A couple of weeks ago I presented to a large group of financial planners a Case Study on constructing a portfolio for a pension drawdown situation. The case study required an annual drawdown of around 10% of the portfolio balance which given dividend yields, current interest rates, and low expected return potential meant the portfolio situation was going to require some type of capital drawdown. To make things a little more difficult the hypothetical investor was classified as a ‘middle of the road’ risk type…or “balanced” investor.
So how should we construct such a portfolio? I would say most financial planners would typically set aside two to three years of drawdown into cash and invest the remaining assets into a balanced type portfolio or maybe a diversified portfolio with a little more risk given the cash allocation. A second common solution is simply to invest the whole lot into a balanced portfolio and draw down across all asset classes so as to maintain the Strategic Asset Allocation that matches the balanced risk profiile. The problem with both of these solutions is that they are quite inefficient due to the possibility of being forced to sell equity positions within three years to fund cash flow.
My proposed solution, put forward for the purposes of discussion, was to firstly satisfy the investor’s cashflow needs with a minimum of five year Nil RCV (i.e. expires at end of term with a zero balance) annuity and with the remaining funds invested in a high growth equities only portfolio that will hopefully grow sufficiently to replace the annuity at maturity. To me, having a minimum of a five year timeframe for an equities portfolio is a lot better than between not much and three years which is largely the current practice. It may not be the perfect solution but satisfying a client’s cashflow needs for at least the next five years is very attractive to most investors and a lot easier to manage.
The response I received from the audience was quite disappointing and could be summed up by two themes…
- Thoughts that the strategy is non-compliant, and
- Existing systems made recommended such a combination difficult
In terms of non-compliance the audience felt that because the asset allocation shifted to 100% High Growth portfolio at the end of the annuity term that it was non-compliant. This is completely false. An investors asset allocation changes every day and there is absolutely nothing in legislation that suggests rebalancing must occur or that an investor’s asset allocation must meet the corresponding Strategic Asset Allocation over time. Once again, what the proposed solution provides is a satisfied client in terms of cashflow for at least the next fiveyears from an annuity and a second portfolio that is designed for growth over that same period so as to, hopefully, continue to provide income for a lot longer. This strategy is completely compliant and first and foremost meets the client’s needs. If the client has concerns then it doesn’t matter what the risk profile of the client is these concerns must be addressed but that is a separate issue.
The second point disappointed me most. Whilst Nil RCV annuities are not currently available in master trusts or wrap platforms that is once again quite irrelevant to the client’s needs. If existing systems don’t quite make it easy for paraplanning or ongoing reporting then tough luck…if its the best solution for the client then a bit of additional work for the client’s benefit should be considered…in fact perhaps it is justification to charge additional fees.
My general observation in recent years of the methods of portfolio construction for the retail investor in this country is that portfolios are designed to firstly be compliant within business rules and secondly to match client’s needs and unfortuantely the thoughts around compliance get a little bit carried away. Client needs must always come first and if they are met and all risks and fees are disclosed and the client is still happy then there will never be a problem. Throw in some ongoign communication and needs reviews and if the strategy still applies then it should be happy days.