"All advice firms may want to get on the front foot and consider how best to measure and respond to the risk to income for those accessing their pension."
The FCA's follow-up information request on the retirement income advice review demonstrates the areas they are keen to investigate in more detail. There are clearly a number of aspects where they are concerned with how the market is currently operating.
I thought a couple of questions, in particular, were interesting. In the second questionnaire, the regulator is keen to tease out “how the investments/portfolios are selected and aligned to the risk profiles for customers in decumulation”. They also ask about “the processes the firm has in place for monitoring and adjusting the income solutions as market conditions and/or the customer’s circumstances change”.
These questions suggest a direction of travel. As we wait for the outcome of the thematic review, all advice firms may want to get on the front foot and consider how best to measure and respond to the risk to income for those accessing their pension. After all, isn’t the core of the matter clients meeting their expenses for life to maintain their standard of living?
Beware of accumulation-related pitfalls
Advising a client in income drawdown means first assessing their risk profile. This is all about determining the likelihood of their income not lasting for life – and how much the income would go down.
The first step is a psychometric questionnaire exploring a client’s attitude to risk (ATR). When clients are building wealth, advisers need to understand their attitude to investment risk. However, in decumulation, a different approach is required to glean the client’s attitude to income risk, and the ATR questionnaire must be specifically suitable for those seeking sustainable long-term income. It’s all about understanding what outcome clients seek and how they feel about the risk of not achieving their desired outcome.
This is key: evaluating capacity for loss is also critical, but risk must be considered in light of long-term income stability, not volatility in capital outcomes.
Capacity for loss vis-à-vis income is the extent of possible loss that wouldn’t badly dent the client’s desired standard of living. At a minimum, this is the income required to pay essential expenses, considering all sources of income, including state pension and other pensions.
From this, it follows that firms must deploy a clear methodology for appraising the risk of income sustainability for funds and portfolios. The alternative is recommending investments that may be unsuitable for clients’ risk profiles.
It’s vital to understand the risk
‘Income at Risk’ is less complex than it might first appear. Think of it as a spin-off of capital risk, but in this context, we’re assessing the potential downside risk to income, not capital. Thus, instead of defining a capital outcome with capital invested, we need to define an income outcome. For this, we can opt for a sustainable income for life; this could be a level of income or allowing for set increases over time. Remember that we’re defining income simply to enable us to gauge the relative risk of different investment options.
There isn’t just one way to measure income risk, but it’s important to think about outcomes relevant to clients' goals. At EV, our methodology is founded on assessing, over three years, the risk of a drop in sustainable income or an income lasting for life.
Our approach assumes that this sustainable income is taken from the fund at a set level for three years and then measures the propensity for a fall in the income level if the sustainable income is recalculated.
Performance at the heart
Depending on how the fund performed over the three years, combining income received and capital growth, it’s possible that the client’s income could stay the same or even go up if the fund’s total return has been very positive. On the other hand, if there were poor performance, the sustainable income would need to be revised lower. The larger the potential downside, the greater the income risk.
This, then, is ‘Income at Risk’. It’s satisfying that this measurement approach creates a linear scale, divisible into five, seven or ten risk levels – with the highest risk being a one-in-four chance of experiencing a c.16% or worse downside in sustainable income level over three years.
Income at Risk also helps weigh up a client’s capacity for loss. The potential for reduced income can be examined in the context of other income sources, e.g. state and other pensions. It’s very useful that the methodology is largely independent of the client’s current age and life expectancy.
A major reason for income drawdown not working properly for many at present is that funds and portfolios utilised for income drawdown are not robustly matched to the risk that retirees face, namely risk to the sustainability of their income.
In a recent survey by NextWealth, 59% of advisers reported using the same accumulation methodology for decumulation. Using capital volatility is just plain wrong for anyone looking to live on an income in retirement. As advisers wrestle with how to respond to the regulator’s likely findings from the thematic review, isn’t it about time to see that funds and portfolios are also risk-rated for income?
When the overriding goal is to secure an income for life, nothing less is letting down deserving clients and their dedicated advisers.
