Platforum: DFMs need to create decumulation models


By now, we have all heard about pension freedoms and regulatory reforms.  If financial advisers ever needed more discussion topics when meeting clients, there is now plenty to talk about.

Stakeholders across the retail finance industry are keen to take advantage of the opportunities the new measures bring. Some are launching innovative retirement solutions with one of the latest being the centralised retirement proposition (CRP).

Until now DFMs, providers and advisers have largely focused on developing centralised investment propositions (CIP) for the accumulation stage. However, CIPs are inadequate in addressing the specific challenges of decumulation.

A CRP, however, is built on the premise that investing in retirement, or decumulation, is fundamentally different from investing during the accumulation phase. The diagram below identifies the underlying sources of this new investment challenge.

So far, advisers don’t appear to have developed systematic, formal processes or policies for their drawdown advice. Every client tends to be dealt with on a bespoke basis. This is time consuming and prone to inconsistent advice. The reform measures have therefore created an urgent need for financial advisers to seek new scalable propositions centred on retirement planning.

Few firms have propositions in place that specifically address retirement planning. For those that do there are generally three approaches – each with its own difficulties and drawbacks:

  • Rely on natural income streams generated by the investment portfolio and avoid drawing funds from the capital base.

Drawback: If the income generated turns out to be disappointing, clients may end up drawing down from their portfolio’s capital base, locking in investment losses at times of market stress.

  • Maintain a large cash or cash equivalent allocation to cushion against unforeseen market conditions or personal circumstances, and to prevent selling assets at depressed prices.

Drawback: The need to replenish the cash cushion as it is eroded over time will introduce market-timing issues.

  • Employ a volatility focused multi-asset approach using derivatives to protect against downside risk.

Drawback: Volatility measures the spread of returns without accounting for the direction. In reality, investors are far more worried about losses than gains. Managing volatility alone also does not take into consideration inflation risk, which is more important in decumulation portfolios.

Only time can tell which, if any, of these approaches will turn out to be the right one, but standing on the sidelines is probably not a prudent business development strategy. Fund managers not traditionally in the retail space are keenly eyeing this emerging opportunity.

Conversations with alternative investment providers reveal that some private equity fund-of-funds managers are at the preliminary stages of developing a retail retirement investment proposition. In light of the limitations of existing DFM propositions in addressing decumulation challenges, developing a credible and sustainable CRP may turn out to be a key distinguishing feature for DFMs.

Sophie Huang is senior researcher at Platforum.