our two investors. Harry continues to earn 6% a year for the next 16 years and sees his investment go up by 40% in the final year. Lucy, sees the value of her investments go up by 40% in the third year and then earns 6% a year for the next 17 years. As the charts show, despite the big return at the end of the period, by the time it arrives Harry’s used up so much of his capital that it makes little difference. By comparison, while Lucy is still having to fund part of her income from capital, the earlier recovery of her investments means this is limited and she is still in a relatively strong position at the end of the period.
To understand what really drives sequence of returns risk we need to think about patterns of returns
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Hapless Harry vs Lucky Lucy - early recovery makes all the difference
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Source: BNY Investments. For illustration only.
Advisers will need to look at whether they have the appropriate platform, investment strategy and technology tools to meet clients’ shifting needs
Few deny that demand for advice in retirement outstrips advisers’ ability to supply it. This ‘advice gap’ is a significant headache for policymakers, who need to ensure that people’s retirement outcomes aren’t compromised by poor, ill-informed decision-making. But what role do advisers have in solving this problem?
Part of the challenge for regulators is that most advisers have a full client bank, and a strong pipeline. While many advisers would love to help those who need advice but cannot access it, there is little commercial incentive to do so. Equally, the regulatory parameters placed around advice currently make it difficult to offer simplified pathways for less wealthy customers. It is a problem that is likely to become more pressing. The population aged 65 and over is projected to grow by 10.6% in the next five years. Auto-enrolment has brought an additional 10.9m people into workplace savings since 2012. With more people retiring and the bulk of assets in defined contribution schemes, advice needs will explode. Despite the obstacles, some advisers have succeeded in building these pathways, whether to help with the advice gap or to create a pipeline of younger clients. However, the proportion of advisers with a specific proposition for low value clients has fallen from 40% in 2023 to 30% this year with Consumer Duty obligations cited as one of the key reasons for this fall. One has to wonder whether the additional requirements set out in the FCA’s Retirement Income Advice Review may further constrain adviser capacity and so limit the supply of advice.
Regulatory efforts
The advice guidance boundary review from the FCA outlines proposals to fill the advice gap, which – if implemented – could have an impact on the way advisers approach this part of the market. It suggests three potential options. The first is simply for the regulator to clarify the boundary between guidance and advice to encourage providers to go further with guidance. While this may help, firms will inevitably be wary of straying into advice and so the regulator may need to provide more explicit direction of what support should be provided and when. A second option looks at a simplified advice regime. This new regulatory framework would enable firms to use limited information to suggest products or courses of action, considering only the relevant information about a specific consumer need. An earlier version of this idea was rejected by advisers as being unviable and it seems this latest rendition is getting the same response. Perhaps most interesting would be ‘targeted support’. Fund groups, product providers, and platforms can give people generic advice by referencing people like them. The idea is that consumers would be asked a limited set of questions to put them into a specific target market. They would then be presented with a course of action that is considered broadly suitable for that target group, such as “people like you tend to withdraw at a rate of 4%,” or, “if you’re investing in an ISA, people like you tend to look for a balanced multi-asset fund.” This ‘targeted support’ has pros and cons for advisers. In theory, it could nibble away at advisers’ businesses by scooping up the more straightforward clients. The proposals envisage those looking for guidance on drawdown withdrawal rate or retirement choices could be serviced using this approach. In reality, most retirement advice clients will have more complex needs, and targeted support will not be able to deliver the holistic planning that advisers can offer. More optimistically, targeted support may create another pathway to full advice. By showing retirees that their needs are perhaps more complex than targeted support can manage, it could, over time, increase the number of people willing to seek and pay for full advice.
Breadth of retirement planningg
While these simplified approaches will never replace full advice, they may mean advisers need to think harder about the retirement proposition they are offering to their clients. Where retirement advice is limited to putting money in a multi-asset fund and taking out 4% each year, clients will quickly find they can get this simple, transactional advice elsewhere at no cost. The value of great retirement advice will continue to come from delivering and managing a holistic retirement plan. In our report, Life Beyond Work: The changing face of retirement, we discussed the need for advisers to ensure they have the skills for the next generation of financial advice, which is likely to be more complex. The average advised client is 59, and the number of clients with the magic combination of defined benefit pension schemes and considerable housing wealth is diminishing. The next generation has more fragmented wealth – across multiple pensions, housing wealth, and even ongoing income from employment or consultancy. Advisers will need to look at whether they have the appropriate platform, investment strategy and technology tools to meet clients’ shifting needs. They will need to build robust, flexible investment propositions for retirement across product selection and portfolios that can meet the complex needs of the next generation of retirees. Building the breadth of skills necessary for a full-service retirement proposition will not be easy and advisers are likely to need robust outsourcing arrangements to bring in expertise where they don’t have it in-house. As the report showed, many of the challenges facing the advice industry have a single solution: a strong and nuanced retirement proposition. This will help ensure differentiation from any simplified solutions put in place to address the advice gap but will also help tackle the greater complexity inherent in the next generation of clients.
1. ONS Principal Population Projections, 2021-based interim projections 2. hansard.parliament.uk, Volume 831: debated on Friday 14 July 2023 3. “The Advice Gap 2024”, The Lang Cat 4. “DP23/5: Advice Guidance Boundary Review – proposals for closing the advice gap”, FCA December 2023
For Professional Clients only. Any views and opinions are those of the author, unless otherwise noted. This is not investment research or a research recommendation for regulatory purposes.
The puzzle of retirement decision-making is inherently behavioural. The solutions must therefore be behavioural too
It is often overlooked, but the role of financial personality in retirement decision making can often be just as important as investing in the right way. Oxford Risk's Head of Behavioural Finance Dr Greg Davies explains.
Having more choices can help you make better decisions. More options mean more chance of one of them being the best one for you. However, having more choices can also lead you to make poorer decisions. Understanding how and why this is should fundamentally change how we go about retirement planning. Retirement decision-making is a case study in how too many choices, added to a lack of ability to navigate them, is a recipe for dissatisfaction. The increased choice in retirement decision-making introduced with ‘pension freedoms’ has been great for some. But the resulting paradox of pension choices has led others to paralysis, or panic, and a host of other unnecessarily bad outcomes in between. The ’right answer’ for the retirement-planning puzzle is, of course, ‘it depends’. It depends not only on financial circumstances and actuarial number-crunching, but on how people will behave with their money in response to different financial recommendations. Even if there were an objective, mathematically ‘optimal’ solution, deliver it to a dozen different retirees and you’d get a dozen different levels of emotional comfort with it. A ‘client outcome’ that ignores this isn’t a client outcome, it’s an exam question that’s lost its way. Real retirement choices are not made in the vacuum of a mathematical model. The puzzle of retirement decision-making is inherently behavioural. The solutions must therefore be behavioural too. The job of retirement recommendations is to move each individual client towards the right answer for them, an answer that leads to a retirement that is both economically and emotionally comfortable. And to do so by increasing their capacity for engaged and informed decision-making. With the right technology, this is now a real possibility for every budding retiree. Even at scale.
Influencing decisions
It has been shown again and again in behavioural research that our decisions are hugely influenced by the way information is presented to us. Importantly, these influences do not work in a universal direction. A message that’s reassuring for one personality signature can easily backfire into becoming patronising for another. Non-behavioural solutions to behavioural ‘problems’, such as reducing risk levels for anxious investors, are usually unnecessarily costly. It is much more effective, and useful, to personalise how we communicate with investors, directly addressing the behavioural roots of a problem. Personalising such communications should be seen as a fundamental part of good advice, rather than a cute add-on for those with resources to burn. Key to this personalisation is an understanding of each individual’s financial personality. At Oxford Risk, we’ve identified nearly 20 dimensions that help enhance investor understanding, and which we can reliably test for in a way that stays valid across countries, cultures, and prevailing market conditions. Assessing investors on these dimensions underpins our Behavioural Engagement Technology, which takes relevant economic and psychological detail about an investor and uses these to weight possible prescriptions, delivering those that are likely to be most useful for a given investor right now.
Investment dimensions
Risk tolerance is, naturally, one of these dimensions. And it tends to be one of the most stable. But that alone does not justify the overreliance placed on it by typical financial-planning approaches in determining the most suitable solution for an investor. It’s also crucial to understand other aspects of a personality signature, including how they interact with each other in that signature as a whole. The best order in which to present information, the frequency and length of reports, what you choose to emphasise (such as the stories behind particular holdings), and dialling up or down the role of the adviser, are all influenced by interdependent combinations of personality factors. For example, investors with higher ‘composure’ (an investor's comfort or anxiety with the ups and downs along the investment journey) and higher ‘confidence’ (how capable and comfortable an investor feels about their ability to make good financial decisions) could be put-off by message content or frequency that otherwise identical investors would find especially comforting. Or consider how portfolio returns are often presented as a dense and detailed table of numbers, with a focus on the performance of individual holdings over the last few months. While some investors no doubt appreciate this detail, and are able to automatically assimilate it into a wiser overall context, presenting information in this way could be daft for many others, especially those who score high on the ‘impulsivity’ and ‘desire for guidance’ scales (and low on ‘composure’, ‘confidence’, and ‘financial comfort’). For these latter types, it would be far better to first draw their eyes to the investing principles that underpin the portfolio, and set stock-specific short-term movements in the context of the long-term, whole-portfolio returns that they should ultimately care far more about. Other key traits include ‘spending reluctance’ (the degree of worry experienced when making purchases or planning future expenditures; closely associated with the ‘fear of running out’, where people worry about depleting their financial resources, pretty much regardless of the size of those resources), and numerous dimensions related to sustainability preferences.
Behavioural engagement technology
One question naturally arises from considering all these psychological moving parts: how on earth do you get on top of them, let alone make use of them all? There is an obvious tension between personalising solutions and applying them at scale. It is, of course, impossible without technology. But with the right technology, this is only the beginning. For a wide range of common contexts, having assessed clients on the dimensions noted above, you can, to a large extent, know how the messages you send are likely to be received by individual clients. Knowing this, you can more easily and reliably equip your clients with the emotional comfort they are seeking. What we want to know is how to account for each investor’s financial personality traits, financial circumstances, and their actions (say how frequently they log-in, or trade) in advising on the right next action to take for a specific person at a specific time. Should we recommend changing the make-up of a portfolio, how decisions are made, the content of a message, the tone, or how that message is sent (e.g. the medium, or the timing)?
And then there’s AI
AI unlocks enormous potential for applying behavioural finance to deliver personalised behavioural interventions at scale. With the right feedback loops, an AI-enhanced system could dynamically adjust a message’s content and tone based on real-time analysis of a client’s financial personality and financial situation, based on what’s been shown to work better or worse for similar investors in similar circumstances.
Retirement confusion….
Because retirees are humans too, understanding one’s retirement options, let alone making the most of the opportunities retirement provides, requires more than merely getting one’s economic ducks in a row. You can manage the material side of retirement perfectly and it still not make much of a material difference to how much comfort and enjoyment you derive from it. A successful retirement means more than merely not running out of money. Yet the behavioural elements of retirement planning are often overlooked. This leads to an uncomfortable confusion around retirement choices, and consequently poorer financial and emotional retirement outcomes.
Dr Greg Davies, Head of Behavioural Finance, Oxford Risk
There is an obvious tension between personalising solutions and applying them at scale. It is, of course, impossible without technology
Greg Davies, head of behavioural finance, Oxford Risks
© A P Wilding
As the complexity of retirement planning increases, the role of technology in enhancing financial advice grows ever more significant. From lifestyle aspirations to evolving financial needs, clients rely on advisers to provide a tailored, comprehensive plan that can adapt over time.
Andrew Storey, Group Innovation Director at EV, discusses how advancements in technology are helping advisers manage the growing web of client variables to deliver better-aligned, flexible retirement solutions.
Variable upon variable
However, the more variables you introduce, the more those outcomes – and the strategies required to produce them – will exponentially proliferate. Working with a client seeking retirement income, you will need to select the level of income required to cover basic needs as well as additional luxuries. You may think about investing a proportion of their funds in guaranteed income and choose between level or RPI annuities. You also need to consider how to invest the remainder of the portfolio – bonds, equities, individual funds, multi-asset strategies. You will want to understand, and be able to explain to the client, how likely the proposed strategy is to succeed in delivering the required income for the required duration. What is the projected age of the first shortfall? How would a lump sum withdrawal now affect that outcome? How much will be left when the client dies? Each choice creates different outcomes and impacts the risk profile of the combined portfolio. And, as we know, financial advice is not a “set and forget” enterprise. These decisions need to be periodically revisited, as client needs, markets and other economic factors may change over time.
A powerful ally
While the very human aspects of the adviser and client conversations cannot be replaced by today’s technology, finding the optimum overall solution when faced with a huge array of variables is almost impossible without it. Evaluating all the data to assess whether the strategy remains aligned with the client’s risk appetite and objectives is all but completely unmanageable unless you have the right software. Happily, technology that can run a huge number of planning scenarios in seconds, along with everything else I’ve described, is already here – and it’s still advancing. For example, our calculations allow an analysis of multiple factors to find or check the best solution for the client whilst reducing the time needed for the adviser. Ultimately, this is the kind of thing a computer should be doing, not an adviser. That means you can concentrate on what you do best: advising. Technology can’t help a client clarify their as yet unformed objectives, nor can it stay abreast of their changing aspirations as they age. But it can help advisers create ever more accurately tailored solutions and take the grind out of delivering better outcomes.
Getting to grips with a client’s financial aspirations
Much of the value of retirement planning stems from conversations which go beyond a client’s current financial position. Lifestyle needs, essentials versus desirables, how priorities may change over time, attitudes to legacy, and so on, all contribute to building a holistic financial picture of the client. Getting to grips with an individual’s true financial aspirations and objectives lies at the core of financial advice, but it’s not an exact science. When so many variables exist, finding the optimum solution that accurately aligns with the client’s objectives – especially with the regulatory requirement to avoid foreseeable harms - can require a lot of leg work in reviewing different outcomes before agreeing on the appropriate plan.
While the very human aspects of the adviser and client conversations cannot be replaced by today’s technology, finding the optimum overall solution when faced with a huge array of variables is almost impossible without it
Andrew Storey, Group Innovation Director at EV
As the use of cashflow modelling becomes mainstream, the FCA has, for the first time, started to make some noise about how it’s currently used and provided some ‘guidance’…
Done properly, cashflow modelling offers clients information they need to understand Investment product and risks. But there are also limitations that advisers must be aware of when advising clients on retirement in particular. Verve Group's Christian Markwick, head of adviser support explains.
I appreciate that there may be audiences in both camps around the use of cashflow modelling within financial advice, those that live and die using it to build financial plans and then those who don’t see the point of it as they believe it’s all wrong anyway. So, to placate both parties, I agree that every cashflow plan ever built is wrong (typically the day after it was created or updated) BUT caveat that statement with the belief that cashflow modelling is an extremely powerful tool for advisers. It truly is a great way to support clients with their financial decision-making, as well as when monitoring how closely aligned a reality is to their objectives being met (or not). As the use of cashflow modelling becomes more and more mainstream across all areas of advice (even more so with retirement income planning), the FCA has, for the first time, started to make some noise about how it’s currently used and provided some ‘guidance’. In this instance, the ‘guidance’ is much of an instruction than the usual guide ropes that are open to interpretation. Cashflow modelling, or creating financial plans, for clients is not a regulated activity however if the FCA continue to see (what they consider) poor practice, it's safe to say that that is likely to change. And that in turn is likely to lead to additional rules and regulations for advisers to comply with. Of course, the best way to approach this is to heed their guidance and adopt the good practices when it comes to cashflow modelling governance.
What have the FCA had to say on this matter?
Cashflow modelling can project a variety of outcomes, depending on the inputs and assumptions used. When used effectively, these outcomes can help clients understand how different economic circumstances could affect a clients retirement income. But if used incorrectly, it can create misunderstanding and unsuitable advice. We know that when done properly, cashflow modelling can give clients the information they need to understand the recommended product and/or service plus the potential drawbacks and risks of the recommended approach. This understanding is crucial to supporting clients with their decision-making and take appropriate action. Foreseeable harm can be caused if firms:
should make assumptions about future rates of return which are not based solely on specific patterns of past returns. may use constant rates of return for different funds or asset types, so long as there is appropriate stress testing. should consider the difference between gross returns for different types of funds or assets, and inflation. should undertake regular reviews of the assumptions used, taking into account wider economic circumstances. should be careful about presuming their ability to predict variable future rates of return (and inflation) to avoid the impression of accuracy. should be able explain to clients the justification for any assumptions and why they are reasonable
Including all charges
Charges have an impact on how long retirement income can be withdrawn from an investment, in the same way that a higher withdrawal rate does.
Cashflow modelling and governance
do not consider how clients will interpret the output. project forward using returns that are unjustified and don’t result in realistic outcomes. do not consider the inputs and outputs objectively.
Each of these has a profound impact on client understanding and could have an impact on the suitability of any recommendation based on the model.
Relying on information without considering accuracy
A firm is entitled to rely on information provided by clients unless they know the information is clearly out of date, inaccurate or incomplete. Advisers and paraplanners must therefore consider if the information clients give them is consistent with their stated goals or expectations for retirement. This information is key to providing suitable advice.
Using justifiable rates of return
The returns used within cashflow modelling are one of the most important parts of the model. As a firm you must use a reasonable and justifiable basis for all assumptions they use in the model. A client’s investment objective may rely on their investments achieving a certain rate of return. So, if your modelling is based on incorrect assumptions, there is a higher risk of poor client outcomes. The result is only as good as what put in. The client is not likely to understand the risk that they will not achieve the returns they need to achieve their objective and so, will not be in an informed position. It’s unlikely that future rates of return will mirror the pattern of past rates. When setting future rates of return for cashflow modelling, the FCA stated that firms:
All foreseeable product and adviser charges
Product charges include platform fees, product/wrapper charges, fund charges, fees for managed portfolio services such as discretionary fund management or centralised investment propositions and any other fees for custody of or access to funds.
Consider the limitations of your chosen cashflow modelling provider. The rise of technology means that there’s several options available…
Planning for uncertainty
Cashflow modelling can be a useful tool to help clients plan for their future. It's based on assumptions, and you as a firm need to ensure your clients appreciate that these are indeed assumptions, not facts. If a client understands that returns are based on assumptions about how the market will perform (and their investment value may go up or down) they are less likely to withdraw more than they can afford from their pension or investments. As a firm, you are required to assess the client’s knowledge and experience of the recommended investment and to check the client’s understanding of risk. If the firm does not explain cashflow modelling clearly, its recommendation may not align with the client’s risk tolerance and capacity for loss which in turn could mean clients could be misled about the sustainability of their pension.
Planning beyond life expectancy
Half of clients will live longer than average. Therefore, provide projections that go beyond average life expectancy. The Office for National Statistics have a great tool, the life expectancy calculator , which shows the aging probabilities of males and females. The calculator considers of how this might change for people born in different years. For example, a current 65-year-old male has an average life expectancy of 85. However, they have a 1 in 4 chance of surviving to 92yrs and a 3.1% chance of reaching 100. The figures are higher for a female of the same age.
Stress testing
There is a risk that clients perceive a detailed projection of their financial affairs as a certainty. Showing plausible alternative scenarios provides evidence that the proposed risk(s) is in line with the client’s risk tolerance and capacity for loss. It also gives clients an indication of the risks of the recommended proposal and what different outcomes might mean for their income throughout their retirement.
Client understanding
As part of your advice process, you several communication points to your clients that refer to future outcomes. Using multiple growth rates across different communications is likely to confuse clients and lead to misunderstanding if not explained. Be consistent with your approach, language and calculations/assumptions.
Considering the output
Review the cashflow modelling outputs to draw conclusions about the client’s potential financial position before and during retirement. These outputs are key factors to consider in your assessment of suitability. The risks of failing to review the outputs are:
5.
the cashflow model given to the client may be factually incorrect or misleading it may recommend a solution that is not suitable for the client’s needs or objectives there is a higher risk that the financial plan will not work out as intended it raises the risk of misunderstanding and poor client outcomes
So, in summary...
Review the practices above to see how your firm is currently documenting all the above. Since the FCA’s thematic review into Retirement Income Planning (and the release of our own whitepaper), we’ve been working with firms to document the above points into a framework document that demonstrates their approach to each of the key points to ensure there’s a blueprint for everyone to work from. In addition to ensuring a consistent approach across a firm, it’s also useful to have these processes documented should the FCA ask to see your CRP and or monitoring programmes (linked to both pre and post retirement advice). If you are using a sustainable withdrawal rate – what is your approach and rationale behind the rate used? Again, these are all points that need documenting. Consider the limitations of your chosen cashflow modelling provider. The rise of technology means that there’s several options available but like anything, do your own research and explore the different options - each firm will have their own preferences.
[Clients should] move away from thinking about what we might be able to achieve…. To how willing and able they are to accept a worse outcome than what they were aiming for
Investing always involves a trade-off between risk and reward but the focus in retirement is very much on balancing the two. We need to take enough risk to generate the return that the client needs to meet their goals but not so much risk that we put those goals in danger. If my client needs 6% per annum to achieve their goals, then I need to aim to deliver 6% per annum with as much certainty and consistency as I can. There’s no point me aiming to generate 8% if that introduces a real risk that I only generate 4% and my client falls short of their goals. A key focus in retirement will be on downside risk. This may be the risk of a fall in capital value reducing the sustainability of future income or, if using an income-oriented approach, the risk that income falls. Managing this risk within the client’s capacity for loss is essential and the FCA’s recent review of retirement income advice suggested more needs to be done here. We can’t just think of downside risk in terms of its impact on the nominal level of income either. Inflation will reduce the purchasing power of a nominal income, and we need to consider how we mitigate this. We need to consider capacity for loss in terms of the client’s ability to withstand falls in their income in real terms. These requirements to balance risk and return, limit downside risk and protect against inflation lead us to three investment ideas that are important for clients taking retirement income. We consider they are relevant whether advisers are building their own portfolios, selecting multi-asset funds our outsourcing to a third party.
When we’re saving for retirement, it’s very common for us to aim to maximise investment returns. This is usually done with some constraint on the level of risk determined either by ourselves, or in the case of Defined Contribution (DC) default options, by those who govern the scheme. This is entirely consistent with the aim of trying to maximise our retirement wealth so that we may retire when we hope, or preferably sooner, with a standard of living somewhere close to that to which we will have become accustomed. But as we start thinking more carefully about when we want to retire and how much income we might need, we may start to think differently about what we need from our investments. We can move away from thinking about what we might be able to achieve to what we need to meet our goals. We can think about risk not in abstract terms of what level of volatility we’re comfortable with but how willing and able we are to accept a worse outcome than we are aiming for.
Risk/return trade-off
First is the importance of active management. It’s true that when markets are rising strongly it can be difficult for active managers to outperform. However, good active managers can demonstrate that they can mitigate losses in falling markets. If our focus is on balancing risk and return and limiting downside risk, rather than maximising return, then active management of both asset allocation and stock selection can have a role to play Second is the benefit of equity income strategies. As well as generating income, which may be helpful for those using an income-oriented approach, equity income has several characteristics that make it particularly interesting for retirement income investors. It tended to have lower volatility and drawdown (ie peak to trough loss) than more growth-oriented equity approaches. This can help where income is being delivered by selling investments. Perhaps as important though is that there are indications that equity income, particularly strategies that are biased towards value and quality factors, recovers more quickly after a market fall than growth strategies. This is important because the quicker the recovery, the less time we are having to fund income by selling assets at depressed prices. On top of this, equity income should provide a hedge against inflation as it will often invest in mature companies that are able to pass on increases in their own costs so maintaining profit margins and generating dividends that keep up with underlying inflation.
Active outperformance
Advisers need to consider capacity for loss in terms of the client’s ability to withstand falls in their income in real terms
Finally, fixed income is likely to be a significant component in most retirement income portfolios. With yields now looking more attractive than they have done in recent years, this asset class has much to offer. Fixed income can be used to generate income, drive growth, provide diversification and mitigate capital loss. Understanding what our clients need from their fixed income holdings will help us choose the best approach. Many “low risk” portfolios saw significant losses in 2022 because they were following fixed income strategies that were more positioned for growth. Of course, 2022 was hopefully a unique year, but it demonstrates the importance of picking the right fixed income tool for the job. With the FCA review of retirement income advice challenging us to think differently about risk in retirement, many advisers will be looking at how they invest their clients’ assets for retirement income. Starting with what makes retirement clients different in the first place will, we believe, quickly unlock how investment approaches need to adapt to recognise that.
Attractive yields
Asset class
Source: BNY Investments. This is a hypothetical example provided for illustrative purposes only.
In recent years, the natural income approach has not been popular with advisers as a result of unpredictable income as well as complexity of the investments
In this example, bonds and alternatives are generating a higher yield than equities. Between them they generate nearly 60% of the income payable but account for only 43% of the assets. Using these asset classes to carry a greater burden of income generation allows us to invest in equities for growth. This in turn gives us the potential to grow the capital value of the portfolio and so generate higher income in the future. But what about the admin? Many funds will pay income less frequently than the monthly payments clients might prefer. Also, income may be paid as it arises leading to “lumpy” payments that are out of line with regular income withdrawals. However, it is possible to structure portfolios to distribute income differently.
The market downturn of 2022 coupled with the Financial Conduct Authority’s review of retirement income advice has prompted many firms to review how they invest for clients taking retirement income. The review stopped short of explicitly saying that firms must use different investment solutions for clients in decumulation from those used for clients accumulating wealth. However, its observation that retirement income clients face different risks from those growing their wealth, and a reminder that investment solutions need to meet the specific needs of the client, point strongly to that conclusion. There are myriad theories about the best strategy for retirement income investors from time segmentation (buckets to you and me) to rising equity glidepaths (don’t ask). But it’s worth remembering that the value of many if not most investments is driven by the income they generate. Building a portfolio of income generating investments seems like an obvious way to deliver for retirement clients yet, in recent years, this natural income approach has not been popular with advisers. Reasons for this range from it generating unpredictable income, through constraining investment choice, to being complex to administer. These are valid concerns but with yields looking more attractive across the market, we believe the benefits of natural income are worth considering The obvious and perhaps most important benefit is that income is generated without having to sell investments so preserving the capital base. This in turn supports the sustainability of future income and avoids having to deal with sequence of returns risk. Moreover, taking the natural income from the portfolio will be an intuitive approach for clients and may offer peace of mind around income durability. Not all income strategies will deliver these benefits, but a thoughtful approach to natural income - let’s call it ‘managed income’, could.
Strategy focus
It might be tempting to think we can just turn on the income share classes of our favourite multi-asset portfolios to generate retirement income. Of course, this is possible but unless a strategy is explicitly managed for income then it is unlikely to generate what the client needs. The first consideration is whether the starting yield is enough to meet the client’s initial income requirement with, perhaps, an allowance for any advice or platform fees that may be payable. With many diversified income funds now offering yields around 5%, this seems more feasible than it has for much of the period since the financial crisis. But once an investor has bought into the fund, the yield becomes largely irrelevant. What the client should focus on is the nominal value of income generated. We want this to at least be stable in cash terms but ideally it should grow over time to mitigate the impacts of inflation. A successful approach to income investing will not only help ensure that this year’s income is more than last year’s but that the portfolio can support a higher income in cash terms next year and beyond. This is no mean feat when markets are constantly moving. Actively managing the asset allocation of the portfolio will be key in aiming to deliver stable and growing income. While an objective to generate income will place some constraints on the portfolio, we can use some asset classes to generate income while others provide capital growth.
New structures
UK fund rules require that all income earned during the fund’s accounting year is paid out in that year but there is some latitude on the timing of payments. This means we can structure income into twelve equal monthly payments with a final balancing payment made at the end of the fund year as shown in the chart below.
Delivering predictable income
Because we now know what we’ll receive each month and when we’ll receive it, the administration of income becomes much simpler. We can simply set the level of income withdrawn from the wrapper equal to the amount being paid by the fund. Alternatively, income can be paid to the client’s cash account and withdrawn from there. Finally, if we don’t want to deal with income units at all, we can buy the accumulation shares of the fund and just take the income that would be paid on the equivalent value of income shares by selling part of our holding. Provided the value and timing of the sales is broadly in line with the income paid on the income shares then we should get a similar overall result. Far from adding to complexity, using managed income to meet a client’s need for income can reduce work and risk for the adviser. Strategies that focus on delivering stable and growing income with a level of predictability can support income durability through changing market conditions while keeping operational overheads manageable.
Equities
BONDS
Alternatives
CASH
3.7%
55%
2.0%
40%
6.1%
27%
1.6%
32%
8.5%
16%
1.4%
26%
5.0%
0.1%
5.1%
Income yield
Allocation
Contribution
% of total income
1,500
Income paid (£)
1,000
500
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
£350
£800
Regular monthly income
Balancing payment at end of year
