There are some situations where the outcome is a disastrous foregone conclusion. Expecting someone with zero medical training, equipped with just a textbook, to be able to perform brain surgery successfully is never going to end well. Equally, putting the onus on non-advised consumers to navigate the many and complex considerations of drawdown will have a sadly predictable outcome, in all but exceptional circumstances.
For non-advised consumers using drawdown, setting realistic retirement objectives is extremely hard as it involves making assessments of longevity, investment returns, tax efficiency, home equity release, the relative merits of an annuity and, potentially, when and what type of annuity to buy. Worse still, the stakes are much higher than for consumers in accumulation, who have time and future earnings to get themselves back into a good position if a bad decision is made. Get it wrong and your standard of living in retirement can be severely impaired. Add to this the ongoing management required with drawdown and we have the financial services equivalent of brain surgery and being one slip away from a tragic, life changing event.
These difficulties are not just confined to the non-advised, many advisers find helping their clients with drawdown challenging. It is not helped by the poor and, often, defective tools being used today by advisers and consumers for financial planning in retirement. To stretch the brain surgery analogy a bit further, consumers and advisers are going into theatre with a blunt scalpel!
Managing drawdown effectively and choosing suitable investment strategies requires the ability to model investment risk and return realistically. Modelling risk and return realistically means understanding the sequence in which investment returns might be earned. An unlucky retiree, who gets off to a bad start with drawdown due to a run of negative returns will find his or her retirement prospects irrevocably damaged, whereas an initial good run of returns initially can lead to a happy and successful retirement.
The problem is that many strategies and solutions are currently designed using an assumed fixed rate of investment return throughout retirement - technically referred to as ‘deterministic return’. This is obviously unrealistic and ignores the important effect that the sequence of returns has on drawdown outcomes. The same problem applies with a common type of stochastic model, known as a Mean, Variance, Co-variance (MVC). Essentially, MVC models provide time independent forecasts and therefore ignore the sequencing risk. The diagram illustrates the effect of using time independent forecasts which ignore how investment markets may vary from year to year.
What this chart shows is the effect of drawing down £25,000 a year from a £500,000 pension account. If a level return of 5% a year is achieved (i.e. a deterministic return – the blue dashed line), the income is sustainable and the retirement pot remains at £500,000. If, on the other hand, initially a run of poor returns is achieved (the red line), the retirement account is exhausted after 20 years even though in later years good returns are achieved so that over the whole 20 year period returns average 5% a year. The dotted yellow line shows the opposite effect – namely a good run of returns at outset. All three scenarios assume that a 5% a year return is earned over the 20 year period. Allowing for the sequence of returns when modelling outcomes is crucial and only Economic Scenario Generator (ESG) models do this. ESG models, as their name implies, generate thousands of future economic scenarios, all different, time dependent and equally plausible.
In addition to sequencing risk, a retiree using drawdown is also vulnerable to high levels of market volatility. Volatility can be beneficial to an investor making regular investments during the accumulation of wealth – the effect known as “pound cost averaging”. For drawdown, the effect is exactly the opposite. A retiree drawing a regular income from his or her investments is vulnerable to high market volatility – the higher the volatility the worse the effect. This is often referred to as “pound cost ravaging”.
Consumers (and for that matter, advisers) need access to reliable modelling tools so that they can develop reliable plans. Not allowing for sequencing risk and realistic levels of investment volatility will systematically result in over-estimating the retirement income that can be supported by a drawdown plan. This will potentially lead to hardship for retirees in later years. Miscalculating sustainability is not life threatening, but it absolutely is quality of life threatening – modelling tools for drawdown need to be scalpel sharp.