Retirement Income: The W1M Solution

Key takeaways

• Retirement income brings new investment challenges. As clients move from saving to drawing an income, managing risk and maintaining a sustainable income become increasingly important.
• Three key risks can impact retirement outcomes. Longevity risk, inflation risk and sequencing risk can all affect how long a pension pot lasts and the income it can provide.
• The W1M Retirement MPS combines growth with resilience. A diversified growth portfolio aims to help pension savings keep pace with inflation and support income needs over the long term.
• A dedicated retirement-focused building block helps manage sequencing risk. By combining short-dated fixed income investments with a protected equity strategy, the W1M Retirement MPS is designed to reduce volatility and help improve income sustainability throughout retirement.

Building up a pension pot (accumulation) over a few decades of working life involves taking some risks with investments. The longer the time to retirement, the less people need to worry about short-term market moves. While working, ongoing payments into pensions can allow “averaging in” which benefits regular savers as they add to investments when prices are more attractive as well as when markets are strong.  However, the nearer to retirement people get and when we are using pension pots to take a regular income, short-term market movements matter much more. We care more about losing money and doing so impacts the sustainability of future income potential. Investment solutions need to address these risks.

We have written separately about three key risks facing people taking a retirement income. When using a pension pot to derive an income, longevity risk relates to nobody knowing how long they will live and the need for retirement income to be sustained over many years. Inflation risk arises from retirement incomes needing to help pensioners maintain their purchasing power as prices go up most years. Perhaps the most important risk to consider when taking a retirement income from a pension pot is sequencing risk which refers to how market movements potentially reduce the number of years a pot may last for if the timing of retirement happens to coincide with a period of weaker investment returns.

The risks explained

Longevity risk: the risk that clients run out of money; they outlive their savings. Their pension plan assumed a life expectancy of 85 and they live until 95.

Inflation risk: even an inflation rate of 2.5% means that a client's money will lose roughly one third of its value over 15 years and so purchasing power diminishes for them.

Sequencing Risk: sequencing risk is the risk of poor investment returns at the start of a client's retirement. If markets fall early on when your client is taking an income, they may be forces to sell investments at lower values, leaving less capital to recover over time. This can have a lasting impact on how long their savings will last, even if markets perform better later.

How do W1M solutions address the issues facing people taking an income from their pension pot?

Perhaps the challenge in having a sustainable retirement income for a given period can be summed up as, firstly, needing to top up the pension pot, given retirement can last a long time, and, secondly, making the pot more resilient given markets will fluctuate.

Our approach

Our solution repurposes our existing track record and expertise

Topping up the pot to deal with longevity and inflation risk

When retired and taking a pension income, people are not normally contributing more to their pensions but growth in underlying investments can top up our pension pots. The W1M retirement income solution uses our long-established Growth Model Portfolio to achieve this objective by providing well diversified exposure to direct investments in four building blocks: Global equities, Bonds, Absolute Return strategies and Real Assets (such as commodities). This “growth engine” aims to beat inflation consistently by around 4% in the medium to longer term; this deals with one of the risks mentioned above which is that prices rise (inflation) so pension incomes need to rise too. The “growth engine” also helps mitigate “longevity risk” in that investment growth topping up the pension pot helps it last longer as an income is drawn.

A fifth building block focussed on addressing  “sequencing risk”

As mentioned above, key risks change somewhat when in retirement and taking an income. The chart below shows how two people retiring at different times, maybe only because of being born in different years, can have very different outcomes because of market conditions in the years following their retirement date. Both people start with a pension pot of £500,000 and wish to take £25k (5% of their pot) in the first year. Both would like the amount they receive each year to rise with inflation.

Why does sequence risk matter?

Retirees cannot control the market backdrop when they retire but it can make a material impact on how sustainable their pension pot is.

As the graph demonstrates, the pensioner whose early retirement coincided  with sustained market growth before a drawdown, enjoyed income for 27 years, 11 years longer than the pensioner who retired into a market sell-off.

Assumes 8% drawdown in each of the first 4 years of retirement followed by 5% annual gains for the following 21 years.
*Assumes 5% annual gains in first 21 years of retirement and then 8% drawdown for years 21-27.
Withdrawal rate of 5% taken from pension each year, increasing in line with inflation.

Source: W1M.

The black line shows the outcome for a pensioner who happens to reach their retirement age just before a “bear market”-  which in this illustration is a period of four years with markets declining 8% annually; they are then assumed to have a period of 21 years with markets making (more normal) positive returns of around 5% per annum. Our analysis shows that this person could see their pension pot meet their income objectives until they reach the age of 81. By contrast, another person who happens to have a retirement date just before 21 years of positive market returns which are followed by a bear market, and losses, could see their pension pot last more than a decade longer until they are into their 90s. The sequence of returns, particularly early on in retirement, can have a drastic impact on how long a pension pot will last.

The W1M retirement income solution addresses sequencing risk directly with a fifth building block which has two elements.

The first element, and the majority of the portfolio, consists of “short-dated” fixed income investments, managed actively, which increase the overall resilience of the portfolio and provide a stable source of income. “Short-dated” means the bonds we select pay out income in the relatively near future which increases the confidence investors have of getting the income; longer dated bonds tend to be more volatile. Short-dated bonds tend to be very resilient so they add not only stable income but diversification in our portfolios. If, for example, stock markets have a sharp fall, as they do periodically, the value of short-dated bonds are not likely to fall much; investors can remain confident in getting the income they expect so there is no great reason for them to fall just because equities might do so. The second element of our fifth building block is a W1M “protected equity” strategy. This aims to give equity-like returns but with lower volatility, enhancing returns in the fifth building block while managing volatility.

Summary

The example given above shows how two people both starting with a pension pot of £500,000 and wishing to take £25k (5% of their pot) in the first year with that amount rising each with inflation can have very different results; the person who has a sequence of poor investment returns at the beginning of their retirement may only see their pension pot sustain an income for them to the age of 81 while the second person, retiring when markets are stronger, might see the same size of pension pot last into their 90s. Retirement income solutions need to be able to cope with longevity, inflation and, crucially, sequencing risks, as discussed above.  When taking an income, the sustainability of that income becomes key and investment solutions need to be active in managing volatility. The W1M Retirement Managed Portfolio Service aims to help meet these needs by using one of our long-established growth-focussed investment strategies, to top up the pension pot as an income is taken, in combination with a fifth building block designed specifically to mitigate “sequence risk” where periodic stock market falls can make it more challenging to achieve a desired income level.

A simple, flexible and cost-effective solution

Our Retirement MPS retains the signature of W1M's MPS:

Simple by design

• Rebalancing and portfolio management are undertaken within the MPS
• Reduces administrative work for advisers
• Portfolio remain aligned to their intended risk profile
• No need for advisers to manually monitor and move assets between different strategies or cash reserves
• Operational complexities are taken away

Flexibility

• Client spending in retirement isn’t necessarily linear; flexibility to guard against overspending, as well as underspending is key to good client outcomes
• As client circumstances evolve, advisers can easily adjust income needs,
  risk appetite or capacity for loss change

Glossary:

Protected Equity Strategy: An investment approach designed to capture equity-like returns while helping to reduce market volatility and downside risk.

Short-Dated Bonds: Bonds that mature relatively quickly, helping provide a more stable source of income and lower volatility than longer-dated bonds.

Diversification: Spreading investments across different asset classes to reduce risk and improve portfolio resilience in changing market conditions.