The process of converting retirement savings assets into an income, which has come to be known as decumulation, needs first to be placed in context. The decumulation phase of retirement savings is that period when an income is drawn from the investment fund as contrasted to the savings period when savings are being contributed.
It is perhaps not well understood that the total pension income achievable is heavily dependent upon investment performance in this post retirement period. In fact, under an investment strategy delivering uniform returns over the entire term of the scheme, the investment accrual post-retirement is greater than the pre-retirement result for most. The importance of post-retirement investment returns increases in relative terms if contribution savings are made later in the working lifetime, and obviously if the period in retirement, and funds permit, is longer.
The relative importance of contributions, investment returns and taxes is also merits bearing in mind. Contributions typically account for less than 10% of the total pensions finally paid with investment returns accounting for the 90% balance. The tax components are also important – under current UK tax concessions and deferrals, they account for 47.5% of the pensions finally payable.
This immediately raises two issues. First, George Osborne’s often repeated line at the time of introduction of “Freedom & Choice” to the effect: “It’s your money” when almost half of it is in fact our (tax) money. Even if all pensioners paid income tax at the highest current marginal tax rate of 45% (and they don’t), it is evident that there is a tax subsidy here. Second, if we move from the current EET arrangement to TEE, and savers maintain their present disposable income, then contributions will be smaller with the consequence that the size of pension pots will decline. The exemption from income taxes of the retirement income will not offset this decline. One incidental effect of all retirement income being tax exempt would be the effective end of the 25% tax-free lump sum. Indeed, the move to tax-exempt retirement income would remove one of the few barriers to the immediate consumption of all retirement savings.
Though more could be said about tax incentives, the subject of this article is decumulation. The effects of uncertainty and variability of investment returns appear not to be well understood. The first point is that the order in which investment returns are achieved matters. Low returns early in the decumulation process will restrict the amount that can be paid if total depletion is to be avoided. We illustrate this below (figure 1) with a sequence of random returns; the same returns are then reordered so that the losses are experienced first. The pension income drawn is 5% of the value of the pot in both cases. The outcomes are starkly different, as is shown in table 1.
Table 1
The minimum pension is £2.00 in the random case and just £0.10 in the ordered. Though these pensions are in each case 5% of the value of the pot, the average pension received with random ordering is £3.69, and just £0.47 when ordered, and highly uncertain as is indicated by the volatility. The ordered sequence generates a pension income that is just 13% of the random; it is clear that luck plays a big part in individual pension outcomes.
Figure 1: Evolution of value of pension pot under ordering and randomness.
Considering, as is illustrated in figure 2, a fixed annual drawdown (of £5) brings out some further points. First, the ordered sequence exhausts its funding after just eight years, far less that average retirement period expectations.
Figure 2: Evolution of the residual pension pot under fixed amount drawdown.
The second point to note here is that random pot also ultimately exhausts its value, after 76 periods. This is not predominantly an effect of the return sample properties. The arithmetic mean of the sample was 4.85% over the period prior to exhaustion, and that small difference from the £5 annual withdrawal would take far longer than is evident to fully deplete the pot. This is an effect of the volatility of the process, which generates a drag on compound realised returns. With 10% volatility, as is used in this illustration, this is expected to be 0.5% p.a. If the volatility of the investment process were 20%, this would be expected to be 2% p.a. and have the effect of depleting the pot far faster – then it is expected to last just 30 years.
Costs, management charges and fees, are obviously important to the performance and viability of a drawdown pension, but the major issues there were covered in my Professional Pensions article “Why costs and fees matter.”
These calculations and illustrations draw out some of the principle technical issues faced by drawdown strategies. First, that investment returns are extremely important; holding cash with little or no investment yield is deficient in this regard and particularly so when this is held in the early years of retirement. Second, the variability of investment returns is important in terms of the evolution of the value of the investment pot even if no assets are liquidated in markets to produce income. The challenge is, self evidently, to select an investment strategy which generates sufficient returns but is not excessively risky.
The second part of this article will cover approaches to this problem.
[1] These figures are derived from a forty year term with annual contributions of 15% followed by 25 years in retirement drawing a two thirds final salary pension and a fixed investment return of 5%.
[2] These are random drawings from a normal distribution of 5% mean and 10% volatility. The sample stats are 4.72% mean and 9.1% volatility.
Con Keating is a genius – (Pension Plowman)