Are you exposing your DC members to sequencing risk?
Helping members achieve the best retirement outcomes under the new pension freedoms remains a major challenge for most DC schemes. Many of the ‘one size fits all’ flexi-access solutions that are currently being touted in the market will fail many DC members and potentially increase the risk of ‘sequencing risk’.
So what is sequencing risk? Sequencing is the order and timing of investment returns and the risk in pension drawdown is that negative returns (especially in the early years) can have a devastating impact on the value of the drawdown fund. This is because investment losses created by selling assets to meet cash/income requirements can never be recovered.
It is probably easiest to understand sequencing risk by looking at an example:
Two pension plans with the same withdrawal rate and same average return over a certain period can end up looking very different. Take the two funds below, from which the saver is withdrawing £6,000 a year in both cases.
Year | Fund A | Return A | Fund B | Return B |
1 | £100,000 | -10% | £100,000 | 20% |
2 | £84,000 | 10% | £114,000 | 10% |
3 | £86,400 | 20% | £119,400 | -10% |
4 | £97,680 | -10% | £101,460 | 20% |
5 | £81,912 | 10% | £115,752 | 10% |
6 | £84,103 | 20% | £121,327 | -10% |
7 | £94,924 | -10% | £103,194 | 20% |
8 | £79,431 | 10% | £117,833 | 10% |
9 | £81,375 | 20% | £123,617 | -10% |
10 | £91,650 | -10% | £105,255 | 20% |
11 | £76,485 | 10% | £120,306 | 19% |
12 | £78,133 | 20% | £126,337 | -10% |
13 | £87,760 | -10% | £107,703 | 20% |
14 | £72,984 | 10% | £123,244 | 10% |
15 | £74,282 | 20% | £128,568 | -10% |
Final | £83,138 | 7% pa | £110,611 | 7% pa |
Both funds average 7% per annum over the 15 year period but fund A ends up 25% lower as a direct result of the different sequence of investment returns.
For members wishing to use flexi-access, it is important to understand that everyone’s retirement will be different. As well as different needs for cash and income in retirement, members will have different personal circumstances, priorities, risk tolerances and finances. As such, how a member invests their pension, pre, at and post retirement, must be driven by all these factors if the best outcome is to be achieved and the risks mitigated. Quite simply, ‘one size fits all’ solutions for flexi-access do not work.
A more personalised approach is needed to mitigate this risk and deliver effective retirement strategies that match a member’s needs and objectives. There are two key elements to achieving this approach and these are:
- Having a tailored strategy.
As highlighted above, pension investment strategies should be driven by a host of factors and no two strategies will likely to be the same. Quite simply however, someone who needs more cash and income in the early years should have more invested in cash and defensive assets, to enable them to ride out a market crash – like the one we are experiencing currently. Some asset classes will typically perform well in adverse stock market conditions and are particularly beneficial when held in a diversified multi-fund strategy so that the gains can be accessed.
- Using a multi-fund strategy.
Not be confused with a multi-asset strategy, a multi-fund strategy uses a range of funds covering different asset classes whereas a multi-asset strategy is one fund that holds a range of asset classes within it. The problem with a multi-asset fund is that in selling units to meet income/cash withdrawals, you must sell across all the assets, crystallising both gains and losses. In a multi-fund approach, by consistently selling units in the funds with the highest gains, you capture profit and avoid crystallising losses in those funds that have fallen in value. As markets are cyclical by nature, these funds will typically recover in due course.
To deliver such a personalised approach requires a different type of member engagement. This isn’t something members can easily learn or decide for themselves and most members will need additional support. It is hard to look beyond regulated advice as the most effective solution to deliver this additional support.
Fortunately, some firms in the advice industry have innovated to develop affordable and effective solutions for DC schemes and their members, whether paid for or simply facilitated by the employer. These solutions are able to deliver the necessary personalised approach for DC members and provide reassurances to trustee, employer and member that the burden of risk, and recourse if necessary, lies with a qualified adviser under the regulation of the FCA and protection of the financial ombudsman scheme. Furthermore, many of the solutions are being delivered within the special HMRC allowance of £150 that exists for member pension/retirement advice.
Unfortunately, there are no deadlines or defined requirements for DC schemes to follow when looking to help members understand and maximise the new pension freedoms. Doing nothing or adopting simple ‘one size fits all’ strategies may unwittingly result in poorer retirement outcomes for DC members and trustees and employers being left holding the burden of risk.
Isn’t it time you found out how regulated advice solutions could help your DC scheme and members?
