Tempted by the flexibility of the pension freedoms and large transfer values, a growing number of people are moving out of their defined benefit (DB) pensions into defined contribution (DC) schemes. But by doing so, investment risk shifts from employer to employee. So how can you ensure your clients understand the implications of transferring their accumulated pension benefits and how can you help them mitigate some of these risks?
The wealth effect
'DB or not DB?' is no doubt one of the burning retirement questions that you and your clients are dealing with. That is to say, should your clients stay with their so called 'gold-plated' DB pension schemes or should they switch to a flexible DC alternative that liberates their pension benefits? This is a huge decision and its impact should not be underestimated.
In many cases, the transfer values assigned to DB pensions are significant. These lump sums can, in some cases, turn people with fairly normal financial provision into overnight millionaires. All very tempting to get access to that cash now, but a huge responsibility to invest wisely for the future.
Pass the parcel
On top of this wealth effect, we also have a perfect storm of historically low interest rates and depressed investment yields. This is making DB schemes, with their pension promises, increasingly expensive for companies to fund. As a result, a number of employers are providing lucrative incentives encouraging employees to switch out of DB pensions and take an enhanced lump-sum payment at the expense of a guaranteed income. Some companies are seizing this opportunity to pass their long-term liabilities onto the individual – your client – who now takes on all the burden of providing for his or her retirement, such as the risk of losses on their investments.
So far, perceived wisdom has been for clients to stay with their sacrosanct DB pension schemes, no matter what. The Financial Conduct Authority (FCA) has been fairly clear on its stance too. In order to protect people from inadvertently giving up valuable benefits, it has made transferring a lengthy and rigorous process that can only be carried out by Pension Transfer Specialists. However, we could see the FCA's position changing as it becomes more evident that a pension transfer rethink is required. Interest in moving out of DB pensions is only going to increase as we see transfer values continue to soar in the current environment. And while the recipients may feel wealthier, this could lead to unrealistic expectations of their standard of living in retirement – a ticking time-bomb for tomorrow.
Investment risk – the gift that keeps on giving
Previously, keeping your pensions invested through retirement and decumulating was the domain of a relatively small group of wealthy people. But with more and more people choosing income drawdown to live off, we will see increasing numbers managing their retirement assets well into old age. This requires a very different approach to investing than in the accumulation phase.
For those clients who decide to move out of their DB scheme, making it over the transfer hurdle is the first challenge. But we need to be clear that this is just the start of a whole host of associated risks; risks that continue throughout the retirement journey. The choices these clients make in terms of what to do with their lump sums are critical in determining their financial future.
The sustainability struggle
Probably the biggest challenge of decumulation is sustainability. Since most people have no idea how long they will live, making their money last is crucial. In drawdown, factors such as volatility and the severity and timing of short-term losses in their investments can be even more important to sustaining their income than the investment return itself.
At Aberdeen Standard Capital, we have carried out a great deal of research on sustainability and understand that the dynamics at play in decumulation are very different to those in accumulation. Indeed, the findings can feel counterintuitive, whereby it is possible for higher returning portfolios to produce worse results than lower-returning portfolios during drawdown. Poor planning and investment could also lead to people running out of money, and hitting 'ruin age', as they underestimate how long they will live and fail to plan for expenses like longterm care. In this respect, portfolio behaviour is crucial, as are the underlying investment strategy and withdrawals policy.
A critical sequence of events
This brings us onto sequencing risk. Volatile or inconsistent investment returns can be devastating when decumulating, especially during the early years of withdrawing an income from a pension fund. This is when pound cost ravaging (the reverse of pound cost averaging) comes into play. In this instance, unlike during accumulation, the investment return is no longer the sole objective. Rather, it is how that return is achieved that is just as, if not more, important. What happens early on in decumulation has a huge impact on portfolio sustainability, so it can be dangerous trying to chase high returns from the outset and risk getting it wrong.
Equally, a client in retirement has multiple and uncertain investment time horizons – after all, no one knows exactly how long they will live. Again, it comes back to sustaining the wealth a person has for as long as possible. Volatility management is critical in this respect for clients in drawdown.
A strategy for success
The retirement landscape is more challenging and complex than ever before, for clients and advisers alike. However, a combination of careful planning and flexible investment solutions can help mitigate some of the challenges. As an adviser, you will undoubtedly be dealing with clients who have become significantly wealthy after transferring pensions, and who may not fully appreciate that a number of risks have shifted from their employer, solely onto their shoulders.
To help take some of the uncertainty out of this new retirement regime, advisers need to ensure they work with a discretionary fund manager that is alert to the very specific challenges of decumulation and can offer your clients a range of risk-appropriate, volatility-managed solutions.