Planning income in retirement: Asset cascade
02 August 2017
Since Pension Freedoms were brought into effect, we have seen an increase in demand for planning income in retirement. One of the strategies investors and advisers can use is 'asset cascade', and it's this method that I will explain in more detail.
Asset cascade is a portfolio construction method used by post-retirement investors to create a portfolio that has the correct level of risk for their income needs.
The central idea to this method is to consider what income is required over each time period and then set the risk level for each component of the portfolio accordingly. (This method is also known as the ‘bucket’ method due to this partitioning of the portfolio). For income that isn’t required for several years, a long-term investment horizon can be used and an exposure to riskier assets is then appropriate. For income that is required in the short term, ie 0-3 years, this part of the portfolio is invested in low risk assets such as cash or money market funds so as to protect against market risk and drawdowns.
Over time as the short-term funds are used up for retirement income, the investor (or their adviser) must rebalance and take income out of their higher risk investments. The more funds invested in the low risk assets, the greater the discretion for timing the rebalance of their portfolio. For example, during a market crash like 2008, the investor would not have to sell as many equities at the bottom of the market, and may been able instead to use more cash or sell low risk fixed income investments which had grown in value due to their ‘safe haven’ status. However, the downside of holding more in cash is that the portfolio will experience cash drag and potentially lower returns over the long-term. This asset cascade method allows some mitigation of sequencing risk, ie ‘pound cost ravaging,’ but requires close monitoring.
This is more easily demonstrated below:
As mentioned, this approach requires careful monitoring to ensure the portfolio risks are well understood. For most investors, it may be more suitable to invest in cash plus 1-3 multi-asset funds or absolute return funds that have their risk explicitly described. This would help ensure a clearer benchmark for performance monitoring and less need to rebalance.
Defaqto Engage can help advisers plan their decumulation clients' portfolios, learn more about how we help you plan income in retirement.