Stop conflating volatility and risk in retirement financial advice

The FCA has said many firms are not taking account of risk factors beyond volatility – often neglecting income risk. We unpack how retirement advice can be more holistic. 

You’re planning your retirement. What if you had the option to take out an entirely non-volatile financial product – one projected to deliver returns in excess of 10% each year? 

Thirty years later, you examine the fund. You find a shortfall amounting to hundreds of thousands of pounds.

This was a real experience for many people – not among those planning for retirement, but for those purchasing a house in the eighties and nineties, who relied on a With-Profits Endowment scheme.

It was a non-volatile financial product. But it turns out, a non-volatile product can still hurt you. Perhaps even derail your future.

It’s a handy warning for the retirement advice industry. Historically, advisers have asked customers about risk but many only translate the answers to fund volatility – not other much more pressing factors.

Volatility is irrelevant. Loss of income is the real risk in retirement planning

In the TR24/1 retirement income advice thematic review, the FCA examined the records of 24 firms and found that in all cases, something was amiss. They couldn’t find any firms that changed their methodology when assessing a customer’s attitude to risk when they shifted from accumulation to decumulation (see section 2.23 of the review for reference).

It’s a serious matter. For as the FCA points out, it’s likely that a customer’s attitude to risk will change when a consumer moves from accumulation to decumulation. 

This is a matter backed up by our own Income Risk Questionnaire. After 7 years in the market, our data shows people are much more risk averse when it comes to risking their income than their capital.

Bruce Moss, Founder and Strategy Director of EV says, “In retirement, it’s about delivering an income, and hopefully a sustainable income that will enable people to maintain their lifestyles.”

And it’s not just a customer’s attitudes that change in decumulation, it’s the cold hard facts of their capacity for loss. 

The trouble is, people aren’t always sure what capacity for loss means. 

Gareth Davis, Pension Specialist at Scottish Widows, told us that when he met with paraplanners, he heard that capacity for loss is the most misunderstood term paraplanners come across on a day to day basis. 

The FCA defines capacity for loss as a customer’s ability to absorb a loss. But this isn’t as easy to calculate as it sounds.

Not running out of money is a product of several factors, says Patrick Ingram, Head of Strategic Partnerships at Parmelion. It’s not only volatility. There's also:

• Returns
• Level and sequence of returns
• Inflation
• Longevity
• The level and sequence of your drawings. 

“And all these factors change over time,” says Patrick. “As you get older, all sorts of unpredictable things happen to you, your loved ones, your family, your children, and you've got to be nimble. “

This, he says, is where financial advice can really add value.

Retirement customers need a more holistic industry

No customers are saving for retirement without other goals in mind. Some are also saving for a house in a safe neighbourhood near the right school. Others are looking to pass on wealth to their children. Many want to go on at least a few good holidays – but they also want to afford later-life care.

Getting to know a customer’s goals in addition to their liabilities acknowledges the emotional aspect of planning for the future. In June 2023, Sonya Lutter wrote in Barron’s that “more financial planners are acting like psychologists,” and it’s because they need to. But they also need to make sure the numbers line up.

Patrick Ingram says that placing various goals into different “buckets” can help here. It helps make sense of a person’s liabilities beyond income.

Mitigating the liability risk

“Property maintenance, your statement holidays, your children's lives, they all come into play,” says Patrick. “Bucketing these contingencies helps to identify where capacity for loss is being held and how it’s being invested — and you might allocate them to solutions with less volatility than you would for core income.”

The risk-mitigation here has little to do with volatility, it’s mostly about getting what you need and not running out of money.

“Advising based on capacity for loss is generally not happening on the whole,” says Patrick. “Only half are assessing risk on an income basis.”

Patrick says a four part model is a great basis on which to offer advice to clients:

• Liquidity
• Contingency
• Core wealth
• Legacy

“Though you also need a robust annual review process so you stay aligned with what’s actually happening in people’s lives,” Patrick adds.

How cashflow modelling can help 

Planning for the above is almost impossible without cashflow modelling. The FCA came as close as they’ve ever come to saying cashflow modelling is the future – and this is why Daniel Marsh, VP of Corporate Development at Octopus Money, told us he wouldn’t consider another approach: “If I was putting together a new advice process: every client would get a cashflow model underpinning it.”

EV can support digital, hybrid or traditional advice in this way – taking both accumulation and decumulation into account. 

Our technology makes personalised, holistic advice accessible: Instead of focusing on just one specific area in isolation – such as investments, pensions, tax or protection – our calculation engine helps identify the actions customers can take to get the future they want.

For more insights from EV, see the state of UK financial advice in our report, the unadvised nation.