The Dilemmas of Decumulation

As increasing numbers of clients finish their full-time work and enter a new phase of their lives, the challenges and responsibilities for advisers are greater than ever. Decisions made on investment strategies can have hugely significant and potentially life-changing consequences for their clients.

There are a plethora of options to choose from in retirement: go all in and buy an annuity early to deliver certainty of income, but risk locking in low rates and deplete your estate; go full drawdown but risk capital erosion and the danger of insufficient income later in life; or try and get the best combination of investment solutions to suit requirements at the time.

The Product is Advice

Product providers have taken to offering all sorts of wonderful solutions for post-retirement or ‘decumulation’ investors, some of them seem incredibly complex when all they’re really doing is taking different investment building blocks (fixed income, mixed investment, perhaps some capital protection elements) and bundling them together with some snazzy literature.

The most important thing to remember is that the advisor is the key part of any decumulation planning – they have regular contact with clients, know them well and can adapt to suit individual requirements and circumstances, in particular as they change or are influenced by different life events: inherited wealth; illness; gifts for children; overall inheritance tax planning; domicile and residence etc. So a range of products should be deployed and, importantly, advisors need to retain the ability to take account of circumstances.

In practical terms, the use of whole life annuities would ordinarily be best much later in retirement, from age 75 and over. This allows for greater flexibility in financial planning in early retirement and also removes most of the interest rate risk from the products. The key determining factors affecting annuity income rates are prevailing longer-term interest rates and mortality assumptions (how long is the annuitant expected to live). At older ages, the biggest influence will be the expected term of the annuity (how long will it be paid for) rather than prevailing interest rates. Additional factors always worth considering include the annuitant’s health and lifestyle choices – unhealthy smokers aren’t expected to live as long as health non-smokers and this is reflected in higher annuity rates.

What is Sequencing Risk?

Perhaps the biggest issue for decumulation investors is eroding their lump sum too soon by drawing down capital to pay their living expenses. How their portfolio behaves during this period can be critical and the order in which investment returns are realised becomes very important. This is often known as ‘sequencing risk’. Even if two investors experience the same average return over time, the one who suffers negative returns early in retirement or income drawdown may run out of money significantly faster.

Withdrawals during market downturns mean the investor sells more units at lower prices, which means there is less capital left to benefit from any future recovery. Once capital is depleted, the portfolio can’t recover — even if markets rebound later.

How Smoothed Funds help manage Sequencing Risk

One solution to the problem of sequencing risk is the use of Smoothed Funds, which are designed to reduce the impact of short-term market volatility on investment returns. By gradually adjusting the fund’s unit price in line with long-term expectations — rather than immediate market fluctuations — it helps to provide investors with greater stability and predictability in the returns they experience.

Smoothed funds can reduce the risk of locking in losses during temporary market downturns, which means fewer ‘units’ need to be sold to fund income payments and the capital preservation extends the longevity of the portfolio.

The Role of Smoothing

This chart shows two return paths with the same long-term outcome.

• Price 1 (green) represents a smoothed return path — consistent and stable.
• Price 2 (grey) experiences early losses and delayed recovery.

Even with the same long-term returns the timing of those returns makes a material difference when withdrawals are involved.

The Drawdown Impact

This chart assumes a starting pot of €600,000 and regular withdrawals of €15,000 every 3 months.

• Pot Value 1 (green) portfolio remains resilient, retaining over €200,000 after 10 years.
• Pot Value 2 (grey) portfolio is depleted before the 10-year mark due to early losses.

More stable returns during early withdrawals help preserve capital and improve long-term outcomes.

If you want to know more about smoothed funds, do get in touch.

Clive Moore, IDAD