Running on empty

I went to a presentation from David Blanchett, Head of Retirement Research at Morningstar Investment Management the other day. The subject was: “Successful Withdrawal Strategies for UK Retirees.” It was pretty depressing.

The first point made related to Bengen’s “Law’. He reminded us that it was not a law and that it didn’t suggest that 4% of the investment increasing in line with inflation was a reasonable rate of withdrawal for a thirty-year term. Actually, it suggested that 4% of the fund increasing with inflation was a maximum withdrawal rate. Anyway, it’s worked out pretty well in the United States so far, based on a 50/50 bond and equity portfolio with all income reinvested. That’s was the good news. The bad news was that using the same approach to historical UK market data, Bengen’s rule didn’t work out at all well. The money ran out. (The UK return was 4.06% pa over the period, compared with 5.01% in the U.S.)

Morningstar also presented forecasts for inflation and a 60/40 equity and bond portfolio and they calculated how likely it was that that data could support 4% of the amount invested increasing with inflation for thirty years in future. Now, of course, forecasts are just forecasts and are no more reliable as an indicator than past performance. But they have to be factored into thinking even though we know that no one knows what’s going to happen next week let alone in the next thirty years.

It wasn’t an encouraging picture. Based on a retirement period of 30 years and total annual fees of 0.5%pa there was a 34% chance of success. With a total charge of 1% pa there was a 25% chance and with a charge of 2%pa just an 11% chance. If the retirement period was reduced to 25 years these numbers increased to 56%, 46% and 27% respectively. So, what do we do about this? Reduce the withdrawal rate? Encourage clients to defer retirement? Keep our fingers crossed? I think there may be some more attractive options.

First: Reduce costs across the entire value chain. And where the rubber meets the road is the active management of mutual funds. Seems to me that the future looks quite challenging for quite a few players. In fact, perhaps the future for most active fund managers may be uncertain. After all, their model hasn’t really changed since M&G launched the first UK fund in 1931. Ironically the objective (borrowed from the US) was to enable the general public to invest in the stock-market at low cost and without complexity. I say “ironically” because there are now many more funds than there are stocks traded on the Stock Exchange. And direct investment in shares can be cheaper that buying a fund. Perhaps one way to reduce the cost might be to have a SIPP invested in direct securities rather than funds.

Second: More index funds. But not conventional index funds. Maybe new indexes could be created where the criteria are based on companies who have a history of producing returns which work well for people looking for income in retirement and bonds which might be held to redemption. You may remember the study based on monthly US share data from 1968 to 2011 which looked at 10 million indices weighted randomly. These “monkey” index funds consistently delivered much better returns than the traditional market weighted approach. There must be possibilities here.

Third: Be more open minded about the entire client wealth. Not just the investments. But other assets such as the client’s home. And I predict great opportunities for the equity release market going forward. Not just as a last resort but in the planning process. Not just “If we have to in later life we can do it”. But as part of the client retirement strategy. After all, most of the clients we are talking about will have “children” in their forties who are likely to already own their own homes.

I think equity release to provide income rather than a lump sum can be quite an attractive proposition as part of the retirement plan as well as a back-stop if – or according to the forecasts above when – the pension fund runs out of money. I do appreciate the many challenges of advising in this space. Not least the time cost and the low initial commissions if it is an income rather than lump sum arrangement. Perhaps a solution to this would be to work on a non-contingent fee basis rather than commission.

Finally, we need to talk about annuities. When long term interest rates increase, annuity rates start to recover and clients work longer, the dynamic will start to change. The Bengen “Rule” is based on the premise that the investment fund is exhausted at death. So is the annuity “rule”. When we start looking at a maximum income of 4% with a very significant risk of it not lasting a lifetime, compared with a guaranteed income which will; then an annuity surely has to be on the table at some stage.

In any event, I think most people would agree that we need to find new solutions in the retirement income space. It’s a huge market which is growing exponentially. A recent ONS report showed that £5.4bn was withdrawn from DB schemes in 2014 and £34bn was withdrawn in 2017. This represents a massive opportunity across the long terms savings and investment value chain. But it also presents a challenge. How will we take care of all these people swapping guaranteed income, albeit with some caveats, for the completely uncertain environment of the market? If we can’t come up with some ideas then maybe many of these clients should be left where they are.