This article was written by Chris Gilchrist and published in The IRS Report in October 2011.

How to manage decumulation

Over the past 30 years, developments in finance in the US have usually been 5-10 years ahead of those in the UK, though the time gap is shrinking. Now, as the baby boomers approach their retirement, the US is confronting what is likely to be the biggest issue in personal finance for the next few decades: decumulation. Already there are indications of what will prove to be the optimal strategies.

Decumulation is the ugly word now being used to describe the process of drawing on the funds accumulated over a working life to fund a longer and longer period in retirement. It presents enormous challenges for society and for investors:

• Longevity has risen steadily over the past two decades and continues to invrease. Today's expectation is that one in four 65-year-olds will make their century. But who will live that long and who will die early? Should you plan to fund a 15- or 30-year retirement?
• Inflation has mostly been low over the past two decades, but even 2% inflation over a 30-year term reduces the purchasing power of £1 to 55p. So the traditional fixed annuity, chosen by the bulk of today's retirees, is highly unsuitable as a way of generating the bulk of your retirement income.
• Investment returns in the past decade have proved more volatile than many had expected, and catering for similar volatility in future makes designing investment strategies extremely difficult.

For the small minority of people approaching retirement in Defined Benefit (final salary) pension schemes which provide fully or partly inflation-proof pensions, none of these factors are relevant. The old DB system insulated members from all these risks. But current DB members, who are having to contribute more and get less benefits, do have to think about the issues and so do high earners who are now limited in the maximum amount they can put into any kind of pension scheme. As for Defined Contribution scheme members (all personal pensions and the vast majority of private sector occupational funds), the issues are key to their retirement provision.

The longevity issue is one where governments, academics and clever bankers are devoting their energy. A powerful lobby group is trying to persuade the government either to assume longevity risk (as a "tail insurer"), or at the least to issue small tranches of "longevity bonds" so that insurers can use these to price longevity. The issue of longevity bonds would independently price one of the elements of the traditional annuity, and enable this risk to be baked into other forms of financial product. The Treasury has reluctantly agreed to engage in research into the topic and DC lobbyists are likely to exert more and more pressure for action.

Inflation risk is already priced in themarket by index-linked gilts, but the problem is that the demand for these has consistently been well ahead of supply in recent years, so the cost of buying an index-linked annuity is so high that very few annuitants contemplate it for more than a few minutes. Crossovers in terms of annual income (index-linked versus fixed annuity) are typically around the 20-year mark for a 65-year-old, and few people at that age feel confident of living those 20 years let alone the further 10 or so years afterwards needed for them to come out ahead in terms of total income payments.

Of course these figures are very sensitive to the actual as opposed to the expected inflation rate, and behavioural finance confirms that our tendency to assume that the future will be like the past dominates our financial decisions. So we overweight the generally low inflation of the past two decades in planning for the future. Yet in a future period of 30 years, I would argue that there is a high probability of a period of at least three or four years of high (5%-plus) inflation. That alone would be enough to slash a fifth off the purchasing power of a fixed income.

Variable investment returns present huge challenges to all investors, but for those who expect - as most retirees will - to consume at least some of their capital during retirement, the problem is most acute. If, as Douglas Moffitt does with the Rising Income Retirement Portfolio, you expect to live off the natural income of an equity portfolio, and can accept the "meltdown" risk on the basis that if these blue chip companies all fail to pay dividends then even gold bars under the bed are not going to save you from disaster, you can ignore market volatility completely. Otherwise, you need a strategy that limits the risk of capital erosion by damping down volatility.

At present, such strategies are in short supply. Construction of a conventional portfolio of collective investment funds for decumulation must rely on one of two management techniques:

• Market timing: this can take the form of taking money off the table in good years to fund the income need until the market recovers, or of much more aggressive buying and selling in anticipation of market trends. Evidence says the latter policy involves high risks, while the former only taken the edges off the knife rather than removing it from the murderer's hand.
• Non-conventional funds: hedge funds, absolute return funds and funds investing in "alternative" asset classes such as timber or infrastructure aim at non-correlation with equities. And there is good evidence that a more widely-diversified portfolio in terms of asset classes is more resilient. The two major problems are actual fund selection and the costs, which are typically expense ratios greater than 2% of the assets.

So what are the solutions being tested in the US market? They build on the success of target date funds, which manage the asset allocation of a portfolio based on the number of years to retirement. And they do away with the cliff-edge separating accumulation from decumulation.

One decumulation plan involves the pre-purchase of fixed annuities with part of the capital, though the providers refer to "guaranteed income" and never use the hateful word "annuity". By the time you retire, you have a slice of your target retirement income, say 50%, secured (with partial inflation-proofing), and as you get older you switch more and more of your capital from investments into annuities.

Those with long memories among you may recall a UK product called the "deferred annuity", which operated on a similar basis.

Such strategies require huge scale to be operated at reasonable cost, because for each cohort of 65-year-old retirees the provider needs to offer several different profiles depending on their requirement for jam tomorrow, and also taking into account their actual life expectancy based on their state of health. Huge size also permits the wide and low-cost diversification of asset classes. Most such products in the US are therefore offered by insurance companies. A few solutions offer a set of elements that you can mix-and-match to create your own profile, and these products are mediated by financial advisors. That is probably the first way such products will become available in the UK, but their cost will be high - though perhaps not as high as that of the few "guaranteed" products currently available.

It is only when such solutions are integrated into DC schemes, so that they can capture the benefits of scale, that the cost will come down to a reasonable level. For that reason the National Association of Pension Funds' proposals for "Super Trusts", using a mutual structure to consolidate DC schemes into giant funds in the way the Australian "Supers" have done, could be the key development that prevents decumulation turning into a nightmare.

For now, my view is that investors who are dependent on their fund income should avoid high-risk equity-heavy strategies and preserve as much flexibility as possible. There are currently no solutions out there that I think merit locking into for life, but in the next few years it is likely that some will become available.

You can see all of Chris Gilchrist's articles at www.TheIRSReport.com

Chris is the editor of The IRS Report every month

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