In his final diary entry of the series, Tim Jablonski, EValue Product Director looks at the ‘natural income’ withdrawal strategy, and considers whether holding a ‘cash reserve’ could benefit your clients.
As in previous weeks, Tim outlines the key benefits and drawbacks of each, so you can help your clients to make better financial decisions when planning for their retirement.
Watch Tim’s latest video diary entry now:
Natural Income Strategy
The method of withdrawing a ‘Natural Income’ involves your clients taking the distributions their pension investments provide, while leaving the capital value of the fund invested.
Income can take many forms depending on the underlying investment. For example, dividends from shares, interest from bonds and cash deposits, or even rent from any property holdings.
Say for instance, the MSCI World Index (global equity benchmark) was yielding 3.0% at any given time. This would mean from a £1,000,000 investment, it would generate £30,000 in natural income.
Taking this approach into consideration
The main advantage of this approach is that retirees’ funds will not run out since no capital is drawn down. The twin risks of sequencing risk and ‘pound cost ravaging’, do not arise as the income taken each year is simply the income generated by the investments.
For retirees, not running out of money is clearly good news, as no one can’t predict the length of time they will live in retirement. This is known more widely as ‘longevity risk’. Also because capital is not touched on death there will be money available for dependents and other beneficiaries, so living off the natural income may be appropriate if pension assets are part of an inheritance planning exercise. However it is still important for retirees to realise that their income will be substantially lower because they are not drawing down capital and worse still, that their income will fluctuate with changes in the yield on their investments. There is no direct correlation of income to inflation and income can fall significantly. Indeed, at the present time, we’ve all seen the recent headlines about dividend cuts. If a retiree is relying on natural income to meet essential expenses, there could be serious trouble.
Scores on the doors
Simplicity - The retiree chooses an income fund; it pays out the income. Easy. 9 out of 10
Flexibility - Not flexible. The retiree receives the income from the fund, which might be less than is needed. Choosing the income wanted is not possible without potentially eroding capital. 0 out of 10
Durability - There is no risk of running out of money, so high durability on that measure. However, the income level is volatile - we’ve all seen the recent headlines on dividend cuts - so anyone relying on this income could be in serious trouble and find they have to change strategy and draw on their capital. 5 out of 10
How easy is it to manage - The process is very easy to manage. The income paid out by the fund goes straight into your nominated bank account. Some help might be needed in selecting the fund at the outset to try to select the right fund for the client’s risk profile - although this is currently a poorly-understood area for which the intended help might not be helpful. 7 out of 10.
Cost - By definition, because the capital is not drawn down, income is lower, so there’s a cost to the retiree. That said, the ongoing management of the strategy is low - in part because of its ease - and you can invest in relatively low cost income funds. 6 out of 10.
Investment performance - The investment performance relies on the performance of the fund’s underlying assets - obviously. Some funds are designed specifically to generate an income, which sounds good, but the income is not guaranteed: companies in times of crisis will cut their dividends, and if a retiree is relying on this income, this could be a real problem. For a more stable income, an increase in the allocation to bonds would be necessary but this might be expected to reduce the expected return. 5 out of 10.
Cash Reserve Strategy
This is where a portion of the retirement fund is set aside in cash. It might be any amount between one year’s spending and five years’ spending. Retirees then draw income from the cash account, then top up the cash account from the investment fund when it makes sense to do so.
It is a long-held financial planning belief that a portfolio should have a cash reserve strategy to mitigate the risk of having to sell investments at depressed price levels. This reduces the risk of ‘pound cost ravaging’ by not being forced to sell investments when markets have fallen. The strategy also aims to mitigate excessive taxes and transaction costs.
In addition, cash reserves might provide behavioural benefits to retirees as the existence of a cash reserve may increase a client’s willingness to tolerate volatility in the portfolio and stick with a long term investment strategy during periods of high market volatility.
However, the cash reserve strategy comes with some management difficulties. How much cash should be held? When should the cash be topped up, and by how much? These are active management decisions, which are not easy to answer.
Also, holding a portion of a retirement portfolio in cash is likely to damage the long term return. This is sometimes referred to as a ‘cash drag’.
Taking this approach into consideration
- Probably looks relatively good now - falls only on investment, not cash.
- Over the long-term such an approach is similar simply to de-risking using cash/money markets as part of a portfolio - so lower risk but lower expected returns
- It requires active management of the cash reserve - relies on timing the market.
Scores on the doors
Simplicity - Although this approach sounds simple at first, it quickly becomes more complicated when the practical aspects are considered - in that it requires active management as part of the process. When should you top up the cash and when shouldn’t you? 2 out of 10
Flexibility - There is some flexibility in this. Retirees can withdraw whatever amount that is needed, subject to enough money being available and cash being available. Beyond the reserve investments will need to be sold. 7 out of 10
Durability - The presence of a cash buffer, on average, reduces returns and hence the income that can be drawn. If so the ability to provide inflationary increases could be impaired depending on the level of income drawn initially. 5 out of 10
How easy is it to manage - Managing this requires difficult decisions to be made. When should money be moved to and from the cash buffer? This is an active management, which is a role that most people are not suited to. 2 out of 10.
Cost - Because of its requirement for active decision-making, a financial adviser might well be required to implement this strategy. Also, there is an overall expected cost in missing out on potential growth that the amount held as a cash buffer might have achieved had it been invested. 5 out of 10.
Investment performance - Other than holding a cash buffer, this strategy is not prescriptive about how to invest, which means that good, low-cost, efficient funds suitable for drawdown can be chosen. Although there is some downside protection in the very worst of scenarios, in most future scenarios you would be better off without the cash buffer, since having one misses out on future growth. 5 out of 10.
Bringing it all together
Natural Income - It’s easy to invest in a fund that pays its income directly into a bank account and, if the retiree is not overly-reliant on the income to cover essential expenses, it might score highly. However, because of the volatility of the income, and that it cannot be relied on to meet essentials, it should be marked down to 5 out of 10.
Cash Reserve - The use of a cash buffer is a popular approach in the immediate aftermath of a market crash, since it might have fared well in such conditions; however, holding the buffer, while offering some downside protection, also means retirees miss out on the growth that could have been achieved with the investment. The most difficult part about the approach, however, is the active management of the cash buffer - when to top it up and by how much - which are really very difficult decisions to make. 6 out of 10
So what next?
Tuesday 9th June saw Tim host a special webinar “A Tale of Two Retirees” with Bruce Moss, EValue Founder, which brought together all that has been shared throughout the series and introduced a new strategy for Tim to assess. A replay of the webinar will be made available shortly, for those who want to revisit or may have missed it.
Also, watch out for more blogs and webinars on drawdown over the coming months, as EValue prepares to launch its new range of drawdown propositions.
In the meantime, read our eBook to see how a stochastic model can benefit both you and your customers, and learn about the risk of using deterministic models.