Most of us will be familiar now with the starting point for most discussions of this kind – the Bengen 4% rule. This research was a landmark in establishing a new kind of calculation, but Bengen's research only dealt with US historical returns, and our intention here is to outline how Bengen's approach might be applied in a UK retirement context today, using modern stochastic techniques.
Additionally, we wanted to show you one more graph that beautifully captures the role of investment risk, impact of withdrawal and probability of success.
First of all, the use of cash-flow plans
As readers will know, cash-flow models are prescribed for DB transfers, but in his recent report 'An-ex-regulator's guide to cash-flow planning', Rory Percival explains why cash-flow plans should be taking centre stage in a wider context of advice:
- 'Cash-flow planning can be about any form of income and outgoings and does not have to be related to the client's overall position.' A cash-flow plan need not be a holistic view of a client's finances.
- The second point is that the cash-flow plan can establish a client's Capacity for Loss for most clients. In fact, writes the author, 'it should be the main way of assessing Capacity for Loss for most clients.' Capacity for Loss is the lynchpin of compliance, and meeting the funding requirement for future income is central to any plan. An adviser needs to make an expert, objective assessment of Capacity for Loss, or using its FCA definition, identify the level at which loss may make a 'material impact on the standard of living'.
Moody's overview of sustainable retirement income
Synaptic users can use growth assumptions from the Synaptic Risk profile, but the calculations remain deterministic. In our view, retirement advice is most effectively delivered using a combination of cash-flow modelling and stochastic analysis. In the last edition of this publication, we provided graphs illustrating the 'longevity' of retirement funds, created by Synaptic Modeller.
Additionally, we wanted to show you one more graph that beautifully captures the role of investment risk, the impact of withdrawals and probability of success.
The graph shows a greater than 80% chance of success (income sustainability over 25 years) for everything:
- With a greater investment risk than -0.1, which is equivalent to a portfolio with Moderately Cautious risk profile (loss of up to 10% of portfolio in a bad (1 in 20) year).
- Drawing down 5% or less of portfolio (adjusted for inflation). The 0-800 are bps i.e. 400 is 4%. Notice also that the classic 4% level of income will return a 90% chance of success if the funds are invested above Moderately Cautious Strategy.
- Summary – investment risk is obligatory for meeting most retirement investment needs!
- 25-year retirement decumulation projections for portfolios ranging from 0% to 100% equity, for a range of fixed income levels.
- The Strategic Asset Allocations (SAAs) used are a blend of Equity (70% Global ex UK; 30% UK) and UK Fixed Income. EBR (Equity Backing Ratio, i.e. proportion of equity) is stepped in 5% increments from 0% to 100% – shown on the chart as points.
- For each set of Strategic Asset Allocations, we run a decumulation scenario with fixed income level ranging from 0% to 8% of the initial fund. Lines show constant income levels, as specified in the RH legend: 0bps, 30bps, 70bps, 100bps, 130 bps and so on.
- For reference, the current single life fixed annuity rate is about 5.0% for a 65-year old – shown as a red dashed line.
- On the y axis is income sustainability, i.e. probability of maintaining the stated income to age 90.
- On the x axis is max 1yr 95% var. That is, the maximum 1-year loss at the 1 in 20 level over the investment horizon. This loss reflects losses on the fund due to investment returns only and does not reflect the income cashflows.
What does it mean?
This is a "2-risk" chart showing two of the principle sources of investment risk for decumulation investors: "shortfall risk", as represented on the y-axis in terms of "income sustainability", and "market risk" represented on the x axis as the "potential 1yr loss".
Use of retirement withdrawal statements
Synaptic recommends the use of retirement withdrawal statements to anticipate the various market conditions. Abraham Okusanya has written a fantastic book, Beyond the 4% Rule, that explains the maths and the various rules that can be applied in more detail than we have room for here.
To make a withdrawal statement work, the adviser should establish the probability-based parameters for success or failure (easy with the Moody's model), and signpost the likely responses. The latter will include several simple rules that can be applied, for example the expectation of increasing the withdrawal rate by inflation, except when the portfolio has lost 10% over any 12-month period. Inflation-linked increases to be resumed when the portfolio has regained the former valuation. The rules to address different market conditions are also the best way to demonstrate the suitability of the plan, as the rules will be designed to prevent the depletion of the principal and breach of the client's Capacity for Loss. Abraham Okusanya's book 'Beyond the 4% Rule' is a great place to research the various strategies in more detail.
A major concern of course is the cognitive ability of the client (and the adviser!) in later years, so the due diligence and research needs to be very thorough, including a detailed understanding of how the reviews will be undertaken.
There are many interesting considerations that come out of this research, for example, how different asset allocations and investment styles might work; whether the use of natural yield to determine withdrawal rates might help, or what happens when you allow the asset classes to drift, which again provides some interesting results and options for the adviser.