Spinning out savings
To make their savings last through retirement, taking advantage of the new pension freedoms, private clients have three options: balanced management, cashflow matching and insured packaged products. All the product and portfolio alternatives for delivering retirement income that can replace inefficient annuities, whether or not the capital sits in a pension wrapper, fall into one of these three distinct types of solution.
In a recent article for Citywire’s New Model Adviser journal, Stuart Fowler briefly describes the three options and sets out the main advantages and disadvantages of each. Though the heading implies the three could be combined, this is not at all the assumption of the article: clients have to choose, so advisers have to be able to inform that choice.
The three options are:
A static, time-independent portfolio that conforms to ‘balanced management’
A portfolio organised to match the planned cashflows
An insured packaged product that delivers the cash flows.
Balanced management assumes that the volatility of the broadly static asset mix is low enough and predictable enough to answer the question ‘how much can I safely draw every year for it to be sustainable for a lifetime whatever happens to markets?’ The answer depends critically on assumptions about the price correlation of assets making up the diversified (hence ‘balanced’) portfolio. It is also better designed to answer a question about a fixed nominal draw than a draw rate that increases with inflation because the assets that are relied on to smooth the volatility of returns are ones that introduce inflation risk: long-maturity fixed income investments.
Cashflow matching adopts the principle of Liability Driven investing that is increasingly replacing balanced management in institutional pensions. The assets are organised by both type (real or nominal) and timing (or duration) of the liabilities. In drawdown, liabilities are the amounts required to be drawn (as a cash flow, whether called ‘capital’ or called ‘income’) from the stock of savings assigned to meeting lifetime spending. In this goal-orientated approach, time preferences and tolerances (perhaps varying with age) and roles for ‘contingent assets’ like property sales, equity release or inheritance can all be factored into the cashflow plan that the portfolio is optimised to deliver. Compared with balanced management, risk control relies on the separation between liabilities matched perfectly or without risk (by date and in real terms) and risk assets, rather than on uncertain future correlations.
Insured products add to some underlying portfolio either options or guarantees whose role is to change the possible distribution of portfolio outcomes, such as limiting shortfalls or providing upside options to a low-return portfolio. The underlying is required to be a volatility-constrained balanced portfolio but some of the assumption risk is borne by the insurance company not the investor. That may look like a free lunch but options and guarantees are expensive relative to the return potential. It is much easier to demonstrate the superiority of a balanced portfolio with guarantees over a level annuity than it is to demonstrate the value relative to the other two options that don’t involve any ‘risk transfer’.
The article aimed to be quite objective about the three options advisers could recommend in preference to annuities. But our clear preference is for cashflow matching for four key reasons:
The advice given about sustainability is likely to be more robust by replacing reliance on uncertain diversification benefits with cash flow matching
The cash flow planning foundation makes the whole process more intuitive and personal for the clients themselves (as well as playing to financial planners’ strong suit)
Most clients find it easier to live with equity-type risk when equities are only funding long-dated liabilities and all early liabilities have been fully ‘hedged’. It changes the way they experience volatility which may then change their preferred risk level
A leaner asset mix using a few core building blocks is cheaper to deliver, with no loss of returns.