Author: Rebecca Fenton of Baillie Gifford
“The nastiest, hardest problem in finance.”
That’s how Professor William Sharpe, the Nobel Prize-winning economist, described decumulation. This and future generations will themselves bear the investment risk associated with turning their hard-earned DC pension savings into retirement income.
Why is it so difficult? The blunt answer is that no existing approach perfectly solves all the most pressing financial risks in retirement. The ‘big three’ are longevity, sequencing and inflation risk. So how should you go about balancing those three?
Firstly, on longevity risk, it is essential to grow your capital in order to provide an income that lasts a full retirement. Put simply, today’s capital growth funds tomorrow’s income growth. Countless stocks can provide very high dividend income in the short term, but they often lack the growth opportunities to sustain these dividends over time.
In decumulation, a retiree’s portfolio should focus on companies committed to paying their dividends and growing them in real terms. They need to be growing their underlying revenues and profits, allowing them to both pay higher dividends and reinvest in their business.
Those approaching retirement age today can expect to enjoy a retirement spanning multiple decades. Yet it’s difficult to plan your retirement finances based on an ‘average’ life expectancy. Preserving the real value of a retiree’s income and capital in the early years of retirement will keep their options open in later life.
Sequencing risk occurs when markets fall early in a person’s retirement while they are taking a regular income from their pension. Selling down capital at inopportune moments can permanently impair its value. In extreme examples, two people retiring with the same pension pots just one year apart can experience dramatically different financial outcomes. This is undesirable and it can be mitigated.
The best way to do this is to rely upon a natural income stream of dividends and bond coupon payments, which are resilient to shocks. That way, a retiree is not forced to fund an income shortfall by selling down their capital during weak market conditions.
The third risk – inflation risk – has resurfaced recently. The optimal asset mix to keep pace with inflation changes over time. We saw ‘default derisking’ towards bonds come unstuck when interest rates rose rapidly after the pandemic. Many approaching retirement gravitated towards bonds and were effectively forced buyers of very low-yielding bonds. This left them open to large capital losses when interest rates began to rise. Having asset allocation flexibility is essential to overcoming inflation risk, rather than adopting a simple, textbook approach to derisking.
A major advantage of the higher interest rate environment is that retirees can now achieve positive real income returns from those same lower-risk investments. This means there are more levers for retirees to pull to overcome the damaging effects of inflation.
Those higher interest rates have prompted a surge in annuity sales. While annuities can overcome two of the big three risks (longevity and sequencing), protecting against inflation in the annuity market is expensive. We believe there is a strong case for retirees to stay invested in the early stages of their retirement, but they need to have options crafted around the specific challenges they face in decumulation.
A decade on from the introduction of pension freedoms in the UK, innovation in the income drawdown market has been scarce. There are good reasons why that might be about to change. Partly because of the rapid growth in the number of retirees facing these challenges – more than 2,000 people turn 65 each day in the UK. But also because DC pensions will, over time, form a growing share of a retiree’s asset base.
Maybe Professor Sharpe is right in his assessment of the decumulation problem, or perhaps we just all need to be more open about how we tackle its trade-offs.