David Prosser examines a recent Master Adviser study and tells us why investment companies are well suited to pension pots.
Conventional wisdom has it that older investors need to hold their savings in asset classes regarded as less risky. All the more so if they’re using those savings to generate an income on which they depend for living expenses, as is the case with the rapidly-growing numbers relying on income drawdown plans in retirement. But conventional wisdom isn’t always right – and in that regard, a study from the financial planning specialist Master Adviser makes fascinating reading.
One of its arguments is that the way we think about risk can sometimes lead us to the wrong conclusions. Regulators such as the Financial Conduct Authority tend to define risk in terms of market volatility – the extent to which an asset has a propensity to rise and fall in value. That seems logical and is no doubt important, but income drawdown savers are looking for consistency of income rather than worrying about capital performance, at least in the short term. The ups and downs of the market, even when quite pronounced, concern them less than whether they can rely on the income they need to keep flowing.
In which case, maybe risk needs to be considered with greater nuance, viewed through the lens of the needs and aspirations of the type of investor taking it, rather than in absolute terms. Short-term volatility may still matter, but less so if lows are followed by highs (or vice versa). If volatility has no impact on income drawdown savers, why should they worry about it?
With risk regarded in a different way, where might such savers invest their pension funds to secure their income during retirement? Well, here too Master Adviser has some interesting thoughts.
It modelled the performance over the past 20 years of a £100,000 fund invested according to five different approaches: a portfolio of global equities, a portfolio of UK equities, a portfolio allocated 60 per cent to equities and 40 per cent to bonds, a standard annuity contract, and a basket of eight global investment companies.
The results were striking, with the investment companies trouncing the competition. Over 20 years to December 2018, the investment companies portfolio delivered a final capital value of £234,520, with its closest rival, the global equities portfolio, achieving only £119,931.
Not only this, but the investment companies portfolio also delivered substantial amounts of income. The study assumed that income drawdown investors would take 4 per cent of their fund each year from the equity and equity/bond portfolios. In the case of the investment companies-invested fund, it measured the natural income the funds had paid out. This came to £129,142 – more than £20,000 more than any of the portfolios could generate with a 4 per cent withdrawal rate. Only the annuity contract paid out more income over time - £164,875 over the full 20 years – but its final capital value at the end of the period was zero.
Back in the real world, many financial advisers are making increasing use of investment companies as they work with older savers to design income drawdown portfolios that generate both income and capital growth. They are attracted to features such as investment companies’ ability to smooth out income payments over time, funded by dividend reserve funds.
However, this approach has often sat uncomfortably from a risk perspective, since it requires savers to accept elevated levels of volatility compared to, say cash or bond holdings. The evidence of Master Trust’s research is that the risk pays off – and that we should in any case be reappraising our approach to risk in the first place.