DFM roundtable: Tackling the challenges of retirement income
In a recent DISCUS roundtable, four DFMs came together to talk about the challenges faced in the retirement income market. Here, Abbie Knight of DISCUS provides an extract from the discussion.
The roundtable was chaired by Gillian Hepburn of DISCUS. A link to the full roundtable can be found at the foot of the page.
CHALLENGES OF MANAGING INCOME
Gillian Hepburn: What do you think are the challenges of managing income and how can these be mitigated?
Lawrence Cook (Thesis Assert Management): I think that there is a temptation to chase yield, which for a time may deliver what is required but will be difficult to sustain over time and inevitably new or increased risk is imported to the portfolio.
Stewart Sanderson (Seven Investment Management): Currently the main challenge is the low interest rate environment. As such we believe that there are significant advantages in adopting a total return approach to managing income. Firstly because a portfolio can be invested without an income constraint, given an income bias will likely reduce the efficiency of the portfolio’s returns and potentially increase risk (e.g. by steering investment towards high yield/ emerging market bonds and high yielding equities). Instead, a portfolio can be invested to seek the best returns possible for the agreed mandate through a combination of income and longer-term capital growth.
Secondly, the client can receive a regular fixed amount of withdrawals that are generated tax efficiently rather than receiving the natural income that may not be generated consistently on a month-to-month basis.
David Coombs (Rathbone Unit Trust Management): One of the challenges is the assumption that a pre-determined level of regular withdrawal can be made indefinitely – perhaps based on past annualised returns. This fails to take account of the randomness of returns and the fact that taking regular withdrawals in times of market stress can gradually increase the yield requirement on the portfolio which, if left unchecked, can destroy portfolio longevity.
Hepburn: So how might that challenge be overcome?
Coombs: Essentially there are three options open to clients: ‘income only’ – set a static regular drawdown sum based on the natural income yield of the portfolio which is sufficiently modest as to have a minimal effect on portfolio longevity. The problems with this is that the level of drawdown is often too ‘modest’. It can also introduce a bias against stocks or asset classes that pay little or no income.
Secondly, there is the total return approach as described by Stewart, where the benefits are that it matters less that income yields are low, as regular withdrawals are funded out of both capital and income. Portfolio risk can be better managed through wider investment choices and it can support higher withdrawals (than just income). However it does not solve the problem of ‘pound cost ravaging’ on a portfolio’s longevity.
Lastly the ‘flexible approach’. This is perhaps less palatable to clients used to a monthly pay-packet as it involves harvesting more of a portfolio’s gains in the good years to sustain income requirements in the less benign years, placing less drawdown strain on the portfolio during times of market distress and ultimately giving it the chance of greater longevity. This is where investment managers can work in partnership with the adviser and clients to agree the best strategy.
WORKING WITH FINANCIAL ADVISERS
Hepburn: Working closely with the financial adviser is extremely important. How do you approach this?
Cook: It varies. Some advisers will know exactly how they want to achieve their client’s income requirements in which case we will receive a very clear mandate without discussion. However, at times a discussion is useful and the adviser can ask an investment manager to prepare an Investment Proposal that encompasses the client specific requirement. This provides a basis for ongoing discussion between the adviser and investment manager before finalising a recommendation to client.
Marcus Brooks (Cornelian Asset Management): It’s all about communication and being guided by the adviser and client as to the level of income required. We would always discuss these requirements and match portfolios to meet them, pointing out any implications taking income from the portfolio will have from an investment standpoint.
For example, take a customer with £1 million looking to take £80,000 per year. Whilst we can manage this, the implication is that you are likely to be depleting the assets in real terms but if markets are at high levels, we can then apply a little more active management and lock some money into cash for future drawdown – but it’s important that we maintain a regular dialogue.
Hepburn: How do you work with advisers on an ongoing basis?
Coombs: At Rathbones, we do not employ relationship managers so the relationship between the Rathbones investment manager, client and adviser is direct and it is important that we agree the distinct roles and responsibilities. So for example, Rathbones are responsible for the day-to-day management of the investments whereas the adviser monitors portfolio performance and ensures the investment strategy remains suitable and relevant for the client.
The adviser will also let us know if the client’s cash flow needs to change so that we can adjust the strategy and work closely with the client on broader financial planning issues, such as inheritance planning and tax or regulatory changes, which might require a change in strategy.
Sanderson: If an income is needed our role is to blend the appropriate investment strategies and take the income in the most tax-efficient way, utilising Capital Gains Tax allowances, 25% Pension Commencement Lump Sums and Dividend Allowances, as well as taking the client’s own income tax circumstances into account. We will then take charge of managing the ‘income pot’ and make sure that it is regularly topped up and payments made on the agreed timeline. We then review the strategy and the income requirements on an ongoing basis and make any changes needed.
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Go to pdf for the full roundtable.