Drawdown Master Class
For people who have not built up final salary pension rights, such as self-employed professionals and small businessmen, living off accumulated capital in retirement is a challenge whose complexity is matched only by the importance of the outcomes. Even if advised by financial specialists, they still have to make the high-level decisions that will determine whether the benefits to be derived from their hard-earned capital are maximised. How are they supposed to do that?
When defined in terms of a set of explicit benefits, success can also be measured explicitly, such as by • spending the maximum that is both sustainable and desired • meeting preferences for different spending at different ages and stages • taking the right amount of risk to create as much additional wealth as is valued • making the best decisions about gifting or managing ‘surplus’ wealth • avoiding unnecessary costs.
Success is of course measured by outcomes but also by the way the progress of the journey is experienced. This depends heavily on clarity and confidence about these outcomes, both at the start of the journey and at every stage, whatever happens to markets, inflation, your health.
In this Master Class, I explain why the methodology of liability-driven investment (LDI) used by institutions should be used by private investors to manage money to meet defined outcomes, such as annual spending in real terms, at defined dates (or ages). It deals robustly with the three sources of risk that need to be addressed by all those approaching or enjoying retirement:
In contrast, the typical industry products, portfolio solutions and planning advice do not deal properly with these risks and cannot confer clarity and confidence. Their simplistic premise, based on industry convenience rather than client need, repeats the common errors of unrealistic assumptions and bad product design that people are likely to have encountered in the past when accumulating financial assets.
The principles of drawdown
Funding retirement spending involves assigning to some money the role of meeting spending needs when earnings cease. Money does not need to be held exclusively in a pension account to be assigned this role.
The process of funding retirement spending is divided into two sequential phases: accumulation and drawdown. Using a bath-time analogy, accumulation is about filling it and drawdown is about emptying it. As long as there is some water in the bath, its volume is subject to a capital-market process of expansion and contraction, as a function of any trend rate of return (expansion) and volatility (over short periods, expanding faster than trend or even contracting). The return and risk characteristics of a ‘portfolio’ (which you can think of as describing a particular stock of water) depend on the sort of assets it holds and how they are put together.
Whilst the bath is filling up, the effect of volatility will be cushioned by the new inputs. Whilst drawing down, however, the speed with which the capital stock is exhausted depends critically, for any given rate of draw, on the volatility of the portfolio.
The returns we are interested in are called ‘total return’ and include both change in capital value and any dividend or interest. Cumulative returns are calculated assuming this income is reinvested as received. Investors collectively trade off yields and growth potential against each other on a presumption of a common required total rate of return. It follows that consuming income is in any circumstances (including distributions from trusts) a form of drawdown from capital.
How the entire process is planned and managed depends on the constraints imposed on the goal. If these are not specified correctly, the plan will not be managed efficiently and the benefits derived from the capital are likely to be less than they should be.
The first general constraint is that the target outcomes need to be expressed in real terms, whatever the actual rate and profile of inflation over the life of the plan. Unless outcomes have comparable purchasing power, they are as meaningless as if expressed in Turkish lire.
The second is that the bath must not run out before it has achieved its minimum objectives. This constraint needs to bite hardest if all spending depends on the plan assets alone.
To the extent the assigned money is held in a pension account, the rules governing personal pensions now constrain each of:
the level of inputs
the stock (in the form of a ‘lifetime allowance’)
the rate of draw
the benefit of generation-skipping bequests.
These constraints are general but in my introduction I referred to explicit valued benefits, such as time preferences and competition between goals that constrain drawdown in a way specific to each individual. This calls for a high level of customisation of the management of the journey that standard industry solutions cannot easily provide.
For a plan to have integrity, that things that define it must be quantified and the values must be internally consistent. What defines it are:
the resources applied (availabel or required)
the target outcomes
the time horizons (if drawing down, these are a sequence of dates not a single date)
the amount of risk accepted or sought.
This inconvenient truth about internal consistency, or balance, flows from the same theoretical source as the tenet ‘there is no such thing as a free lunch’. For instance, taking more risk increases the uncertainty of outcome so achieving a given minimum acceptable outcome at the same level of confidence must call for additional resources. The investment industry generally does not like inconvenient truths.
The entire process is subject to several sources of uncertainty that need to be allowed for when planning but also call to be managed thereafter. The management techniques can be one of three:
avoiding a risk
insuring (or hedging it)
embracing it but also trying to control it.
As financial management tasks go, living off capital subject to constraints is one of the toughest, needing to deal jointly with the three different sources of risk. It is mostly performed with hopelessly inadequate technical resources.
“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hitman”, said Ronald Reagan in 1978. Inflation risk is also very well disguised and difficult to model. No Monkey Business addresses this problem by modelling the return and risk of asset classes in real terms, based on all available histories for inflation-adjusted returns from equity markets around the world.
The uncertainty inherent in different asset classes can alter significantly when expressed in terms of either long-term real wealth or short-term nominal volatility. The largest transformation occurs for fixed-income investments or bonds. They are inflation’s most frequent and most damaged victim. It happens because inflation is so well disguised that the markets’ implicit estimates of future inflation, which make up most of the nominal yield of a bond, have historically shown very large cumulative errors. Cash also has uncertainty of real outcome but the impact of errors in estimating inflation are at least dampened by the market effectively making fresh estimates all the time instead of once only, when the bond is bought.
Longevity defines how long the plan needs to last. Uncertainty about longevity for a single life is very high so self-funding of the risk means you have to plan on a long life and draw less. This risk can be eliminated by an annuity, whose payout reflects the mean mortality of all insured lives of the same age.
You have a choice about the form of annuity you buy, affecting the level of income. Options include:
a pension for the surviving spouse
maximising starting nominal yield (leaving inflation risk uncovered)
maximising inflation protection
covering mortality risk while still enjoying payoffs from equity bets.
Once drawdown starts, the option of leaving the casino by covering some or all of the longevity risk needs to be constantly assessed as part of the management of the plan. The impact on the welfare value assigned to a bequest has to be part of this assessment.
Investment risk is, as we have seen, best described as the uncertainty or possible error associated with assumptions about the portfolio’s real total return. Since we are interested mainly in risk as the uncertainty of real outcomes, we need this to be specific to the time horizon.
This level of specification of the investment inputs to the plan is a problem for the retail investment industry, because of the economics of matching, or managing the mismatch, of assets to specific date-stamped liabilities, which is the essence of modern approaches to liability-driven investment for occupational pension schemes. The problem of applying the same portfolio to different needs or liabilities was once thought to have been solved by with-profits policies and that failed solution has not been replaced by a more robust one, except in rare firms like ours.
The industry’s solution to non-customised portfolio management (multi-purpose, multi-horizon) relies on diversification between several asset classes. As we have seen, this gives a role to bonds which is suboptimal in terms of real outcomes. A better approach is to manage outcome risk by diluting equity exposure using a risk free asset. In real terms, the only risk-free asset is a horizon-matched index linked gilt, incorporating an inflation guarantee. Cash can only be considered risk free for very short horizons.
We divide the plan into time slices (each funding say two or three years of draw) and manage the asset allocation for each time-slice portfolio dynamically as market conditions and horizons change. Broadly speaking, early years are matched by cash, middle years by a combination of equities and index linked gilts and later years by equities. Clients see the aggregate portfolio allocations.
The approach is described graphically in the chart below. The plan runs from age 60 (now) to age 90. The assets assigned to the goal are the sum of all the time-slice columns, each of which represents the present value of the resources required to fund the acceptable range of outcomes for real spending in a particular two-year period based on age (normally the age of the younger of a couple). That range, capturing in this example 99% of probable outcomes, is shown as future values, with a mean level, an upper boundary (with just 1% chance of being achieved) and a lower boundary (with 99% chance of being exceeded) equivalent to the worst acceptable outcome. In this example, the minimum spending target starts at £160,000 pa gross equivalent draw, in real terms, tapering at several stages of retirement. Note that if the minimum was scaled down to £16,000, say, everything else adjusts proportionately.
The relationship between the floor and the mean is a measure of both the investment and the inflation risk being taken. But the preference for that amount of risk will have been exhibited by the client directly, from the information we provided about different ranges of real outcomes, anchored on different minimum levels and associated with different levels of resources required. They will have processed that information by thinking about personal consequences (which they know best) and applying their own values (that they may not even explicitly know they hold).
This approach to discovering risk preferences is far superior to the solutions they would be forced to use if not given information about probable outcomes, such as self-diagnosis of risk ‘scores’, hypothetical questionnaires or psychometric testing. These are all means the industry wants to use to connect individuals, regardless of the diversity of their horizons and constraints, to a relatively small number of standardised, collective portfolio solutions. In fact, those risk assessment approaches make no such connection, because they can mean everything or nothing and certainly not the same thing to all parties to the conversation.
The resources assigned to each time slice are shown in the chart divided between the different assets held. Blue denotes risk-free assets, which are cash for the first two and thereafter index-linked gilts. Red denotes equity, diversified geographically across markets representing over 90% of the world’s total market capitalisation. These are markets that can be invested in cheaply using index-tracking funds.
The plan as a journey
As time passes, the early time slices drop out, as the money is spent, and the later slices become shorter, and so their asset allocation will move from risky equities to risk free. The speed of that change is responsive to market conditions as well as to the time remaining.
If the plan is funded to achieve its lowest tolerable outcomes, instead of an outcome with only a 50% chance of being reached, projected surpluses are likely to build up. As the journey progress is reviewed, these can be used as a basis for assigning some money to other goals, taking less risk or increasing spending. This is clearly more robust than funding on a 50:50 basis, an approach which we have seen lead to large deficits in UK occupational pension schemes and shortfalls in mortgage endowments.
Prepared with route maps marked out with realistic objectives and planned with proper respect for the many and complex sources of uncertainty, self-funded retirees are far more likely to maximise the benefits, exactly as they define them, from their capital.