This is one of a series of 8 chapters which we hope will stimulate thought around the difficult issues that people may face while investing in retirement. Spire Platform Solutions does not provide advice and does not advocate any particular investment solutions.
In the previous chapters of this look at Sustainable Income investing we have focussed very much on longevity. We would, however, be remiss if we didn’t also look at the risks and dangers posed by ‘Pound Cost Ravaging’.
Pound cost ravaging is a combination of volatility drag and sequencing risk which, when incorporated with regular income withdrawals, can deplete a pension surprisingly quickly. In order to understand this a little better let’s look at each of these factors individually.
Firstly, Volatility Drag: This refers to the difference between arithmetic and compound investment returns. Sounds complicated! Actually, it’s very straightforward, as shown by this example below:
Your client has £100,000 in their pension which grows by an amazing 100% in the first year to £200,000.
In the second year, however it drops by 50% (£200,000 x 50% = £100,000). This means at the end of year 2 the client is back where they started, having £100,000 left.
So, the compound mean return is zero, however the arithmetic mean return is 25% (100% - 50% / 2 years).
What does this mean in reality? It might look like volatility drag is just playing around with numbers. But what it actually shows is that negative investment performance has a greater impact than positive investment performance. And this is where the eye can deceive, as a fund factsheet may show five individual year’s investment performance in a line, which for a volatile fund may be a mix of some positive years and some negative years. An unwary client may easily add up these numbers in their head and conclude that overall a fund is moving forward strongly, when its actual performance is either weak or even negative.
Now we come to ‘Sequencing Risk’: This shows how the timing of investment returns can significantly damage the overall return when your client is making regular withdrawals. It can therefore reduce the ability to generate a long term sustainable income.
We’ll use another example to show what we mean below:
Your client has £100,000 in their pension and over the next four years the investment returns exhibit three years of growth and one year of losses:
Ignoring charges for simplicity, if the client takes an annual income of £4,000 at the end of each year, then by year 4 the pension pot will have grown to £100,998.
Now let’s shake the order of the numbers around a bit.
All we’ve done is change the order of the numbers used in Sequence 1. By just changing the sequence of the investment returns, while keeping the withdrawals the same, your client’s pension pot would be worth only £98,874 at the end of the four years. It’s gone backwards, and in total is £2,124 (or six months’ worth of income) less than in Sequence 1! Imagine the impact of this over a lifetime in retirement.
So, what is the takeout from Sequencing Risk?
Firstly, be careful of being over reliant on retirement planning tools that assume the same return each year. That’s not how investment portfolios work in reality. It’s better to use a stochastic model that can measure the impact of a whole range of likely investment sequences.
Secondly, the management of downside volatility is the key to mitigating this risk. This is much more important for clients that have retired than for younger clients who are still paying pension contributions, who may regard pound cost averaging as their friend. The action point here is to note that a fund that is suitable for clients in accumulation may be quite unsuitable for clients in decumulation if it is prone to high downside volatility.
So, there you have it. Pound Cost Ravaging is one of the key areas to focus on when helping a client investing in retirement.
By Adrian Boulding - Chief Innovation Officer at Spire Platform Solutions.