1. Why market volatility is not synonymous with market risk
2. The importance of creating and reviewing an investment plan
3. How volatility affects the accumulation and decumulations stages of the investment journey
PRESENTER: In this Akademia module we are going to be looking at how to manage client expectations in periods when markets are volatile. Our tutor is Paul Fiddell, head of business development for investment at the Prudential. Here’s what’s going to be covered. Volatility and risk, putting together and reviewing an investment plan, how volatility impacts clients at different stages of the investment journey, cashflow modelling and calculating long-term rates of return, accumulation and volatility, the switch from accumulation to decumulation, decumulation and sequencing risk, the importance of portfolio diversification, the pros and cons of smoothing investment returns in a portfolio, natural income vs cashing in capital to generate a set level of income, working out a client’s future cashflow requirements.
When I sat down with Paul Fiddell in the Akademia studio I began by asking him what constitutes a volatile market in the first place?
PAUL: Well I guess in the strictest definition of the word volatility is the movement in the price of something, either up or down, and that’s an important point to start with that actually volatility is a two-way street. It tends to get a bit of a bad rep and people think of it in negative terms, but of course if you didn’t have volatility you wouldn’t get the additional return that you get from some of the riskier asset classes. So there is a good side to it.I guess the wider issue with volatility is that we do tend to use it in the industry as a sole proxy for risk, which is a dangerous thing. Risk is much more multidimensional than just volatility. Everything from inflation risk, counterparty risk, so on and so forth. But in stark terms are we in a more volatile market at the moment, then I guess the answer is yes.
PRESENTER: And when it comes to managing client expectations, what dictates what client expectations are when markets get volatile?
PAUL: I think there are three key elements. And two are very well known: one is attitude to risk and the other one is capacity for loss. The third one, which is perhaps the most important of all, is how much risk does the client actually need to take to achieve their objectives, so in a way it’s almost starting with the end in mind and working backwards. So this is where I want to be at this particular point in the future, what is it I need to do to get there from where I currently am? And that defines and dictates how much risk you effectively need to take. Then there’s the attitude to risk, which in essence is how does the customer feel about risk, and then there’s capacity for loss, which is how much risk can they actually afford to take. And it’s the combination of those three things. And I think we’re particularly good as an industry at doing that attitude through questionnaires, behavioural analysis, so on and so forth, we’re getting better at the capacity for loss, but I still don’t think we’re particularly good as an industry at the how much risk do I actually need to take to get me where I need to be.
PRESENTER: So how important is it to get that plan right at the outset, and how much margin for error should you build in?
PAUL: I think it’s crucial that you get that plan right at outset, and more importantly that you review it, and review it on regular staging posts – if that’s once a year as part of an adviser’s business model, then fine. It could be done more frequently; it could be done less frequently. The key point is that it’s reviewed because things change. You know, markets change, investments change and the plan itself might change. So, start with the goal in mind, but be prepared to be flexible and move it as you go through. But do it in conjunction with the client.
PRESENTER: But if you’re planning, as a rule of thumb should you be quite conservative about what people are going to be able to afford to do in the future, or should you give them a sunny outlook?
PAUL: Yes, it would be lovely to give them a sunny outlook wouldn’t it? I think you’ve got to be realistic, and you’ve got to be realistic in terms of the return that you can achieve from a portfolio of assets: be it all risk based assets or all more secure nominal type asset classes. And there I think we have to be realistic that the numbers that you can achieve now are substantially lower than they were even five years ago. And that’s a function of the low interest rate environment we’re in, low inflation, and I think the generally held consensus view that we’re in this for the long haul. You know, it’s lower for longer.
PRESENTER: And to what extent is it also being affected by the fact that people are living longer as well?
PAUL: Absolutely. So what used to be maybe a 15/20 year journey in retirement, if we took that as an example, is probably now stretching out 30, 40 years.
PRESENTER: And at what point on the client’s journey from accumulation through to retirement does volatility become a particular issue for them? Whether real or imagined, are there any obvious pinch points?
PAUL: Yes, I think potentially it’s an issue all the way through. What volatility does of course is it impacts upon people’s behaviours. Volatility is actually a good thing, as I said earlier, and we do need it to get those extra returns from the higher risk asset classes. The trouble is from an investor’s perspective it makes them feel nervous when they buy something. They have negative volatility, the price goes down, they think it’s the worst decision they’ve ever made, and they perhaps want to bail out.
Now in an accumulation journey you have time on your side. You can maybe live with that volatility a bit better, because you recognise that actually it’s still got time to recover before you need the funds. You could theoretically put more money into the accumulation pot, so on and so forth. In decumulation it’s that realisation that that pot of money now effectively has to last for your lifetime. And the problem we have of course is we don’t know how long that’s going to be. So we’re planning for an uncertain time period, and I guess people’s natural instinct there is to take less risk.
Now, that’s fine, except you may need to take risk to achieve the income levels that you’re requiring from that pot of money. So it’s the way people think I think in terms of the volatility drive.
PRESENTER: So a lot of this is about behavioural finance and fighting psychology.
PAUL: Yes absolutely.
PRESENTER: And I suppose the other quick question to ask before we move on is are the long-term nature of returns themselves changing over time, or are they pretty constant?
PAUL: They do change, and obviously it depends on how you arrive at the figure, and people will have lots of different ways of doing it. At Prudential, we use a fairly simplistic, almost a building block approach, where we’ll start with the return that we can achieve from our cash. We’ll build in an inflation measure, and then we’ll add on to start with a risk premium for government bonds. And that gives us a return effectively that you could get, that we believe you could get from government bonds. Because quite frankly if you could get the return you needed from that asset class why would you bother investing anywhere else? It’s 100% guaranteed your money back in the future. The reality is of course you’re not going to get the return you want, so you need to add on additional risk for different asset classes.
Add those four things up and you arrive at a total expected long-term rate of return for each individual asset class. And those figures have definitely been reducing predominantly in line with the reduction in the cash assumption. So cash is the start point. If cash, your expectation of cash returns halves, and halves by 100 basis points for example, that’s going to bring every asset class expected return down by the same amount.
PRESENTER: So does that tell you, is there then a formula that says in an environment such as that here’s how much more money you need to put in in the first place to get what you need out the other?
PAUL: In terms of working out what you need to do to arrive at a particular point, then that’s where things like cashflow modelling can potentially become very useful. The problem with cashflow modelling of course is that you’re always going to put in – and it’s the same with any computer system, it’s that old adage isn’t it of rubbish in rubbish out – what you’ve got to be is realistic in terms of the assumptions you’re making around things like your growth rate assumptions. But yes absolutely that can help in working out whether or not you’re going to meet your goals. And that enables you to have a sensible conversation with the customer.
PRESENTER: Well let’s if I may move back to the accumulation phase. We touched on volatility there. How do you help investors with say a 30-year run into retirement, how do you set things up so that they don’t make the wrong decision in the face of downside volatility?
PAUL: I mean here there’s a number of things you can do, so one of which is making them aware of volatility in terms of its impact both negative and positive. Educating them that just because markets are volatile it doesn’t necessarily mean you need to panic and start trying to sell out of your investments. Remembering of course that what people need to be is effectively long-term investors. Volatility is a short-term thing which impacts upon their behaviours, but actually getting them to think as long-term investors. Now we do that as a business. We are long- term investors: that’s fundamentally what Prudential are about. And then we try and manage volatility partly through that education process, but also then partly through product structures like the smoothing mechanism we can apply on PruFund.
PRESENTER: But are things like regular savings the best way around this, it’s just automatic?
PAUL: Yes, I mean regular savings, this is the old pound cost averaging idea which is, you know, it works and you can prove it mathematically. Rather than trying to time the market with a single lump sum and potentially getting the wrong side of a downturn or a movement up, what you do is you phase your investment in over a period of 12 or 24 months or whatever it might be. And yes absolutely those things can work, providing of course the market does recover at the point when you actually need the funds out. But they can only take you so far. Other mechanisms you can do in terms of helping customers to manage that, because volatility is about the journey between the start and the end, so helping them to manage that journey as I say through education, through things like pound cost averaging, through things like smoothing, but also through the way in which you’re building the portfolios with a view which is trying to dampen down that short-term volatility.
Now that might take you into asset classes which have a completely different return profile to traditional asset classes, such as equities and corporate bonds. Infrastructure would be an obvious one where you have a much longer payoff, you know, a 30 year payoff on some of these things, and that can dampen down the effects of short-term volatility.
PRESENTER: Well I was going to say 30 years out, I guess, a bit of volatility probably doesn’t affect you as much as say if you’re two years to retirement. So we’ve mentioned accumulation and then decumulation, what’s the bit in the middle; how long should that be?
PAUL: Yes. I guess in a way as short as possible. The ideal would be to accumulate your funds, get to a point where they’ve effectively reached their peak, whether that’s in real terms or in the customer’s own mind that they’ve reached a high point, and at which stage switch it over into the decumulation space. In practice, trying to time markets is a bit of a mug’s game: chances are you’re going to fall the wrong side of it. One way you can do it, and this is the sort of old, I guess they used to call it lifestyling didn’t they, which was the idea of you’d start with a high risk portfolio and then there’d be staging points where you would reduce the risk in your portfolio. The problem again with that is that it was very formulaic. It happened on a set date in the diary, in the calendar so to speak, and there was no guarantee that the markets were going to be behaving themselves at that point.
Another way of doing it is to, and this is certainly something that we do within our PruFund range, where we will have effectively different varieties of the same thing. So within the PruFund range we will have something which will have a much higher exposure to risk assets, and a fund which will have a much lower exposure to risk assets, and then a couple in between. And what that means of course is you’ve got exactly the same smoothing process applying to all of those, it works in exactly the same way but a different underlying asset mix. And what you can do is you can start high and move low, but do it at your own pace and when you want to, rather than it being a programmed switching exercise. But behind the scenes it’s exactly the same smoothing process, which is taking out the effects of that short-term volatility.
PRESENTER: And when advisers are using this with their clients, do they tend to automatically switch percentages across, or do they tend to think actually I want a certain percentage of the overall portfolio should be less volatile because that’s what we want to be using up over the next few years, and let’s leave everything else where it can afford to take more volatility for the long term?
PAUL: Yes, individual choice. I mean what we would tend to see is, I guess, most people would actually take the whole thing. So move, you know, so if you’re in the high risk portfolio day one, day two you’re in the next one down and so on and so forth, rather than trying to stage it. Because all you’re doing there is you’re effectively mix and matching the asset allocations underneath it.
PRESENTER: Well thanks for that. And then in decumulation, moving on to that, I mean again how does volatility affect clients, not least you retire, it’s day one and your £100,000, the market falls and it’s suddenly £75,000?
PAUL: Absolutely. I mean this is where it has its biggest impact. In the journey we’ve been talked about, the accumulation journey, things like sequence of returns, which is a fairly well known concept now, this idea of the order in which returns come. In accumulation arguably that doesn’t matter. It doesn’t matter whether you get the negative first and then the positive year, then the negative then the positive; it’s the mass. Three times two times one is exactly the same as one times two times three. You’ll ultimately end up with the same return irrespective of the order in which those returns come.
In decumulation, once you start taking withdrawals from your portfolio, that’s when the sequence becomes crucially important. And as you say if you start off on a bad foot and you have a negative in the early years, very difficult to recover from. It would be difficult to recover from if markets were performing at previous levels, but they’re not, we’re in a low return environment, so now a 5% fall in your portfolio value can have a significant impact, not just on the overall portfolio size, but your ability to recover from it if you’re taking withdrawals. That’s quite a challenging environment.
So it does mean that advisers constructing a portfolio to work in a decumulation space need to be absolutely focused on those early years and getting it right: making sure that you get off on the best possible footing.
PRESENTER: So what can you do to manage that? Is that about managing clients’ expectations of what they should take out of their pension, or is it about the assets you put it into?
PAUL: Both of those things, absolutely. I think there is a huge need for advisers and customers alike to be almost painfully realistic about what they can expect to achieve. The old days, you know, there used to be the old idea that you could build an investment portfolio, you could strip 5% a year out of it, and pretty much that would weather the storm and you’ve leave your capital intact and maybe get a bit of growth. Those days are behind us; you’re not going to get that any more.
PRESENTER: 2016, what are the new rules of thumb that we should be thinking about for the next 10, 20 years?
PAUL: Well the figures I’ve heard and read about, and this is the safe withdrawal rate idea that’s come out of the States, which used to be 4%. That was the perceived wisdom of if I have a balanced portfolio split between equities and bonds, then that can support a 4% income being withdrawn from it and protect my capital. That’s fallen to 3% and I’ve heard talk of it being reduced to 2½%, so half the old perceived level of 5%.
PRESENTER: And when we say protect capital, is that capital after inflation or just the nominal value of capital?
PAUL: Yes, nominal value actually thinking about it, yes nominal value.
PRESENTER: We’re in a low inflation time so maybe that’s not as important but.
PAUL: Yes, absolutely, although I think inflation again is one of those things that, you know, people have got very comfortable with the idea that inflation is low and have almost forgotten about it. It doesn’t take much of a ramping up to actually have a significant impact. Inflation at 1-2% can actually tear your portfolio apart if you’re not getting substantial amounts of real growth over and above it.
PRESENTER: Well then I guess move to saying well what can the investment industry do to make up the shortfall between what people need and fundamentally what some of the markets are paying? So we hear a lot about diversification, is that the answer?
PAUL: I was always taught that there were two methods of managing investment risk: one was diversification and the other one was market timing. Arguably, if you get market timing right, buy on the bottom and sell on the peaks, then you don’t need to worry about being diversified because you’re always on the right side of it. In practice nobody can do that consistently. So that leaves us with diversification. The trouble with diversification is that it’s actually not that easy to achieve. You know, risk assets now are more highly correlated than they have been for some time, which means you need to look outside traditional asset classes. The problem there is once you go outside of traditional asset classes then you’re buying into things like an illiquidity premium.
Property is an obvious example of that recently, but things like infrastructure, private equity, all of these things are very useful in building a diversified portfolio, because they have that additional premium, that illiquidity premium. But that illiquidity means you’ve got to try and make a long-term investment work in a short-term timeframe. And that’s a challenge for the industry. And we’ve tried many mechanisms, you know, the way we try it through PruFund is one, absolute return funds is another way of trying to play that particular game. And it requires knowledge, skills, expertise and a long-term timeframe.
PRESENTER: But fundamentally as a product provider would you, to generate a level of return these days, are you happy to go up the risk scale to get it, or is it more important to keep your risk level right rather than try and generate a headline reward?
PAUL: I think it’s most important to keep the risk level right and help manage people’s expectations. I mean there's an old phrase which is the best return a customer can achieve is the one they most expect. At the end of the day I don’t think many people actually are looking to shoot the lights out and double their returns necessarily. What they’re looking for is beat cash, beat inflation and ideally provide me with a little bit extra over and above that, irrespective of whether I’m taking income out of it or not, just leave me with a little bit of forward motion. If we can do that within the risk budget that we’re setting for ourselves, then in essence that’s the whole thing isn’t it?
PRESENTER: Well you’ve mentioned smoothing a few times while we’ve been having this discussion. Does smoothing actually produce a better outcome for clients, a different journey path, or does it basically just make them feel more comfortable on a journey they were going to take anyway?
PAUL: OK, that’s three questions and it’s more the latter than it is the first one. So does it give a better return? If you do smoothing correctly then arguably no. Over a decent timeframe, let’s call it 10 years, smoothing should be neutral. If you’ve got it right the ups should counter the downs. And what you actually should get is the value of the underlying assets coming through. In the short term that relationship might break down, and that’s when markets tend to go. So in 2008 for example markets go down a lot, the smoothing protects you to a certain extent but not fully. So if you looked over a one or two year period there you’d see a disconnect between the value from the underlying assets and the smooth value. But over a decent timeframe you would expect to receive asset share and smoothing should be neutral.
PRESENTER: But presumably you have to, if you’re offering smoothing there’s a cost to that. So wouldn’t you always be a little bit under what the market offered?
PAUL: Well there will be situations where you’re in surplus or you’re in deficit. So obviously at some stages you will be actually under-paying. If the value of the assets is increasing at a rate which is greater than the smooth return you’re offering, then effectively you’re in surplus. So at which stage somebody is benefiting from that, whoever’s providing the ultimate guarantee around the smoothing. The key thing about smoothing is it has a psychological impact. It makes the journey that we were referring to earlier between start and finish points much smoother.
Now that’s an obvious thing because it’s called smoothing, but it’s crucially important. It’s a bit like putting shock absorbers on a car. If you want to go really fast up a motorway what you do is you buy a car with a big engine up front, it’s quite low to the ground, so you get all the impact of it and you just put the pedal to the metal and away you go. If you want to drive that same vehicle over a bumpy field you’re not going to choose it are you? You’re going to choose something which has got a lot of suspension travel. Markets are not flat smooth motorways. They are more like ploughed fields.
So what this does is it takes out a lot of that short-term bumpiness, which from an investor’s perspective makes them much more comfortable and less inclined to bail out of their investments. And the problem that most investors have, and actually institutions have this as well, is being forced sellers of assets. Now that’s forced sellers because somebody’s calling on you for the liquidity, or it’s because your mind is telling you now is a good time to get out because the markets have fallen and you’re effectively forcing yourself into a sell position. If you can stop people doing that, because you’ve put the comfort blanket around it, if you like, the smoothing mechanism, then they’re more inclined to say in there. And actually that would ultimately deliver better returns for them, rather than chopping and changing.
PRESENTER: We’re talking there really about smoothing in the accumulation phase, where if you like the maths works for you but the psychology works against you. Now when you were talking about decumulation earlier you were basically saying the psychology works against you and the maths works against you if you get it wrong. So does having a smoothed return in the decumulation phase have any advantages?
PRESENTER: A positive advantage, because you effectively get the reverse of pound cost averaging. So what happens when, you know, the conventional wisdom as we said was rather than trying to time your market and put a lump sum in, phase your investment over a period of time. Well imagine the reverse. If I’ve got a lump sum that’s invested, and I’m withdrawing money on a regular basis, chances are I’m going to get the timing of that wrong. If I’m cashing in units of my investment to meet my income, for want of a better description. And income is one of those words that we do tend to misuse quite badly as an industry, but the encashments I’m taking, so if I’m cashing in units and the price has fallen, I’m having to sell more of those units to meet my income payment. And of course they’re then sold; I’m not going to get any growth on those going forward.
So, absolutely, negative pound cost averaging, reverse pound cost averaging, whatever title we want to assign to it, the problem in decumulation is the reverse of the situation at accumulation, which is taking regular payments out of an investment portfolio. The ideal is to have a fund which just goes in a straight line, but of course that doesn’t exist.
PRESENTER: Well, as a rule of thumb though, we talked about income in retirement, is it a good idea to be cashing in units, so in a sense turning capital into income, or should you try and live off natural income? So the income flow that’s thrown off your assets naturally.
PAUL: I mean this is an idea or a debate that’s taken place over many years, and I don’t think there is a simple answer to this. I mean in the natural income world, which is effectively where you’ve living off the yield from the investments, the theory is fine. Which is that these will spin off natural income, you take that, you leave the underlying capital or the number of units intact. Yes it can vary in line with capital values, but the idea is that you haven’t sold those, so they can still generate that income for you. The problem we have at the moment is that yields across the board are far lower than they have been, and to get the sort of numbers that people want, you’re having to chase higher risk investments, which in itself might spin off the right amount of income, the right yield, but it puts more volatility into the underlying capital value.
We tend to prefer to think of things in a total return way. So don’t worry too much about whether the return comes from capital, from gains, from income, from yield, whatever it might be, actually it’s the total return, and you’re extracting regular amounts from that total return pot. And that’s certainly the way we look at it in most of the products we offer.
PRESENTER: What’s the role of annuities for income? Take your point that yields are quite low, but if you’ve got some income needs that just have to be met, is there still a point in taking an annuity and locking into that certainty?
PAUL: It’s a sort of cost-benefit analysis. I mean fundamentally what an annuity does of course is it takes away all of that problem of you having to worry about how you’re going to support your income, because somebody else is doing that for you. They’re providing you with that fixed payment. The big downside, the two big downsides, one the absolute level of annuity you’re going to get is based around cash rates and interest rates which are extremely low. So the ultimate amount of annuity you can get for £1,000 worth of purchase price is at extremely low, historically low levels. And the other problem of course is that you’ve given away your capital. So once you’ve bought the annuity that’s it, your money’s gone. So if the unfortunate happens and you die very early in your decumulation journey, then there’s nothing for your beneficiaries.
So I still quite like annuities, but it’s very much right place, right time, right person, and it’s one of the many tools that’s available to an adviser when they’re having the discussion with the client. I don’t think you should necessarily discount them outright, I accept there are challenges around them, but as part of an overall portfolio absolutely. It may be that you could use it as a core for example. That bit ticks away and does what it’s supposed to do, and then you use investments to deliver the rest of what the client requires. It’s very much individual choice.
PRESENTER: Well let’s bring some of these themes together: the really important points then from this for advisers and their clients. So to what extent is this about really working out in a lot of detail what a client’s cashflow requirements are going to be?
PAUL: I think it is. I think that’s absolutely crucial. I’m a great fan of cashflow modelling as a tool for people to use to help that conversation. I’m not saying you have to use it, and the FCA aren’t being prescriptive on this, but I think it’s a very helpful tool. Once you understand the limitations of cashflow modelling tools, which is ultimately they are just a spreadsheet and it’s a function of what you put in drives what you get out. So the key point is that being realistic at outset in terms of your assumptions. What are you using as your assumptions for asset class returns? Where are you getting those numbers from? You know, is it based on historical returns? So if you’ve looked over the last 10 years for example, is it just what the markets have done over that period? Well arguably the last 10 years isn’t a good way of looking at the next 10 years.
You know, we’re in a new environment. This is a lower for longer environment. But providing you can do that bit, and be realistic about your assumptions, then I think cashflow modelling is a great start point. It doesn’t take over from having the conversation with the client, and sitting down and getting a feel for what it is they want to do. The adviser and the client relationship is absolutely crucial in this whole thing. And it’s one of the three strands. So that helps you work out how much risk you need to take. And then you need to think about how the client feels about that level of risk, which is their attitude to risk, so a questionnaire or whatever process the adviser uses, and then can they actually afford to take that amount of risk? And it’s the combination of those three things and balancing them together.
PRESENTER: How is it to work out what your expenditure might be in the future? I mean I look at my own life and my ideas of what I was going to spend and where 10 years ago, well really naïve is probably the politest way to put it, 10 years later with, and what I’m going to spend in another 10 years, I don’t know.
PAUL: Absolutely, and I’m exactly the same. I’m spending on things now which I wouldn’t have dreamt of spending on 10 years ago. And I think that’s where the flex comes into it. That’s where the ability to flex the whole plan. There are going to be certain things which are, you know that these are commitments that you’re going to have to be making, so housing costs or heating costs, so on and so forth. And you make some realistic assumptions and build in inflationary increases and so on and so forth. But I think you’ve got to have some discretionary spend in there as well, which is we might currently be spending it on this but in the future we might spend it on that. And again that’s where the whole review process comes in.
This isn’t a matter of building something and going right that’s it, job done for the next 30 years. This is a matter of starting a journey. And I think your point about annuities, I think one of the aspects of annuities is that advisers often worked with clients right up to the point when they retired, at which point we had to buy an annuity – and effectively my work is done, I can take a step back. There might be other things I can do around estate planning, for example, but actually in terms of their journey I’m now hands-off because somebody else is taking onboard the risk and providing the annuity. That doesn’t work any more. Now the adviser relationship with a customer goes right through accumulation to the point of decumulation, and then through that decumulation journey. And keeping constant contact with the client and reviewing the plan and how you’re delivering against the plan, that’s absolutely crucial. So I think it’s much more about a lifetime relationship rather than maybe up to retirement and no further.
PRESENTER: We have to leave it there. Paul (Fodell?), thank you very much.
PAUL: My pleasure, thank you.
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