A client reaching retirement with a substantial money purchase fund is faced with many choices. One ...
A client reaching retirement with a substantial money purchase fund is faced with many choices. One may be whether to take pension benefits at all, or to defer that and live off other assets, or perhaps to take benefits from some plans and defer others.
Having made that decision, there is a choice between conventional annuity, investment-linked annuity, income drawdown and phased retirement, taking into account the many variants and hybrids now available on the market. This choice may be largely driven by three main considerations: The relative importance of death benefits and survival benefits, of guarantees and growth potential, and of income flexibility and income certainty. But even with all these choices made, the decision process is far from over, particularly with income drawdown. There are several key choices still needed.
At present, drawdown clients must buy an annuity by age 75 at the latest, but do not automatically assume that everyone will be best to wait until 75. In fact, most clients will be best advised to buy an annuity before then.
One way to approach this is to look at the critical yields for annuity purchase at different ages. Critical yields show the investment returns needed over the period of drawdown on set assumptions. Most providers show these on their quotes, and they give a useful guide to the feasibility of drawdown.
The relevant figure is the 'Type A' yield, which is based on drawdown income at the same level as the annuity that could be bought now, with no change in the general level of annuity rates during drawdown. The red line in the chart below shows a typical shape for this yield curve, based on a 60 year old single male.
This pattern is typical of such curves. A 5% initial charge has been assumed, so the critical yield is high in the early years. However, this charge gradually becomes less significant, and the main issues become the annual charge (assumed to be 1% throughout) and mortality drag. This is the effect of the loss of the cross-subsidy in annuities from those who die quickly to those who live for a long time. Drawdown does not have this cross-subsidy, but instead provides superior benefits when individuals die during drawdown.
Eventually the mortality drag effect becomes much more significant than initial charges, and the yield curve starts to rise. The key point is where the curve starts to bottom out, here at about age 67. It then sits at around 7.6% for a few years before rising significantly. For drawdown to be worthwhile that return of 7.6% has to be achieved (given other assumptions are realised in practice), and that is easiest over a time horizon of 7-12 years.
However, there is a further factor in deciding a sensible target term for drawdown. As well as the critical yield over the whole term, we can consider the critical yield for a single year. Drawdown should be reviewed yearly, and the return required over the next year to match an annuity that could be bought now is important. That is shown by the blue line in the chart.
This starts at the same level as the other line, but immediately drops sharply before rising steadily. The key point on this line is where it reaches a return that you feel presents too high a risk for your client. This might be, for example, 3% above the current gilt yield (which is 5% in this example). On that basis, all else being equal you would be looking to buy an annuity by age 71.
Providers do not normally produce figures for this year-on-year critical yield, but you can estimate it. First calculate the pension that could be bought now, and how much that level of pension would cost in a year's time (if the pension is increasing you need to build in a year's escalation too).
Take the second figure and add in the year's income from the pension, increased by 4% (as a conservative allowance for the fact that income is often taken monthly). Divide the result by the current fund value, and add in the provider's charges as a percentage of the fund. The resulting figure is the yield you need.
For example, you might have a current fund of £100,000, which could buy a pension of, say, £6,500 a year with 3% escalation. In a year's time, that pension would have grown by 3% to £6,695 a year, and to buy it then might cost £99,300. Adding 4% to the £6,500 gives £6,760 and adding that to the £99,300 gives £106,060. Divide 106,060 by 100,000 and add in 0.01 (the 1% charge) to get an answer of 1.0706. This means that the year-on-year critical yield is 7.06%. The method is slightly approximate, but good enough for practical purposes.
The two lines in the chart give us a time horizon for this drawdown. It takes about seven years to run off the initial charges, and after 11 years the level of risk is looking uncomfortable. You may therefore be anticipating a drawdown period of between seven and 11 years, although this could obviously change with circumstances.
The pattern here is fairly typical for drawdown. However, for females and married people the maximum age is higher, although it is still likely to be below 75. The actual charges of the provider also have to be taken into account, and some have loyalty bonuses that change the shape of the curves. In principle, though, it is possible to plan a time horizon for any drawdown contract in this way.
Having established critical yields and a likely time horizon, we can start to consider investment options. Since the critical yield is generally fairly high, typically over 7% a year at present, it is normally essential that a substantial proportion is invested in equities and similar investments that offer prospects of high returns.
Investment in gilt or cash-based funds at present is almost certain to mean that the return
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