Income at risk: a new way of discussing drawdown with your clients
In this blog we introduce the concept of "Income at Risk" and how you can use it to ascertain whether your client's drawdown income levels are sustainable, the key to achieving their financial goals in retirement.
In his 1973 book, Coast to Coast, Alfred Wainwright wrote: “There’s no such thing as bad weather, only unsuitable clothing.” Admittedly, the comment is a bit tongue-in-cheek, but as anyone caught in a rainstorm without a waterproof jacket will acknowledge, there’s some sound advice in there too.
You may be wondering about the quote’s relevance to financial planning. Well, it may be somewhat tenuous, but we can draw parallels with the situation many retirees find themselves in when seeking to secure a sustainable income, namely the importance of suitability. Attempting to weather challenging investment conditions in the absence of a suitable income strategy is unlikely to yield a favourable outcome - portfolios must be positioned to account for the specific risks the individual client will face.
As we know, a client’s investment strategy is driven mainly by their objective, which will broadly fit into needing either growth or income. However, the increasing popularity of centralised investment and retirement propositions underscores the growing importance advisers place on crafting an investment process tailored to each client’s objectives, needs and attitude to risk.
Understanding the risks at play
We also know that poor market conditions tend to have a harsher impact on income investors than those investing for capital growth. In the accumulation phase, volatility is often welcomed; making regular investments to a portfolio can help smooth out returns during fluctuating markets - commonly known as pound cost averaging. With money entering the portfolio but not exiting, the potential pitfalls of encashing equity stocks in poor market conditions when prices are low are avoided.
For those in drawdown, however, the situation is reversed. Continuing to draw income from equities during falling markets runs the risk of being exposed to the likes of pound cost ravaging and sequencing of returns, both of which can hamper a portfolio’s ability to recover.
Despite this apparent disparity, as an industry, we tend to place a heavy focus on capital at risk, regardless of whether a client is seeking growth or income. The tools used to assess risks, such as questionnaires and rating systems, are largely geared towards understanding a client’s propensity to cope with volatility.
However, when needing to draw a sustainable income for the duration of retirement, capital at risk is of less importance - what matters is the income at risk (IaR). Therefore, for advisers in the process of selecting funds for such clients, it’s essential to measure a fund’s risk of providing a sustainable income to ensure that any investment strategy is suitable.
So what is IaR, and why is it important?
The concept of IaR is to ascertain whether drawdown income levels are sustainable, as this is generally retirees’ core objective. However, while there is a significant crossover between IaR and income sustainability, it’s important to delineate the two. The critical distinction is that income sustainability is influenced by age and life expectancy, while IaR is not. As a result, the amount that IaR potentially falls remains a virtually constant percentage of the sustainable income for life expectancies between 20 and 30 years.
We use IaR for our decumulation risk ratings to tap into the advantage mentioned above of being an independent age measure of a fund’s risk of providing an income. The approach assumes that a sustainable income is drawn from the fund at an unchanged level for three years and then measures the potential fall in income if the sustainable income is recalculated. At this point, the fund’s performance is assessed to determine whether income should continue at its current level.
What does this mean to my advice process and clients?
For advisers, a shared key concern is implementing IaR into their advice proposition, understandably wishing to avoid overhauling existing processes to accommodate it. Our risk-rating system has been designed to complement current advice propositions rather than supplant them with this firmly in mind. There is much more to client risk-profiling than purely using risk-assessment tools; the in-depth discussion between adviser and client is equally valuable.
The findings from any IaR assessment can prove vital to both the initial and ongoing discussions around income sustainability to ensure the client understands how any retirement strategy is geared to ensure that their income needs are met throughout retirement.
History tells us there’s no such thing as normal when it comes to stock market behaviour. Rather than a smooth upward trajectory, movements are notoriously hard to predict. IaR enables the adviser to implement a suitable income drawdown strategy for their clients to navigate all manner of market conditions, including the storms when they inevitably arrive.
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