Emma Wall: Hello, and welcome to the Morningstar series, Ask the Expert. I'm Emma Wall and here with me today is Morningstar's Daniel Needham to talk about drawdown. Hello, Daniel.
Daniel Needham: Hi, Emma.
Wall: So we're running a Retirement Week Special. We're going to start with what exactly is drawdown?
Needham: Sure. I think drawdown is a very important concept for those seeking to fund their retirement from their life savings. So, effectively drawdown is building an asset allocation strategy that is designed to fund people's retirement spending right through until their inevitable death.
And so there are different ways that you can build multi-asset portfolios. And the way I would kind of simply describe it is that most multi-asset portfolios that people would be familiar with have been built for accumulation that is maximisng the amount of wealth that somebody has at retirement.
Whereas drawdowns is saying, okay, we've gotten savings to retirement, well, how do I then take them all the way through so I can fund my living expenses as I'm no longer working and saving, and also maybe even leave some assets behind for my family.
So that's the concept of drawdown. There are a few differences between accumulation and drawdown that are quite important when building drawdown strategies.
Wall: And of course, now that we're in a world of pensions freedom, more people will be able to invest in these drawdown strategies. Having said that, they are not suitable for everyone are they because there are some risks with drawdown, there is capital risk unlike with annuities?
Needham: Yes. I think the U.K., obviously, with some of the pension reforms that are being announced, I think, is facing a big shift in demand for retirement products. And so, whereas previously people have needed to take an annuity for a fair chunk of their pension savings, now they're going to have flexibility to buy different types of products.
And in many ways, annuities are a form of insurance. I provide a lump sum upfront and that gives me guaranteed payments for life assuming it's a lifetime annuity. Therefore, I'm removing the risk and uncertainty of receiving those payments. So provided I am alive, I'll receive those income payments.
For drawdown, that's different. You're investing yourself to build a portfolio to fund those payments. So, there are three main risks that people need to be worried about when building drawdown portfolios or when managing retirement savings. The first is longevity. So outliving one's saving. So if you don't have enough in that part then that's going to be difficult to fund retirement.
The second is what's called sequence risk. So imagine that you've been adding to your pot throughout your working life, when you stop adding to your pot of retirement and you start to draw away from that pot, and there is a mathematical sort of dynamic, which is called sequencing risk, which means that if you have really negative returns early in your retirement, it significantly impairs your ability to fund your own retirement because big negative returns early affect the amount of capital that you have later on. And that's something that isn't prevalent within accumulation, because you're adding to the portfolio.
And then the final risk is inflation risk. So changes in inflation reduce or erode the purchasing power of your savings. And so, any drawdown strategy needs to manage those three risks. And I think depending on how much wealth you have or savings you have at retirement, those risks can be quite difficult to manage for individuals.
And so annuities we believe can still have a role in people's portfolios. And so I would say the risk is that kind of people throw the baby out with the bath water. They move away completely from annuities, which I think would be a mistake for many people. And so there are risks that people adopting drawdowns aren't able to achieve what they were able to achieve with an annuity.
Wall: You touched on it there, here at Morningstar we’re real advocates of the long term portfolio approach to retirement income. That's; maybe annuitise part of your retirement savings; use part of your retirement savings in a drawdown strategy, maybe have part as a lump sum. Using those things together, you can in part help to mitigate some of those risks you talked about.
Needham: Absolutely. I think often there is rarely one solution that's right for anybody. I think everybody has their unspecific circumstances, and I think, especially with retirement. So I think a much more sensible approach is to include a number of different tools within the retirement toolkit.
And I think lifetime annuities still should play a prominent role, but I think having a multi-asset portfolio that's geared towards drawdown, that recognises it needs to produce a regular income stream or needs to be used to fund an income stream is important.
I also think that people have that flexibility now to take some money out of their pension savings and maybe put it into a different account that's easy to access. I think it's complicated and it requires people to really think through what is right for them, and obviously, the role of a financial advisor can be quite important with that. I think for those that are looking to do things themselves, they really need to do their homework.
Wall: Daniel, thank you very much.
Needham: Thanks Emma.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
This article was originally published in April 2015
