Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

Post-retirement strategy: can two wrongs make a right?

Investors can turn some of their behavioural biases to their advantage when managing their pension savings.

There is often a conflict between our behavioural biases and rational investment decision-making.

Investors are prone to a whole host of traits that can lead them to making suboptimal decisions. Typical examples include overconfidence, which can lead to excessive trading and the associated transaction costs, and recency bias which can lead to unsuccessful attempts at market timing.

Two such biases that can afflict post-retirement investors are:

• Loss aversion, which can lead to taking too little risk or, as we shall see, adopting strategies with excessive sequence risk*.

• Mental accounting, which can lead to a failure to consider risks holistically. Investors should really think of their strategy in totality, rather than in terms of pots for the short term and long term.

But sometimes two wrongs can make a right. In this blog we argue that in some cases a pot-based framework can lead to better outcomes for investors, by helping them fight their behavioural biases. This complements our research showing that savers can find such frameworks useful.

Pot noodling

We can imagine a simple scenario in which an investor has just two pots (in reality they may have more): one focused on growth for the long term (Pot A), and one low-risk pot to provide income in the short to medium term (Pot B).

Rather than necessarily rebalance these pots on a regular basis per a ‘traditional’ strategy, as an ‘alternative’ strategy the investor could start by taking money from Pot B and only later make use of Pot A.

The traditional income-drawdown strategy effectively ignores the labels and keeps the percentage split between the two pots constant. The alternative strategy uses the low-risk Pot B to meet income requirements over the first, say, 15 years of retirement, and uses Pot A as a vehicle to invest for later retirement.

There are two potential benefits of the alternative strategy over the traditional one:

• It can help avoid reckless prudence. If the investor knows they have enough in low-risk assets (Pot B) to sustain them for the next 15 years, this can help them adopt a long-term attitude with Pot A. Rationally it shouldn’t matter which pot is more volatile – of course it’s their total wealth that matters – but a loss in the ‘long-term pot’ is easier to bear psychologically. Splitting the pension savings into two pots can help prevent investors from panicking in a market downturn.

• It can reduce so-called sequence risk by keeping investors from touching Pot A. If the investor only uses the low-risk pot for withdrawals between the ages of 65 and 80 (at age 80 we might assume they annuitise), then the order of the risky returns in Pot A won’t affect the investor’s retirement outcome. Sequence risk is thus reduced or eliminated.

So how big are these benefits? While it is difficult to quantify how much the alternative approach might prevent volatility from spooking investors early in retirement, it is possible to calculate the sequence-risk benefits.

To do this I looked at a simplified example where the investor starts with a pot of £100,000 at age 65 and withdraws £5,000 each year for the next 15 years. For illustrative purposes I assumed Pot A has an expected return of 4% per annum with volatility of 10% per annum, whereas Pot B doesn’t grow at all but carries no risk.

It’s not pot luck

Under the traditional strategy, the investor maintains a constant percentage mix of around 40% in Pot A and 60% in Pot B throughout, achieved by rebalancing each year**. Under the alternative strategy, the investor starts with £25,000 in Pot A and £75,000 in Pot B and only ever withdraws from Pot B. This has no sequence risk, with Pot B running out after 15 years.

The statistics for the combined value of the pots at age 80 are as follows:

 

Traditional strategy

Alternative strategy

Improvement

1 in 20 upside***

£69,517

£78,570

£9,052

Median

£42,180

£42,180

£0

1 in 20 downside***

£21,719

£22,102

£382

Source: LGIM calculations

As we can see, the median outcomes are the same (by construction). There is a modest benefit in the downside scenario but, more impressively, there is large boost to upside outcomes. Our alternative strategy is more efficient.

The graph below shows how, on average, the percentage allocation to growth of the aggregate portfolio changes over time for the two strategies.

In practice, investors may well find it quite hard to stick to the alternative strategy, notwithstanding the segregation into two pots, because an increasing percentage allocation to growth feels strange and the pernicious influence of loss aversion comes into play.

But at least the pot structure is helping push investors in the right direction. Post-retirement investors are “only human” like the rest of us, but with the right framing and nudges they can become better investors.

 

* For the uninitiated, sequence risk refers to the order in which your returns occur in relation to withdrawals. If merely re-ordering the sequence of returns changes the outcome for an investor, they are said to be exposed to sequence risk.

** The 40/60 split was chosen so that we get the same median as for the alternative strategy.

*** These are the 95th percentile and 5th percentile pot sizes at age 80.

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