Following the advent of pension freedoms in April 2015, risk management has taken on a new dimension as an increasing number of individuals are free to choose how to invest and how to make their savings work for them in retirement. With a typical scheme member likely to enter a retirement that will last over 20 years, any depletion or permanent loss of their pension savings will become a major risk, particularly given the relatively small size of the average UK pension pot.

The dangers of ‘reaching’ for yield

While many retirees seek an income which is sufficient to replace their monthly pay packet, they are facing a backdrop in which yields from ‘traditional’ investments such as government bonds remain low. In this environment, there is a real danger that managers may migrate up the risk curve in an attempt to generate a higher level of income. This may involve introducing complexity into a portfolio, be it through leverage or synthetic strategies, or focusing on high-yielding investments which, by definition, bring with them a greater level of default risk. If a strategy is ‘reaching’ for an income which is unsustainable over the long term, ultimately it will be necessary to sacrifice capital in order to support that income. We therefore think it is important for retirees to focus on a ‘natural’ income which remains achievable, since that is likely to give them the best chance of preserving their pension pot at the same time as generating an income.

If a strategy is ‘reaching’ for an income which is unsustainable over the long term, ultimately it will be necessary to sacrifice capital in order to support that income

When researching investment opportunities, one approach is not to use yield as a starting point, but instead to look for discipline in how a company allocates its capital, or how a government generates its revenues. If capital is invested within a business in order to sustain and indeed grow the return on that capital, it should generate a cash flow which becomes sustainable and which can therefore fund the coupon or dividend. If, on the other hand, an investor decides to generate an income through capital appreciation alone, they may be forced to sell some of this capital when assets are at their lows in order to maintain their income, thereby locking in a permanent capital loss.

Volatility as an opportunity

In recent times, investors have been led to see volatility as the central risk, but by viewing volatility simply as day-today price movements with minimal impact on income generation, it is possible to embrace the opportunities it provides, for example by taking advantage of low prices to buy more of an attractive company. For this reason, in our Multi-Asset Income strategy we view risk not as volatility but rather the possibility of dividends being cut or coupons not being paid, and we look at the fundamentals of our investments in order to have confidence that their income can be maintained.

By viewing volatility simply as day-today price movements with minimal impact on income generation, it is possible to embrace the opportunities it provides

Flexibility in diversification

Many investors view diversification as the primary risk management tool. However, while it can be an effective means of generating returns in a range of different market conditions, true diversification means not having too much of an investor’s wealth exposed to a single risk factor. It is therefore important to maintain the flexibility to adjust a strategy’s positioning at any time to reflect a changing outlook, in order to achieve the desired income objective with an acceptable level of risk. For example, the prices of traditional ‘safe-haven’ government bonds have in the developed world been driven to levels which do not offer much attraction and which, given sovereign debt levels, present unusually elevated levels of risk. On the other hand, certain alternative investments, such as renewable energy and infrastructure assets, are able to generate durable cash flows independent of an economic cycle.

Conclusion

For most DC members entering retirement, the key concern and risk will be the permanent diminution of capital, which will erode their ability to reinvest and recover losses. With this in mind, many investors will be looking for peace of mind in the shape of a sustainable portfolio that will provide a consistent income stream over the long term. One way to accomplish this could be through a multi-asset approach which blends investments across a range of assets in order to achieve the income objective, while giving careful and measured thought to the risk management process.

Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.

Newton defined contribution investments
www.newtonim.com/dc

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