Danny Knight, head of investment directors at Quilter Investors, explains why the findings of the FCA's Retirement Outcomes Review show there is still plenty of room for improvement in the decumulation investment market.
When pension freedoms were introduced in 2015, newspapers heralded the flexibility and choice suddenly available, while politicians celebrated liberating their constituents from the perils of the annuity market.
Britons were quick to embrace the reforms. In less than two years, flexible income payments totalling £9.2bn had been made from UK pension pots. This huge behaviour shift at retirement provided the backbone for a new era of face-to-face financial advice. But crucially, it also presents some big challenges that are putting consumers at risk of sub-optimal retirement outcomes, according to a recent FCA report.
The surprise reforms were implemented at short notice by a Chancellor eager to secure support ahead of the 2015 General Election and took many by surprise. Like most seismic policy changes, while the positive benefits were obvious, they came with unintended consequences that take time to percolate.
Free 'guidance' has been introduced in a belated attempt to address knowledge gaps. Action is being taken against the threat of cold calling. And we have recently seen new rules on pension transfers.
But there are many other unintended consequences creating fires that need to be extinguished to protect retirees.
Time to review
The FCA's recently published Retirement Outcomes Review illustrates how much catch-up is still required. It includes some startling discoveries about the behaviours, bias and attitudes of consumers in drawdown. More than anything else, its findings highlight that there are still plenty of challenges ahead.
Fear of loss
The FCA found that the single biggest driver motivating decisions was a fear of losing money. Over half (52%) rated it as "very important" in shaping their at-retirement choices and fewer than 1 in 10 said they felt it was not a major concern. "As long as it doesn't lose money, I will be satisfied," was the response of one individual surveyed on her investment choices.
Another retiree aged 65+ explained that they were concerned about investing "because I'm against gambling, always have been. I like to know that things are safe, things are in place."
Perhaps as a result of this fear of loss, the FCA found that 1 in 3 non-advised drawdown customers are entirely invested in cash. In total, the regulator estimates 50,000 are exclusively holding cash in flexible drawdown, while we estimate that 10% of all retirees taking flexible income in the 2017/18 tax year were entirely in cash.
The FCA found this has a "significant cumulative impact on retirement income". And it concludes that few are using cash as a short term safe haven and instead "remain in cash for a prolonged period".
It estimates that an individual in cash could increase their annual income by more than a third if they invested in a mix of assets, including equities.
Consumers are rightly worried about loss in retirement. Unlike accumulation investors, they are less likely to be able to leave their savings untouched to recover market falls, or top-up their pot from earnings.
But the temptation to withdraw into cash is a dangerous one. It places retirees at risk from inflation, the corrosive effects of which seem to be under-appreciated. Rates on cash, according to the Bank of England, are somewhere in the region of 0.9%, while inflation is well above 2%, putting the real rate of return well in negative territory.
The answer for many people will be an investment solution that offers growth potential alongside appropriate downside protection.
Risk and rewards
For investors in the accumulation phase of their retirement planning, volatility can be a price worth paying for the opportunity to realise long-term gains. In decumulation, however, losses can be compounded when assets are sold during a downturn. This is the dreaded 'sequence of return risk' or 'pound cost ravaging' as it is variously known.
As the FCA paper notes: "Volatility is particularly important for drawdown consumers as they may rely on the income from their pot and so do not want its value to change too drastically."
However, the regulator found little consistency in the risk/reward balance in investments used for decumulation, with around a third of the drawdown investments it analysed delivering a poor risk-reward ratio based on the relationship between performance and total charges.
The value of advice
Customers using an adviser confront these challenges with the benefit of expert support.
The report found more consistent and logical patterns in the choices made by advised customers in comparison to those not taking advice.
It says that: "While advised consumers seem to invest with a pattern consistent with their profiles, consumers that do not take advice do not. For example, investments in higher-risk assets, such as equity funds, increase for advised consumers in larger pots who have not made withdrawals. We did not see a similar trend for consumers without advice."
It also found that 94% of non-advised customers stay with their incumbent provider when moving into drawdown, compared with 35% of advised customers, showing they are much more inclined to search the market for the most appropriate options.
What comes next?
The report shows there is still work to be done to address a number of emerging issues in the decumulation market. The FCA is taking steps now to tackle the number of retirees ending up in cash, and to encourage consumers to make more active choices at retirement, particularly where non-advised customers are concerned.
Where it has recommended changes, these will be adopted in rules (a policy statement) to be published in January 2019, with further consultation on wider concerns also due in 2019.
It is now up to the industry to demonstrate that it can deliver the right outcomes for customers.
Therefore, the battle is on to ensure the industry matches the pension revolution with bold answers in the way that it manages investment risk in retirement by engaging those clients concerned about losing money, and demonstrate to them the importance of delivering returns within risk parameters that meet their retirement needs.
Past performance is not a guide to future performance and may not be repeated. Investment involves risk. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. Because of this, an investor is not certain to make a profit on an investment and may lose money. The performance data do not take account of the commissions and costs incurred on the issue and redemption of shares. Exchange rates may cause the value of overseas investments to rise or fall.
This communication is issued by Quilter Investors is authorised and regulated by the Financial Conduct Authority.