Helping your members make their money work in retirement: how ‘no risk’ is risky

I’m sure most of us are at least vaguely familiar with the Parable of the Talents, even in this secular age. The version found in the Gospel of Matthew goes like this:

A wealthy merchant departs on a journey. Before leaving, he entrusts three servants with some talents (units of currency). To one he gives five talents, to the second he gives two, and to the third he gives a single talent. When he returns he finds that servants one and two have doubled his money by investing it. The third servant, fearful of risking the money, had buried it in a field during his master’s absence. He digs it up and returns it with no profit. The merchant is pleased with the first two servants and angry with the third for not making his money work. He punishes him by casting him into the outer darkness.

Like all biblical parables, this has numerous interpretations. Here, I’m taking its meaning very literally: failure to take any risk with your capital can be harmful.

Which brings me to the Retirement Outcomes Report (ROR) published by the Financial Conduct Authority (FCA) on 12 July 2018. This report assesses the efficiency and fairness of the retirement market, following the radical changes brought about by the pension freedoms in April 2015. Covering the period April 2015 to September 2017, the ROR is a 78-page document with five annexes. It’s big; and it raises a great many issues. My purpose here is not to attempt to summarise it but to focus on some salient statistics and their implications. First:

33% of consumers in non-advised drawdown were holding their money entirely in cash

As is often the case with pensions, stats like this come as a bit of a shock without being surprising.

Some policyholders, according to the ROR, have their residual savings moved into cash in a drawdown account by default when they withdraw tax-free cash. This is completely unacceptable. It doesn’t happen with modern, freedoms-compatible workplace pension contracts, which automatically move policyholders into investments capable of generating a decent sustainable income. This particular problem occurs with older, pre-freedoms policies.

Many people don’t realise they’ve moved wholly into cash. Others, very averse to risk, have chosen to go there. Either way, they are all in a worse position than the third servant. In an environment where the base rate has been below 1% for nearly a decade, the interest earned by cash will be less than the rate of inflation (2.5% at the time of writing), so its real value is being eroded. Not only that, cash will almost certainly be earning less than the cost of the pension policy it is held in. Being too averse to risk is risky.

That’s not to say that it’s inadvisable to hold some cash. Almost everybody takes their 25% tax-free cash lump sum, so modern default funds usually move that proportion gradually into cash as retirement approaches. Once drawdown income is being taken, it’s a good idea to hold enough cash to meet income needs for up to a year, to avoid continually disinvesting from other assets at what may be inopportune times.

More stats:

Between 56% and 76% (the percentage varies according to pension value) of consumers who went into drawdown did so simply because they wanted to access some tax-free cash

33% of consumers in drawdown didn’t know where their money was invested

Evidently, a sizeable proportion of people don’t regard drawdown as a product designed to generate income throughout their retirement. It is seen as a side-effect of taking some tax-free cash; or as a temporary expedient; or it is not really thought about at all.

Non-advised drawdown, then, is problematic. However, for those with responsibility for workplace pensions, there are a couple of steps you can take to help ensure your members are able to achieve a good outcome:

1. Ensure your workplace pension schemes are up to date and fit for purpose

It’s not uncommon for schemes to predate the pension freedoms by years. Some have been running for more than a decade and are hopelessly unwieldy and outmoded. Employees paying into a scheme that hasn’t adapted to the freedoms are seriously disadvantaged.

Although it is not (yet) a legal imperative, it is prudent for employers to have a governance regime in place so that their scheme’s price, performance, flexibility and efficiency are regularly scrutinised. And it is judicious to test the market every three to five years. How can you evaluate what you’ve got if you don’t know what else is available?

2. Provide financial education in the workplace, especially for those approaching retirement

Time was, nearly everyone bought an annuity when they retired; they had little choice. Now, they have options — and important decisions to make. Annuities are still suitable for retirees unwilling to take investment risk, but the vast majority of people are going into drawdown, giving them the ability to retain their capital and take income flexibly. They need guidance before they finally leave the workplace on how drawdown operates and how to make it sustainable. This means being helped to understand risk and volatility, so that they are comfortable with adopting a multi-asset investment strategy and don’t panic when markets fall. Equities (stocks and shares) in particular will fluctuate significantly in value – but over the long term, a multi-asset approach will provide, potentially, much higher returns than cash.

My final stat from the ROR puts all of this into perspective:

Consumers in cash could get an income up to 37% higher over 20 years by moving to a mix of assets

The third servant, who buried the money to avoid risk, was consigned to the outer darkness, where there is weeping and gnashing of teeth. That isn’t how we want people to be spending their retirement.

By Noel O’Hora, business planning consultant, Lorica

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