The Investment Challenges of a Decumulation World February 217 This document is for investment professionals only and should not be distributed to or relied upon by retail clients.
The Investment Challenges of a Decumulation World The 214 UK pension reforms presented UK pension savers with significantly greater freedom than previously. The reforms have major implications for DC scheme investment strategies in particular for the lifestyle strategies adopted, and for individuals investment choices regarding the post retirement period. In this paper, we examine some of these challenges. To do this, we model different investment strategies using historical financial and economic data, to determine the impact on member outcomes and the certainty of achieving these. Lifestyle strategies and decumulation Much of the analysis in this paper is focused on the post-retirement or decumulation period. However, we note that members investment choices for decumulation directly influence the choice of lifestyle investment strategy adopted for the period approaching retirement. Historically, with the end goal being annuitisation and a tax-free lump sum, this choice has been very straightforward. The new flexibility changes that significantly, and opens up new opportunities and challenges for pension schemes and individuals. In the analysis below, we use a range of scenarios to underline how decumulation investing presents a more complex investment challenge than accumulation investing. In particular, we highlight the material influence of volatility on investment outcomes, owing to the effects of pound cost ravaging. We also show how these effects are greatly magnified when the amount withdrawn is a significant portion of the post-retirement pension pot. We make the following assumptions for our example member: retirement age 6 1, pension pot at retirement pension drawdown of 6, per annum, paid monthly with inflation uplifts. Scenario 1: Perfect world Chart 1 assumes smooth long-term returns of 9% per annum (p.a.) and inflation of 3.5% p.a. This is the level of return you might expect from investing in global equities, judging by historical data. We find that in these hypothetical circumstances, the increasing payments can be sustained for around 35 years, with the pot paying out a total of 48, to the investor for the initial 1, investment. This compares to cash which, assuming a return of 1% above inflation, would exhaust the pension pot within 18 years. Thus, investing in risk assets would seem to be, on the face of it, worthwhile. Chart 1: Evolution of pension pot over time owing to investment returns and pension drawdown 14, 5* per month payout using smooth long-term assumption 12, 1, Fund size 8, 6, 4, 2, 6 65 7 75 *increasing in line with inflation Source: Standard Life Investments February 217 Age 8 85 9 95 Investment Insight: DC Solutions 3
Scenario 2: Real world experiences In this scenario, we use the same payment assumptions but this time we use the actual returns of global equities (taking into account inflation, average policymember fees and assuming passive management). We model this over three different 3-year periods: 1951-198, 1961-199 and 1971-2. For the period 1951-198, global equities returned 11.1% p.a. while inflation averaged 6.9%. These conditions were sufficient to sustain a 3-year payout totalling 434,, with assets of 758, remaining (red line). Clearly, the investor was left with ample money to see out the remaining years to provide income, pay for healthcare, leave a bequest and so on. These are indeed the expectations many investors have of their pension pot, and for this particular cohort, a 1% global equity approach proved highly rewarding. By way of comparison, the payout from cash on deposit during this timeframe would have totalled 138, and lasted just 17 years. This reflects the reality that the interest generated from the pension pot was more than offset by the pension withdrawals from the fund. So, to have a good decumulation outcome, it is essential to generate growth. Chart 2: Evolution of pension pot over time due to investment returns and pension drawdown 9, 8, 7, 6, Fund size 5, 4, 3, 2, 1, 1 2 3 4 5 6 7 8 9 1 11 12 13 14 15 16 17 18 19 2 21 22 23 24 25 26 27 28 29 Number of years of payment 1951-198 1961-199 1971-2 smooth return Source: Standard Life Investments February 217 For outcomes during 1961-199 and 1971-2, investment and inflation conditions look markedly less positive. Pension payments for the 1961 cohort last less than 23 years with total payments of 311, for the initial 1, investment. Interestingly, over the payment period, equity returns were at the same level as the 1951-198 cohort of 11.1% p.a., although average inflation was higher at 8.7%. During the period 1971-2, pension payments totalled just 175, with funds exhausted in less than 13 years. Equity returns over the payment period averaged an impressive 12.8% p.a. However, inflation averaged 13% p.a. too this helps explain the rapid exhaustion of funds, through ever higher pension payments. The outcomes from each time period are clearly significantly different. Given that the outcomes cannot be known in advance, it is clear why an investor would prefer a more cautious approach. For instance, the 1951-8 experience would obviously be a good outcome, but if it can only be achieved at the risk of experiencing the 1971- outcome, the average member would understandably seek to avoid this degree of risk. 4 Investment Insight: DC Solutions
Scenario 3: Real world using more recent 3-year market periods Perhaps these stark differences are explained by the 1-year difference in starting points? We therefore also looked at the three more recent 3-year cohorts (1984-213, 1983-212 and 1982-211) to assess whether there was greater consistency of investment outcomes, given the high degree of overlap for these periods. Chart 3: Evolution of pension pot over more recent 3-year cohorts 5, 45, 4, 35, Fund size 3, 25, 2, 15, 1, 5, 1 2 3 4 5 6 7 8 9 1 11 12 13 14 15 16 17 18 19 2 21 22 23 24 25 26 27 28 29 Number of years of payment 1982-211 1983-212 1984-213 smooth return Source: Standard Life Investments February 217 We find that, even though there is only one year s difference between the start periods for this drawdown approach, the outcomes are markedly different. The outcome for the investor beginning in 1982 is decidedly rosy, with payments totalling 382, after 3 years and 221, still remaining in the pension pot. By contrast, the investor in 1984 receives a total of 262, before funds are depleted after 25 years. What is different? Firstly, the 1982 investor benefited from very strong equity returns in the first two years of drawdown. This mitigated the subsequent financial impact of inflation-related pension payments, compared to the unlucky 1984 cohort. So, here the incidence of volatility and when in the investment cycle it occurred made a material difference to the drawdown outcome. In fact, we can compare outcomes for all the 3- year periods starting from 1951 to 1987. Chart 4 illustrates the total level of returns generated (in s), and the length of time these were sustained. Investment Insight: DC Solutions 5
Chart 4: Total returns and payment duration for 3-year cohorts 1,8, 6% initial payment increasing with inflation 35 1,6, 3 Total payments over payment lifetime 1,4, 1,2, 1,, 8, 6, 4, 2, 25 2 15 1 5 Cohort payment lifetime 1951 1952 1953 1954 1955 1956 1957 1958 1959 196 1961 1962 1963 1964 1965 1966 1967 1968 1969 197 1971 1972 1973 1974 1975 1976 1977 1978 1979 198 1981 1982 1983 1984 1985 1986 1987 Global equity total return Source: Standard Life Investments February 217 First year of 3-year payment Global equity payment length Just over one in three cohorts could support an initial 6% drawdown increasing with inflation for the full 3-year period. Specifically, we noticed that downward market volatility occurring early on in the decumulation phase had a greater impact on wealth than if it occurred later on when the pension pot had reached a much larger size relative to the size of the outgoing payment. There was not a single cohort in which placing cash on deposit generated enough returns to support 3 years of pension payments. For the cohorts in the study, equity investing extended the payment period by an average of 2% and doubled the total returns versus cash. The worst year to have started decumulation in equities was 1973, where the pension pot was exhausted after only 1 years. Indeed, one has to decrease the initial payment level to just 2.8% (or 2,8 p.a. initially) to ensure 3 years of payments are made. The effects of extreme inflation over this period were such that the final-year pension payment would have been eight times the size of the original 2,8 annual payment in 1973. While this may be a worst case scenario in terms of the level of income we can take from a 1% equity investment without running out of money, we can never be completely certain. It may be of interest that at 31/12/216, 1, would secure an inflation-linked annual payment of 2,25 for life for a 6-year old in good health ( 3,69 for a 65-year old both single life annuities). This would provide 1% certainty of payment, whatever happened in investment markets over the retirement period. 6 Investment Insight: DC Solutions
Observations and summary Our analyses suggest that investing for returns during decumulation is generally worthwhile. Positive returns can be significantly beneficial in extending the life of the pension pot; taking investment risk is likely to be rewarded. However, the effects of volatility can be significant, and arguably catastrophic under particular scenarios. Moreover, this effect is amplified as wealth decreases, owing to pound cost ravaging. Managing volatility Managing risk should clearly be a key aim if we are to achieve good member outcomes. Active investment management in the form of multiasset risk-controlled funds as well as absolute return funds clearly have a role to play here, given their risk and return characteristics. Additionally, there are other techniques that can be employed to improve outcomes. We look at two: variable income lower-risk equity. Variable income As our scenario analysis highlighted, most damage is done to a pension pot from which income is being taken during down-markets.to mitigate these impacts, we can design a simple pay mechanism. For example: the investor withdraws a base amount of 333.33 per month ( 4, p.a. and adjusted for inflation as before). in any month where equities rise, the investor receives a 5% bonus payment. Historical data suggests equities would have delivered positive returns in around 66% of all months over a 3-year period. This gives our investor an average bonus of around 33% p.a. If equities were to rise every month, the investor would withdraw 6, annual income, as in our previous scenarios. However, the alternative approach shows that, by withdrawing less when markets are weak, pound cost ravaging can be reduced and capital preserved. This effect is shown in Chart 5. Investment Insight: DC Solutions 7
Chart 5: Evolution of pension pot over time due to investment returns and pension drawdown 2, 18, Total payments over payment lifetime ( ) 16, 14, 12, 1, 8, 6, 4, 2, 1 2 3 4 5 6 7 8 9 1 11 12 13 14 15 16 17 18 19 2 21 22 23 24 25 26 27 28 29 3 1984 Theory 1984 variable Source: Standard Life Investments February 217 Number of years of payment Compared to the 6% initial payment and inflation model, the total payout for this variable approach is increased by 13%, with payments lasting for an additional 5 years. What does this mean for the end investor in terms of dependability of income? For this approach, if we describe the 4% base level payments in terms of a current account and the additional payments in terms of a bonus account, we can break down the payout, as shown in Chart 6. Chart 6: Current and bonus account payout model 16, 14, 12, Payment amount 1, 8, 6, 4, 2, 1984 1986 1988 199 1992 1994 1996 1998 Year Basic Bonus 2 22 24 26 28 21 212 Source: Standard Life Investments February 217 8 Investment Insight: DC Solutions
Given that the investor is aware that the pension pot is invested in risky assets, this outcome should be intuitive, albeit different from what might be expected from a traditional flat or inflation-adjusted pension payment. This approach provides a 2% increase in the average total payments, compared to the 6% flat payment approach, lengthening the time span of payments by 8% on average. We can fine-tune this type of approach to include a withdrawal cap. For example, capping the maximum single payment withdrawal to 15% of the pension pot would make it go considerably further. So, for instance, members wishing to accumulate assets to pass on to family might choose to accept variations in income. Reduced-volatility equity As mentioned earlier, multi-asset absolute return funds are attractive in DC solutions because of their expected risk and return characteristics. However, as we have shown, despite the inherent risks, equity investing can still be beneficial for DC pension savers given their longterm investment objectives, particularly if we implement some simple controls around the payouts. Another method of achieving the same outcome is through active asset management that seeks equity-type returns over the long term while also dampening shorter-term volatility. For instance, by delivering an equity-level return but with say 2/3rds of equity market volatility, we could materially improve the financial outcome and provide greater certainty in a decumulation environment. We show this in Chart 7. As before, we map the outcomes (in terms of total payout/value and the length of payment period) over every 3- year period since 1951. This time, we compare standard global equities with a theoretical reduced volatility approach described above. In the analysis, we assume that the TER of reduced-volatility equity is.4% p.a. higher than passive global equity. As Chart 7 shows, utilising such an approach enhanced total returns, resulting in longer payment periods. For the cohorts included in this study, the average improvement in total return was 25% with a 1% longer payment period than passive equity alone. This extra benefit more than justifies the extra cost of this actively managed solution compared to a passive approach. Chart 7: Benefits of reduced volatility equity investing 1,8, 35 Total payments over payment lifetime 1,6, 1,4, 1,2, 1,, 8, 6, 4, 2, 3 25 2 15 1 5 Cohort payment lifetime (years) 1951 1952 1953 1954 1955 1956 1957 1958 1959 196 1961 1962 1963 1964 1965 1966 1967 1968 1969 197 1971 1972 1973 1974 1975 1976 1977 1978 1979 198 1981 1982 1983 1984 1985 1986 1987 First year of 3 year payment Global Equity Total Payout (R.H. Scale) Global Equity Payment Length Source: Standard Life Investments February 217 Reduced Volatility Equity Total Payout (R.H. Scale) Reduced Volatility Equity Payment Length Investment Insight: DC Solutions 9
Conclusions and further work The new flexibility in UK pension provision is likely to result in a greater flow of assets towards drawdown products, rather than annuity purchase. The post-retirement drawdown investment options are important as they directly influence the default fund investment strategies adopted by pension schemes. As our analysis using real data has shown, the continued generation of returns in the period approaching retirement, and thereafter, can be powerful. However, volatility has a significant impact on member outcomes and the sustainability of the drawdown pension. In adverse market environments, volatility combined with withdrawals can result in cliff-edge-type positions, which are virtually impossible to escape without resorting to additional finance. Therefore, delivering low-volatility growth is a crucial objective for the DC solution. Absolute return funds are well suited to meet this objective. However, as we have demonstrated, traditional equity growth funds can be made to deliver improved outcomes by, for example, imposing variable income controls or by adopting reduced-volatlity equity strategies. Used as part of a pension solution, active management techniques such as these can add substantial value to members opting for decumulation, more than justifying their costs compared to passive approaches. We have carried out further work quantifying the benefits of reduced volatlity in decumulation, which we hope will form the body of a future paper. 1 Investment Insight: DC Solutions
This material is for informational purposes only. This should not be relied upon as a forecast, research or investment advice. It does not constitute an offer, or solicitation of an offer, to sell or buy any securities or an endorsement with respect to any investment vehicle. The opinions expressed are those of Standard Life Investments and are subject to change at any time due to changes in market or economic conditions. Standard Life Investments Limited is registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. Standard Life Investments Limited is authorised and regulated by the Financial Conduct Authority. Calls may be monitored and/or recorded to protect both you and us and help with our training. www.standardlifeinvestments.com 217 Standard Life, images reproduced under licence INVBGEN_14_129_Investment_Insight_DC_Solutions_TCM 317