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Avoiding losses is a very important factor for investors approaching retirement.
Since pension freedoms were introduced in 2015, there has been a fundamental shift in the retirement landscape. For pension providers, advisers and other investment professionals, long-held assumptions are being questioned. For example, the rule-of-thumb that a withdrawal rate of 4% a year could be considered as a ‘safe’ rate of withdrawal or that investors should hold an allocation to bonds equivalent to their age are no longer accepted wisdom. There’s a growing awareness that managing the decumulation phase is just as important as the accumulation stage.
For investors, the change has been even more profound. For the first time individuals have significant choice in how to take retirement income. Consequently, it’s more important than ever to work with clients to help them determine if they want to stay invested after retirement, the level of risk they’re comfortable with and the type of lifestyle they wish to maintain after they’ve stopped working.
A number of industry studies have dispelled the ‘Maserati myth’ – the theory that retirees have been using their pensions for big-ticket items and reckless purchases.
For the first time individuals have significant choice in how to take retirement income
At the time pension freedoms were being introduced, opponents derided the proposal as irresponsible, suggesting retirees would opt to take lump-sum withdrawals, spend it recklessly and ultimately wind up on the state pension.
Since then, a number of industry studies have dispelled the ‘Maserati myth’ – the theory that retirees have been using their pensions for big-ticket items and reckless purchases. Indeed, many have concluded that, if anything, those entering the drawdown phase are in fact much more prudent and cautious than expected.
Data from the Financial Conduct Authority (FCA) backs this up. From April 2015 to September 2017, more than half of all pension pots accessed were fully withdrawn. However, these were mostly small pots (88% were worth less than £30,000) and almost all who withdrew the full amount had other sources of retirement income. In addition, more than half didn’t actually spend it but in fact transferred the funds into other savings or investments.
It’s worth considering that, for those in or approaching retirement, investor’s concept of risk is not always the same as what investment professionals think of as “investment risk”. For advisers and providers, reducing risk is often a matter of asset allocation, gradually shifting into a higher concentration of lower-risk investments as the client nears retirement. There’s growing evidence that investors feel their primary challenge is how to make the money last after retirement. In other words, for pensioners, running out of money too early is the biggest risk of all. But it is also becoming clear that many clients equate running out of money with investment losses and as a result are extremely loss averse – they simply don’t want to lose their retirement money.
There's growing evidence that investors feel their primary challenge is how to make the money last after retirement.
Loss aversion is not quite the same as risk aversion. In their pioneering work on behavioural economics, Nobel laureate Daniel Kahneman and Amos Tversky coined the phrase “prospect theory”, which asserts that people are less concerned with making gains than with avoiding losses. In the context of pension investing, this means investors often favour a low-return, low-risk portfolio over the prospect of losing everything in a higher-risk portfolio, despite potentially higher returns. As behavioural scientist Richard Thaler, another Nobel winner, puts it: “Losses hurt roughly twice as much as gains feel good.”
Research carried out by the FCA backs this up. It found that avoiding losses was a very important factor in the investment decision of 52% of people approaching retirement, compared with 34% who say investment returns are very important. For investors who said both were very important, more said they want to avoid losses rather than pursue higher investment growth if they had to choose between the two.
There is, however, a contradiction between wanting pension investments to last as long as possible and being completely risk averse. Holding all your pension investments as cash, for example, would mean inflation eroding the value of those investments, even before any income is taken.
Reducing risk is often a matter of asset allocation
The FCA is aware of this contradiction and is currently looking at measures to improve customer outcomes. In June 2018, the FCA released the final version of its Retirement Outcomes Review, in which it warned that many customers do not fully understand how their pension pots are invested, what their options were, or what the risks associated with drawdown are.
The Retirement Outcomes Review has found that up to one in three people who have moved in to drawdown since April 2015 has their entire pension fund in cash. This means that due to a lack of engagement or extreme loss-aversion, many pension savers are actually increasing their chances of their pension savings running out early.
According to the respondents of the FCA’s survey, there are three primary reasons why customers are so disengaged:
1. their pension pot was not significant enough to warrant much attention;
2. they weren’t really interested in investing;
3. they didn’t feel confident in making investment choices.
To help address this mismatch between what people want from their pension savings and investor behaviour, the FCA has proposed a number of potential remedies.
In the run up to retirement, the FCA has suggested that pension investors are sent regular communications from age 50, including risk warnings. It has also suggested pension providers introduce ready-made retirement income pathways, similar to default investment strategies currently offered to many members of workplace pension schemes in accumulation. It is also considering forcing new retirees to actively choose to move into cash rather than allow them to end up there by default. Finally, it has also proposed that customers in drawdown continue to receive regular updates on their investments.
Christopher Woolard, Executive Director of Strategy and Competition at the FCA said: “We know that the choices introduced by the pension freedoms have been popular with many consumers. However, they’re now required to make more complicated decisions than ever before. Many people need more support when making choices. The measures we have outlined will help them think about that earlier, create investment pathways to help them with their choices and make costs and charges easier to understand.”
Engaging with consumers to help them understand their options will help close the apparent gap between their conflicting priorities when investing in retirement, and should help provide a more comfortable and sustainable retirement income for many.
“I don’t care. I don’t know. As long as it doesn’t lose money, I will be satisfied.”
FCA survey respondent on where his assets are invested in drawdown, with a pension pot worth £100k, and a separate DC pension.
Investment markets and conditions can change rapidly and, as such, the views expressed in this update should not be taken as statements of fact nor be relied on when making investment decisions. Forecast are opinions only, cannot be guaranteed and should not be relied on when making investment decisions.
Many customers do not fully understand how their pension pots are invested