The A-Z of CRP

Hands up if you’ve heard of the PROD Handbook? Okay, now keep them up if you think your practice is compliant with PROD?

If you just lowered your hand, don’t worry (well, not too much …), you’re not alone. Of the 500+ advisers who came along to our recent roadshow up and down the country, only five advisers still had their hands in the air when former regulator, Rory Percival, posed the same question.

Rory has written some articles for AJ Bell Investcentre advisers, with PROD compliance in mind, which you can find on the new Info hub. In there, a key theme you’ll see is the need to ensure that propositions are client- and not business-centric.

In practice, that’s about rethinking propositions based on the client’s position in life and different needs and objectives, rather than offering different propositions based on the amounts they have to invest.

Nowhere is that brought into starker contrast than for those clients who have made it to drawdown. Having accumulated pension pots over time, the transition to later life and an investment strategy that needs to look after their spending needs from here to the grave introduces a set of risks that they didn’t face in accumulation mode, and a set of challenges to advisers that come from dealing with a client in the later years of their life.

In investment terms, the biggest new challenge is that of ‘sequencing risk’ – and unfortunately, it’s not something you, I or the rest of the investment community can reduce on the client’s behalf.

For those unfamiliar with the concept, sequencing risk centres around the problem that comes from the withdrawal of funds from an investment pot over time, and the ‘order’ in which investment returns are sequenced.

It’s best described with an example. Let’s suppose we start a 30-year investment journey in either 1906 or 1923. Here a portfolio spilt equally of UK bonds and UK equities, rebalanced annually, would have produced the following returns.

Source:E Dimson, PR Marsh and M Staunton, Global Investment Returns Database 2018 (distributed by Morningstar Inc). AJ Bell Calculations.

Note how both the annualised returns and volatility are identical. For a client in accumulation mode, either of these outcomes are equally preferable.

Source:E Dimson, PR Marsh and M Staunton, Global Investment Returns Database 2018 (distributed by Morningstar Inc). AJ Bell Calculations.

But let’s now start a 30-year decumulation journey on both of these dates, with a 5% withdrawal rate.

Source:E Dimson, PR Marsh and M Staunton, Global Investment Returns Database 2018 (distributed by Morningstar Inc). AJ Bell Calculations.

Here, because the sequencing of the returns is completely different (Mrs 1906 makes a pedestrian start before making strong gains in the later years, whilst Mr 1923 gets off to a ‘flier’), the damage has been done, leaving Mrs 1906 with only a couple of years’ worth of income left to survive on. So, what’s an adviser to do?

First and foremost, the most important thing is to ensure – especially in the early years – that the client doesn’t panic. As a financial adviser, you’ll be more than aware of the behavioural aspects of dealing with the public, and that offering a financial planning service is as much about counselling as it is about product, wrapper and tax knowledge. So, anything we can do to put clients at ease ought to be built into the proposition – particularly for clients who may be facing a drop in their cognitive ability.

On that basis, the following tips and techniques might be of value when building a Centralised Retirement Proposition (CRP) or investment proposition for clients in retirement.

Go deeper into spending patterns

For clients in accumulation, the discussion around spending probably goes something along the lines of ‘how much do you earn?’ and ‘how much do you spend?’ from which we then subtract the latter from the former to determine how much the client can safely tuck away on a regular basis.

In decumulation, the spending discussion ought to go deeper. Not only should we be asking ‘how much?’, but ‘on what?’ is the client spending their hard-earned on. From here we can start to think about some form of spending hierarchy, building from basic living expenses, right through to leisure and luxury items.

Consider annuities as a tool for retirement

One method worth considering to ensure clients don’t panic could be to make sure that their basic living expenses are taken care of come what may. Armed with a detailed understanding of a client’s spending patterns and how these might change in later life, the use of annuities alongside state and defined-benefit pensions could be used to cover all of life’s necessities, leaving the remaining spending needs to be met from investment income and capital gains. Safe in the knowledge that these items are taken care of, clients are more likely to be relaxed about the daily fluctuations in investment values.

Bucket the portfolio

As slightly more advanced chimps, humans have a bunch of irrational flaws in how their minds work which we should be aware of when building a CRP. Amongst these flaws is the common trait of ‘mental accounting’, which all humans do when dealing with complex problems.

Since the biggest risks associated with sequencing are faced in the early days of the portfolio’s life, a common method used to manage investors’ moods is that of ‘bucketing’, in which the overall pot is split into a series of sub-pots with easier-to-understand aims and objectives.

A standard set up for this type of strategy involves the ‘ring fencing’ of the first few years’ worth of spending in a cash or cash-like portfolio. The remainder of the assets are then carved up into a ‘defensive’ bucket and a ‘growth’ bucket, with the defensive assets likely to be used up after the cash pot in order to allow the growth assets sufficient time to make capital gains.

Create a natural income

Another helping hand to the mental accounting process is the concept of ‘natural’ income. Here, the idea is to create an investment portfolio that produces a yield from the bonds, equities and properties within it for the client to live on. Readers of Jane Austen will be familiar with the concept, where a character’s wealth is expressed in the form of how much income their portfolio produced each year.

In a manner similar to the annuities concept, with spending needs taken care of, the temptation to constantly check on the capital value of the portfolio is lowered, along with the client’s stress levels.

Rebalance when it makes sense

An associated risk that comes alongside ‘sequencing’ is that of ‘pound cost ravaging’. This is the process where portfolios are eroded by virtue of being sold after dropping in value. It’s the opposite of how ‘pound cost averaging’ can help in accumulation mode. To guard against this, it makes sense to have a disciplined approach to rebalancing the overall portfolio over time, with the aim of rebalancing only after a period of strong gains. In a 30-year investment journey, investors should expect to witness at least four or five bear markets alongside multiple episodes of 20%+ annual gains. Rebalancing after the gains makes much more sense than locking in losses after a period of poor returns.

Bringing it all together

Using bucketing, natural income and a rebalancing trigger in combination won’t avoid sequencing risk in its entirety, but it can help clients avoid the pain and panic that comes with it. Without that panic mode, the likelihood of making sound, rational choices increases and clients can get on with enjoying their retirement, rather than worrying about whether they have enough funds to live upon.

To assist further with this aim, the use of a withdrawal policy statement (WPS) is also recommended. Through a WPS, a sustainable withdrawal rate can be agreed upon, together with a plan of what to do if investment markets are poorly behaved along the way. With an advance plan in place – and more importantly, a plan that is agreed in a non-stressed environment at a time when the client is likely to have more of their faculties about them – the stresses and strains of managing a portfolio through retirement are lowered again for the benefit of both clients and advisers alike.

Managing Director, AJ Bell Investments

Kevin began his career in the financial services industry as an Investment Analyst, eventually progressing to become Chief Investment Officer at a major private bank. He then took on the position of Group Head of Research & Strategy for a Luxembourg-based private banking group, before moving into a number of consultant roles for various investment management and banking businesses. In October 2017 he joined AJ Bell Investments as Managing Director and CIO.