Overview
In a research paper we produced last year1 we observed:
“Soon, many individuals in the UK will reach retirement with accumulated pension savings solely in defined contribution (DC) form. The “freedom and choice” reforms to the UK pension system introduced back in April 2015 (yes, it was eight years ago) offered individuals greater flexibility in how they structure and manage the provision of their retirement income but did not deliver the supporting tools in terms of products, advice and services, to help them navigate the new world. The working assumption has been that the insurance and pension industry would address this and fill the gap over time. Indeed, progress has been made though we believe many would agree it has been slower than envisaged back in 2015.”
Picking up on the theme of “making progress,” we note that the UK Financial Conduct Authority (FCA) published, in March 2024, its thematic review of retirement income advice.2 The review has highlighted several areas requiring improvement from firms within the retirement market to ensure that the needs of retirees are robustly addressed. Those of particular relevance to the topic in this note are:
- Where customers move into the decumulation phase, there needs to be a greater emphasis on tailoring customers’ risk profiles to an income-focused objective. This includes consideration of an individual’s capacity for loss and planned withdrawal profile to help avoid customers taking on more risk than is appropriate in their circumstances or drawing down excessively large amounts and risking running out of money later in retirement.
- The advice given to customers is more likely to be suitable if the advice model was developed with the needs of customers in mind, including for Centralised Retirement Propositions (CRPs).
The FCA’s thematic review has led to advisers developing or revisiting their CRPs and considering incremental solutions that can improve customer outcomes in a decumulation context.3 One such solution is to combine a drawdown product with an annuity, which aims to provide a level of guaranteed income for life whilst still offering scope for long-term investment growth on the proportion not annuitised. Such hybrid retirement products are not new in the market and some insurers have been offering them for some time. However, we understand there is renewed interest amongst retail financial advisers as they think about their approach to addressing some of the challenges raised within the FCA’s thematic review.
A detailed discussion of the rationale for combining annuities and drawdown is beyond the scope of this note but, for those seeking more information, please see the Milliman paper “Annuities Reinvented.”4
Residual risks of hybrid products
Although hybrid products offer scope to improve customer outcomes and deliver some risk protection, there are residual investment-related risks in the drawdown element that remain to a material extent: sequencing risk and the risk of extreme market volatility.
Market volatility
Advisers seeking to achieve reliably good customer outcomes within their CRPs are likely to consider the level of protection in place against adverse market shocks, in particular given market volatility in recent years.5 Traditional investment strategies seek to mitigate market volatility through diversification across a variety of asset classes whose returns are expected to behave differently. Taking a simple example, investing in both equities and bonds can reduce portfolio risk if, when equities fall in value, bonds tend to increase in value to provide some offset (a negative correlation between the two asset classes). However, in recent years this negative correlation has been less reliable. For example, in 2022 equities and bonds were positively correlated and both fell in value as shown in the “bear market” graph in Figure 1. This had a negative impact on the investment performance for many pensioners’ accumulated funds.
Figure 1: “Bull” and “bear” market years
Note: Results shown are historical and do not guarantee future results.
Sequencing risk
Another difficulty for advisers aiming to achieve good outcomes for their customers is sequencing risk, i.e., the fact that the choice of timing of retirement relative to the market cycle can lead to wide variations in customer outcomes. This is demonstrated in the graph in Figure 2, for a retiree aged 65 with a £100,000 fund, invested in 80% equity 20% bonds, taking an income of £5,000 each year increasing in line with the UK Retail Price Index (RPI). In the first scenario starting at the end of 2001, commencing retirement in a market downturn and experiencing another market crisis in 2008, the fund value at age 75 is £64,000. In the second scenario starting at the end of 2011, commencing with markets rising for several years, followed by a market crisis in 2020, the fund value at age 75 is £168,000. Annuitising part of the retirement pot helps to offset a portion of the sequencing risk, as that part of the income is guaranteed. However, there may be considerable residual exposure as the remainder of the pot is invested in the equity and bond markets.
Figure 2: Example outcome for customer aged 65 with £100,000 pot
Note: Example shown for illustrative purposes only. Does not represent an actual outcome or actual investment.
A solution to further mitigate these residual risks and narrow the range of potential customer outcomes is to have in place a risk management strategy applying to the fund, to stabilise the volatility of fund returns and mitigate some of the impact of material market downturns on the fund value. This could be achieved by using well established hedging techniques, for example by allocating a small proportion of the portfolio to a managed futures strategy. The managed futures would sit alongside the remainder of the fund invested in equities and bonds. In benign market conditions (i.e., with low volatility), there would be an ongoing cost for the managed futures. However, in more volatile markets, should the remainder of the portfolio perform negatively, then the managed futures would “pay out,” act to provide a cushion to offset against the extreme losses.
Utilising hedging techniques such as managed futures within the fund can greatly reduce sequencing risk and volatility, which as described are major residual risks with popular decumulation strategies, even those with a partial annuity holding. The graph in Figure 3 shows the example as described above in Figure 2 for a customer aged 65 with a £100,000 pot invested in 80% equities and 20% bonds, with and without an allocation to a managed futures strategy. Within the modelling for this example, we used Milliman’s Managed Risk Strategy6 for the managed futures component.
Figure 3: Example outcome for customer aged 65 with £100,000 pot, with and without managed futures
Note: Results based on simulated or hypothetical performance. Results have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-compensated or overcompensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. Milliman does not manage the underlying fund.
The results show that, by including the managed futures fund component, the range of outcomes after 10 years is narrowed by approximately 50%—a considerable reduction in uncertainty for the customer in this example. We note that performance may differ over different scenarios, investment choices and model assumptions, and past performance may not be a representation of future performance.
Summary
Although annuitising a portion of the fund provides a level of guaranteed income, which can act to cushion against negative performance in the remainder of the portfolio, investment-related risks remain in relation to the drawdown fund. These risks can drive potential variability in income that may still be significant for customers and could lead to poor outcomes in adverse market conditions.
Hedging techniques can help to complement a partially annuitised decumulation strategy by including an additional layer of risk management, alongside traditional asset diversification, to reduce the residual investment-related risks, offering scope to improve both the stability and sustainability of customer income. Thus, we believe including managed futures within a decumulation portfolio can enhance advisers’ CRPs.
Please reach out to Milliman if you would like to discuss further.
Disclaimers
The information, products or services described or referenced herein are intended to be for informational purposes only. This material is not intended to be a recommendation, offer, solicitation or advertisement to buy or sell any securities, securities-related product or service or investment strategy, nor is it intended to be to be relied upon as a forecast, research or investment advice.
The products or services described or referenced herein may not be suitable or appropriate for the recipient. Many of the products and services described or referenced herein involve significant risks, and the recipient should not make any decision or enter into any transaction unless the recipient has fully understood all such risks and has independently determined that such decisions or transactions are appropriate for the recipient. Investment involves risks. Any discussion of risks contained herein with respect to any product or service should not be considered to be a disclosure of all risks or a complete discussion of the risks involved. Investing in foreign securities is subject to greater risks, including: currency fluctuation, economic conditions and different governmental and accounting standards.
There are risks associated with futures contracts. Futures contract positions may not provide an effective hedge because changes in futures contract prices may not track those of the securities they are intended to hedge. Futures create leverage, which can magnify the potential for gain or loss and, therefore, amplify the effects of the market, which can significantly impact performance.
The recipient should not construe any of the material contained herein as investment, hedging, trading, legal, regulatory, tax, accounting or other advice. The recipient should not act on any information in this document without consulting its investment, hedging, trading, legal, regulatory, tax, accounting and other advisers. Information herein has been obtained from sources we believe to be reliable but neither Milliman Financial Risk Management LLC (Milliman FRM) nor its parents, subsidiaries or affiliates warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties.
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1 Dissanayake, D., Howell, C. & Ward, R. (October 2023). Retirement Income in a Defined Contribution Pensions World. Milliman Report. Retrieved 7 August 2024 from https://www.milliman.com/en/insight/retirement-income-in-a-defined-contribution-world.
2 FCA (20 March 2024). Thematic Review of Retirement Income Advice. Retrieved 7 August 2024 from https://www.fca.org.uk/publications/thematic-reviews/thematic-review-retirement-income-advice.
3 Smith, S. (4 June 2024). Financial Advisers Take Action Following FCA's Retirement Income Advice Review. Retrieved 7 August 2024 from https://www.pensionsage.com/pa/Majority-of-FAs-reviewing-retirement-offering-following-FCA-thematic-review.php.
4 Lin, P., Tassoni, M.-L. & Vosvenieks, F. (October 2018). Annuities Reinvented. Milliman White Paper. Retrieved 7 August 2024 from https://www.milliman.com/en/insight/annuities-reinvented-are-annuities-the-missing-asset-class-for-sustainable-drawdown-solut.
5 For the MSCI World Index, in the period between 2020 and the present day the 30-day realised volatility reached a high of 73% (in 2020). We do however note that in 2023 and 2024 volatility has been more subdued (remaining below 19%). Source for quoted figures: Bloomberg.
6 This has been modelled using the Milliman Managed Risk Strategy calibrated to a particular risk profile and with assumed futures transaction costs of 0.03% per annum (p.a.) and a management fee of 0.2% p.a. More information on the strategy can be found at: Milliman Managed Risk Strategy at https://www.milliman.com/en/services/milliman-managed-risk-strategy .