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.
When thinking about income in retirement, it can be helpful to segment income needs into three categories. View them as a pyramid, with the bottom slice called “Essential Income”, and that’s for the monthly bills that have to be paid, come what may. The middle slice, called “Lifestyle Income”, is for the things that you’d like to spend money on in retirement, but could cut back on if investment markets are not kind to you. The top of the pyramid, called “Legacy Assets”, is there because we’d all like to leave something from our pension pot to our nearest and dearest, when the time comes for us to pass beyond the veil.
You’ll need different investment strategies for each slice of the pyramid. The Essential Income needs to be secure, and State Pension, a Final Salary Pension or an Annuity can fit the bill here. The other two slices, Lifestyle Income and Legacy Assets, can be met from an income drawdown plan. But you will need different fund choices for each slice.
The Lifestyle Income needs funds that will produce a stable monthly income, as whilst these are things you could cut back on, nobody likes doing so. Many investment funds are conveniently labelled “income” and diligent reading of the fund’s Key Features documents will reveal the strategy that the manager is following to deliver a stable income, such as investing in mature companies and markets with a proven steady dividend flow.
Meanwhile the Legacy Assets slice can be met from funds that are going to give you long term capital appreciation, preserving the real value of the eventual inheritance.
There is no hard and fast rule as to how much of the pyramid of retirement needs should be in each slice. It depends very much on individual circumstances; at the margins, what one person may regard as almost an extravagance can be someone else’s absolute essential. So, the forward planning and calculation will be very personalised here, but attention to detail will ensure that your pension is able to support a fulfilling retirement.
The pyramid of retirement needs is a helpful way of constructing a retirement income portfolio, but there are also some useful measures for looking at the asset blend as a whole.
The European Union’s KIID Risk Ratings are available for all funds, and grade them on a scale of 1 to 7, with 1 being low risk and 7 being high risk. A fund management tool can be used to calculate the risk rating of the blend of funds that make up your whole retirement portfolio. Make sure that the overall risk is appropriate to a pensioner’s holistic circumstances.
Although the EU didn’t give an annuity a KIID rating, I would give it a zero score as the income the annuity promises is twice fully guaranteed, firstly by the insurer underwriting the annuity and then again by the Financial Services Compensation Scheme.
Unless you have an exceedingly large pension pot, you will want not only to draw the natural income from it but also to steadily deplete at least some of the capital. Otherwise you will be living an un-necessarily modest retirement lifestyle! This tells us that pensioners must pay attention to overall returns – income plus capital appreciation – as well as simply to the level of income their funds are generating.
Fortunately there is another useful tool here for gauging an investment portfolio. It’s called the “Sortino Ratio”, named after the American academic Dr Ralph Sortino. What this does is to measure the downside volatility of an investment fund, which as we’ve seen from earlier chapters, can pose a nasty risk to income sustainability when pension withdrawals are made following falls in asset values. The higher the Sortino Ratio is, the lower the prevalence to downside volatility.
Skilful blending of investment assets, using the overall Risk Ratings and Sortino Ratio as a final check, can maximise the likelihood of a pensioner meeting their targets for all three components – Essential Income, Lifestyle Income and Legacy Assets.
By Adrian Boulding - Chief Innovation Officer at Spire Platform Solutions.