The natural income buffer to sequence risk

Building a retirement pot can be psychologically difficult – it often requires locking up today's capital in order to save for the future. Thankfully, the order in which an investor pursues the accumulation phase does not matter all that much.

So long as nothing is withdrawn from the pot until retirement, the sensitivity of the pot's total value to the sequence of events leading up to it, sequence risk (often referred to as pound-cost ravaging), is quite low. However, when an investor moves into the decumulation stage – challenges such as taking a regular retirement income, the timing of withdrawals and the level of drawdown matter a great deal, exposing the portfolio to much more sequence risk than before.

A retired investor who is drawing down their investments for daily needs is a seller of assets. This can be particularly problematic if they are required to sell assets to meet spending requirements following a fall in asset prices – in other words they are forced to sell at a comparative loss. The sequence risk is subsequently high since it becomes less likely that those losses can be recovered when the market begins expanding. Conversely, an investor withdrawing at the height of the market is in a better position, able to sell assets at a much improved price.

But the investment world rarely allows investors to control the order in which market returns unfold. Even with fairly accurate medium or long-term return forecasts, predicting the path that's going to take us there is much more challenging. Two in five investors withdraw the same absolute amount of cash from their funds year-on-year, regardless of stock market performance, the same percentage of people who receive no financial advice or guidance on the topic1. Hence, approaching sequence risk is much more about managing that risk rather than removing it altogether.

Figure 1: Illustrating the impact of different withdrawal scenarios

 Illustrating the impact of different withdrawal scenarios

Source: LGIM, Bloomberg LP. As at 30 April 2018.

Not all income is created equal

If investors in the decumulation phase are interested in receiving a regular stream of income from their portfolio, they can either opt for fixed withdrawals or natural income distributions.

In the first case, they would withdraw a fixed amount from their portfolio, for instance a percentage of capital such as 4%, or an absolute figure, say £25,000.

In the second they would only collect whatever income is available in a given period (in terms of dividends or coupons). Interestingly, investment outcomes can be very different under these two scenarios even when the fixed withdrawal is aligned with the average realised yield on the investments over the investment horizon. This is all because of the impact of the sequence of returns.

If they opt for natural income distributions, they will effectively collect lower distributions on the way down, protecting the size of their pot, and could be rewarded with higher distributions when the market rallies, effectively participating in the recovery.

Natural income has another benefit which is harder to quantify and more psychological. Investors have typically favoured income generating assets due to the visibility of the cashflow they can receive and the element of comfort from knowing their investments are paying for their lifestyle.

Reversing the sequence

Actual / Reversed table

Using annual returns of the FTSE All Share, we can attempt to assess the impact of the difference in the accumulation and decumulation stages for the investor. Above, we apply the annual returns of the index from 2000-2017 to a £100,000 investment and then reverse the order of the return stream. In the accumulation phase the path varies from year to year but the end outcome for the investor is exactly the same, with the investor ending the 18-year period with exactly the same amount (£238,179) whether they use the actual return stream or reverse it.

However, if we assume a 4% initial withdrawal (£4,000) and assume this amount is continually drawn down each year, taking into account a 3% inflation rate as well, the results are turned on their head somewhat. If invested in the actual return stream, the investor ends up with around £50,000. If we reverse the return stream for the investor something remarkable happens. The pot size is significantly increased leaving the pot slightly above the starting value. In essence this shows the sequence of returns is of utmost importance during drawdown. In this case the negative returns were more detrimental in the actual series as they were experienced earlier on during the drawdown period and made it difficult for the pot to recover.

Natural income first, capital second

Some investors rely on and may take comfort in knowing that they can receive an absolute level of income from their retirement portfolio.

However, many retirement drawdown investors continue to use funds designed for the accumulation phase. Where taking a fixed level of income from a growth-focused portfolio often requires the selling of fund units, thereby exposing the portfolio to market movements, taking the majority of the income from natural sources (or a portfolio that is designed for drawdown) and only topping this up with units to meet the desired amount can still act as a minor risk buffer. Whilst it may not eliminate sequence risk, highlighting the risk-management benefits of using natural income alongside other strategies that investors have used in the accumulation phase appears a sensible solution, in our view. By blending the two, our findings show this can still help mitigate the effects of sequence risk for investors.

When investors begin withdrawing from their portfolio, advisers are often faced with two key concerns (1) how much will an investor need to withdraw and (2) where will the income be drawn from within the portfolio. Due to the dangers of sequence risk, we believe income investors should be inspired to think about how portfolios that distribute a natural income can sit within their wider centralised retirement proposition.

Figure 2 – £100,000 in accumulation

Figure 2 - £1000,000 in accumulation

Source: LGIM calculations for illustrative purposes only

Figure 3 – £100,000 in decumulation with annual 4% drawdown

Figure 3 - £100,000 in decumulation with annual 4% drawdown

Source: LGIM calculations for illustrative purposes only

  1. Adviser Points of View, Retirees failing to account for market volatility as they drain funds, July 2018
  2. It is worth noting that some solutions have been developed that are designed for drawdown which are out of scope for this paper.

Important Notice

This is not a consumer advertisement. It is intended for financial advisers and should not be relied upon by private investors or any other persons. The value of investments and any income from them may fall as well as rise and investors may get back less than they invest. Legal & General (Unit Trust Managers) Limited. Registered in England and Wales No. 1009418. Registered office: One Coleman Street, London EC2R 5AA. Authorised and regulated by the Financial Conduct Authority.