Pete asks Matthew Yeates of 7Investment Management how to rebalance your portfolio in retirement if your cash pot is running low on funds.
PM: You mentioned some rules on rebalancing – that they are very strict. There is a slim possibility that someone gets to the end of a two-year cash pot because markets have been depressed for a long period of time, and it hasn’t recovered.
What happens if it gets to the point where the cash is running out and we’re going to need to draw from the portfolio? How does that work? Is it part of the rebalancing? What are the mechanics of that?
MY: That’s an important question, and one that stood at the centre of a lot of the research we did around the last step. I spend a lot of my time, along with my team, on programming, and we build systems that we can use to test these rules. We look at historic markets, particularly against some of the worst.
We really want to be able to dive into these situations. If markets do keep going down for a long time, how are we going to act? Those are the things we want to build some structure around. In short, by simulating where we think the portfolio would end up if we had those bad events, we can prepare.
We’re talking about situations that only happen 5-10% of the time, depending on how much risk you took for you to have eroded your cash. In those, rather than just saying, ‘sell the low-risk assets’ or ‘sell the high-risk assets’, we try to keep the overall mix of the buckets consistent.
That may mean selling a little bit of everything, but always keeping the risk profile of the client consistent, and minimising turnover. The idea is that it’s not enough to say you’ll always sell the lowest or highest risk asset; instead, whatever we do, we’re keeping the risk of the profile as consistent as possible, and minimising portfolio turnover.
PM: The logic would say, ‘Draw from bonds’ because they’re the lowest-risk.’ All things being equal, the bond element of a portfolio will have suffered the least, particularly if it’s investment grade or government bonds. So that makes sense, but by doing that, you tilt the portfolio to have a higher proportion of equities, potentially getting outside of the client’s risk profile level where they’re comfortable.
What about general rebalancing, then? Rebalancing is so counter-intuitive on paper – sell the good stuff and buy the duff stuff! You don’t really want to be messing around with that, particularly if markets are suffering. I can imagine it must be a bit of a balancing act.
MY: It is. The biggest criticism that always comes up against this idea of bucketing is that by doing so you create cash drag. But you can now tell them that’s not true, if you balance it with high-risk assets from elsewhere.
Importantly, when you do that, you can imagine that as you reduce the amount of capital in the portfolio, you are potentially moving the risk profile. When we carried out our testing, we found that you have some natural rebalancing that takes place as well.
Because you have this high-risk pot, when markets are down, that’s going to fall by more. You’ll have less cash, but you’ll also have less in your riskiest investments, so that will balance it.
The main point that we wanted to achieve was to match the risk profile, but also to ensure that we’re matching that through time. Yes, you could sell bonds, but what happens if markets go down for three years? These things sound very unlikely, but you only have to look to examples like Japan, and you see that it can happen for a very long period of time.
We wanted to set up a process where we knew with a degree of confidence, having tested through markets that were much worse in history, that we would continue to provide income but keep that client consistent with their risk profile.
The worst thing I’d ever do is set out on a journey saying, ‘If markets go down for five years, we’ll continue to sell down bonds and then leave the portfolio more exposed to a significant drawdown.’ That’s what we wanted to avoid against.
The rules that we’ve set up essentially mean that after two years, we rebalance to a portfolio that minimises turnover but keeps that client consistent with their risk profile, and then we keep rebalancing to that portfolio every six months from then on.
There’s this idea about crystallising losses, which people refer to as ‘sequencing risk’ or ‘pound cost ravaging’ – the opposite of averaging in through time. It’s impossible to eliminate those risks, so what we can do is manage them, and in a way that stays true to the risk profile.
Those are the two competing things we want to do – keep the same amount of risk in the portfolio and minimise crystallising losses – and also provide that income through time.
Our rules, by not having those defaults of automatically selling a single type of asset, allows us to achieve that through the testing that we’ve done. That should, over the long run, keep clients comfortable. One of the benefits of having this sort of approach is it that we know how every single client at 7IM has been rebalanced as far as March this year.
If you told me how the markets would behave over the next five years, I could tell you exactly how those portfolios would be rebalanced accordingly. And those rules have been tested through significant down markets. We think that’s the sort of comfort that clients want; people investing for their retirement will want to know.
PM: For me, this should be more science than art. There should be quant behind it, and obviously the world is a chaotic place sometimes. But, I think it should definitely be backed up by research and testing and so on.
I imagine that some people come to you who’ve been invested in 7IM for years, and they’ve got pension and ISA pots, perhaps GIA… how on earth do you go about balancing where to draw from? Or is that the financial planner’s job?
MY: That is part of the financial planner’s job. There are basic rules for people to follow regarding which of those pots to draw down first, in terms of leaving pensions and ISAs and drawing from GIA first.
One of the beauties of the bucketing-based approach is, as it’s already being split up, it works well to split across different tax wrappers as well. We could just take the instructions from the client or the advisors on the order in which they’d like to take that down, but there are usually sensible defaults that we follow.
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