We seem to talk a lot about risk these days. Whether it's risk of infection or the risk of investment, that four letter word is high on most peoples' agenda.
Of course, managing risk is nothing new – and as an insurer with a 178-year heritage, risk is a currency we're pretty familiar with.
Last year reminded us how unforeseen external factors can quickly escalate to challenge even best laid plans. A 1-in-20-year market shock was a very real risk that many experienced for the first time and, if you were in drawdown, that potentially hurt.
Whilst advisers are skilled in communicating the risks taken by investment managers to generate returns, few clients would have appreciated the likelihood of double digit dips. Last year tested everyone's composure, particularly those clients who are predisposed to investor anxiety.
Managing the risks which emerge as clients move through later life is fundamental to a successful decumulation plan. Many advisers use a Centralised Investment Proposition (CIP) to build a bespoke investment journey that helps clients ascend the accumulation mountain. Increasingly, advisers are also developing an equivalent Centralised Retirement Proposition (CRP) to build a decumulation journey that offers clients a safe descent in the drawdown phase.
Whichever journey, advisers need to master a three-part balancing act to ensure they are choosing the right investment engine:
- The risk required for the client's journey.
- The client's attitude to that risk journey; and crucially.
- The client's capacity for loss.
This, in particular, is key post-Covid. Our own research, the Wealth and Wellbeing Monitor*, shows that 66% of mass affluent customers aged 55-64 are not 'retirement confident', 36% said their finances were worse now than 3 months ago, and 66% of mass affluent parents with 18-30-year-old children spent money helping them out. Clients' lifestyles are changing, their finances are under different pressures, and they are re-evaluating what's important.
Chart 1: Comparing realised volatility of the LV= Smoothed Managed Funds with relevant risk profiles
Chart 2: LV='s smoothing mechanism throughout 2020
Running out of money or having to reduce future withdrawals are the main concerns for many clients in drawdown. While each adviser will bring expert knowledge to help their clients navigate drawdown over possibly a 20 or 30-year planning horizon, two potential problems to address are volatility drag and sequencing risk.
- Volatility drag is the difference between average returns and compounded returns. For example, if a £100,000 pension plan fell by 10% to £90,000 in year 1, it would need to grow by 11.1% in year 2 to get back to parity (ignoring withdrawals). Volatility drag is amplified by withdrawals, which can lock in losses meaning the portfolio needs to work harder to get back to its original valuation.
- Sequencing risk refers to how the order of returns impacts the longevity of a drawdown plan. Once regular withdrawals are underway, poor returns in the early years can have a disproportionately negative effect on the value of the plan, even if poor returns are subsequently followed by good returns. The emotional and financial impact of this can be particularly detrimental.
These risks can severely reduce the level of income clients can sustainably withdraw and impact the longevity of the drawdown plan. As such, the ability to access a smoother investment journey is proving attractive for many clients.
Of course there are key differences in the smoothed solutions available in the market. One that's proven to absorb the impact of market shocks, provides a low-volatility investor experience, and delivers steady performance over the medium to long term is surely worthy of consideration.
The Smoothed Managed Fund range from LV= provides effective downside protection for investors when they need it most, such as in March 2020 (see chart 1).
Through the funds' unique smoothing mechanism, LV= take on the significant majority of the investment risk in volatile markets (see chart 2). You can see that the smoothing process effectively dampens market fluctuations when comparing the realised volatility of the LV= Smoothed Managed Funds with relevant indices for their risk profiles (2010-2020).
While managing risk is essential in drawdown, the first hurdle for any plan is being able to stick to it. Smoothing can help deliver emotional comfort to investors along their investment journey, and for anxious, risk-averse clients that could just help provide them with the best plan they could realise in practice.
* LV= Wealth and Wellbeing Monitor, December 2020
Chart 1: FE fundinfo performance as at 31st March, 2021
Chart 2: LV= Smoothed Managed Fund range mapped to independent risk framework. Based on Data to the end of June 2020.
Disclaimer: In exceptional market conditions (when the underlying price is 80% or less of the averaged or `smoothed' price) the fund will be valued on the underlying or daily gradual averaged price. We reserve the right to move to the underlying or daily gradual averaged prices at other times.
Past performance doesn’t reflect what will happen in the future. The value of your investment can go down as well as up.