This means that unless investment returns are higher than expected in the longer term the drawdown fund might not be able to sustain future income payments or there is increased risk of lower income and, in the extreme, of running out of money.
The classic way to demonstrate sequence of return risk is to show a drawdown fund over a given period where the returns rises in the early years, but falls in the later years. This is compared to the situation where the returns are reversed, that is, fall in early years, but rise in later years. The second scenario produces a lower fund value compared with first scenario one.
This example might seem too abstract, so it is helpful to look at a real life example. Chart B shows the sequence of return risk in practice over the period 1 May 2012 to 1 August 2017.
A total of £100,000 was invested in May 2012 and income equivalent to 3.5% of the fund value and increasing by 2.5% per annum. The fund was invested in a typical pension fund, which had 60 per cent equity content.
Chart B shows the value of the fund each month.
Although this is a short and perhaps untypical time period, it shows that sequence of return risk is real, not just something in text books.
There several ways of investing in order to reduce or eliminate the sequence of returns risk and these include:
- Paying income out a cash fund and topping up the cash in good years.
- Investing in "smoothed returns" funds.
- Using guaranteed funds and structured funds.
- Reducing (or stopping) drawdown when returns are negative.
Reviewing
In many cases, the success or failure of a drawdown plan hinges on the quality of the review process. This means reviewing the investment strategy to make sure it is on track to achieve the required returns in line with the client’s attitude to risk and is meeting the stated objectives. Reviews should take place at regular intervals and advisers should keep a watching brief to make sure the investment strategy reflects any changes in the economic and financial outlook as well as any changes in personal circumstances.
The point I make about reviews, especially as I am practising what I preach, is to keep a regular watching brief once a quarter and be clear of the parameters of the review. For example, reviving income requirements, any changes in attitude to risk and health.
The effect of charges
My view is drawdown is a premium product and so although price is important it is not the main driver. For most advisers it is more about quality than quantity. When looking at the costs of running a drawdown plan, the charges between the main Sipp providers are competitive and there is downward pressure on fund management fees. In practice, one of the biggest costs of running a drawdown is adviser fees.
