‘Volatility alone is no longer a sufficient risk measure’
The move towards income drawdown has created an urgent need for a more sophisticated approach to retirement investing, says Matthew Wright
The role of the financial adviser in the UK is undergoing a significant transformation as clients increasingly rely on flexible drawdown strategies instead of traditional annuities.
With approximately £1.4trn in UK Defined Contribution (DC) pensions and the lasting impact of pension freedoms, managing retirement investments has become one of the most pressing challenges facing IFAs today.
While most investment conversations have historically centred on the accumulation phase, the decumulation phase demands far more nuanced risk management. Fulcrum’s paper, Managing Drawdown Risks for Retirement Investing, sheds light on the underestimated but crucial aspect of drawdown risk and its broader implications for retirement income sustainability.
Why decumulation is a different beast
Nobel Laureate William Sharpe famously described retirement decumulation as the “nastiest, hardest problem in finance.” This complexity stems from the unpredictability of three interrelated variables: lifespan, spending needs, and investment returns.
What sets decumulation apart is the issue of sequencing risk. Even if average returns are healthy over a 20-year period, poor returns in the early years can have a devastating impact on long-term wealth when withdrawals are being made. Two portfolios with identical average returns can lead to vastly different outcomes, simply due to the timing of those returns.
A portfolio experiencing a negative return in the first year followed by positive returns ends up significantly worse off than a portfolio with the same returns in reverse order, once annual withdrawals are factored in. The lesson for advisers is clear: the order in which returns occur can be just as important as the returns themselves.
Rethinking risk: Beyond volatility
Volatility has long been the industry’s default metric for measuring investment risk, but its shortcomings become particularly evident during the decumulation phase. In retirement, it’s not just the size of portfolio fluctuations that matters – it’s the length of time a portfolio spends in a depressed state, or “underwater,” that can be most damaging.
An alternative approach involves using measures that account for both the depth and duration of drawdowns. One such measure is the Ulcer Index – a lesser-known but insightful risk indicator. It captures the psychological and financial impact of prolonged losses, highlighting how extended periods of underperformance can lead to investor anxiety and potentially poor decision-making.
For IFAs, this redefinition of risk offers a valuable framework when explaining investment strategy to clients in retirement. It also supports the shift away from traditional performance metrics like the Sharpe Ratio as sole indicators of success.
Investor behaviour: The hidden risk
Even the most robust portfolios are vulnerable to one critical threat: human behaviour. Investors often react emotionally to drawdowns, shifting to lower-risk assets after losses and missing out on subsequent recoveries. This reactionary approach can permanently impair their capital.
Effective drawdown management can help mitigate this risk by creating a more stable investment journey, reducing the likelihood that clients will abandon their long-term strategy at precisely the wrong time.
Tools for managing drawdown risk
How can IFAs actively manage drawdown risk in client portfolios? Here are five key strategies:
- Diversification – Combining uncorrelated assets to reduce overall portfolio volatility without sacrificing expected returns.
- Volatility Control – Adjusting exposure to risky assets based on prevailing market volatility, ensuring more consistent risk levels over time.
- Dynamic Allocation – Using trend-following or momentum strategies to adjust portfolio weights in response to market signals.
- Tail Hedging – Employing options or other instruments to provide protection against extreme downside scenarios.
- Stop Loss Techniques – Limiting losses by automatically reducing exposure after certain thresholds are breached, although this must be used judiciously.
A combination of these risk management techniques can offer far greater resilience than relying on any single approach. In practice, strategies that integrate elements such as diversification, volatility control, dynamic asset allocation, and tail risk management have shown particular promise in navigating retirement decumulation more effectively.
One such example is a diversified absolute return strategy, (an example being Fulcrum’s DCAR strategy, which has been operating since 2008). These types of strategies bring together multiple defensive tools to deliver lower volatility outcomes compared to traditional equity portfolios. When evaluated through the lens of drawdown sensitivity – rather than standard volatility metrics – such a strategy has demonstrated stronger capital preservation and shorter recovery periods from losses, even when matched to the same level of risk.
For IFAs, this type of multi-faceted investment approach provides a compelling option for clients moving into or already in retirement. By aiming to minimise time spent in a drawdown state, rather than chasing headline returns, advisers can support more stable income outcomes and mitigate the risks associated with longevity and market sequencing.
The move towards income drawdown has created an urgent need for a more sophisticated approach to retirement investing. Volatility alone is no longer a sufficient risk measure. Understanding and managing sequencing and drawdown risks are essential to delivering sustainable outcomes for clients.
For IFAs, embracing this framework and exploring strategies that directly address these risks could mark a significant step forward in retirement planning. The future of advice lies not just in chasing returns but in managing the journey – especially when that journey could span a 30-year or more retirement horizon.
By: Matthew Wright, a partner at Fulcrum Asset Management