Billy Mackay discusses what income drawdown can offer people coming up to retirement
How are retirees looking to utilise income drawdown as part of their retirement planning strategy? How has it evolved as a result of the current economic turbulence?
The income drawdown market has evolved in many ways over the last 14 years. The benefits that attracted people to it remain true - control of the underlying pension fund income, timing of annuity purchase and death benefits. We understand how this particular vehicle behaves in all kinds of market conditions. It has been the subject of regular regulatory scrutiny and guidance so we have a clear picture of the risks that need to be understood by the client.
More than ever, clients are using income drawdown as part of an overall retirement strategy. The market is driven almost entirely by clients under the guidance of an IFA. Strategies for how you invest and draw income are common. Clients will know whether their pension plan is likely to be their primary source of income. They will be provided with information to outline the overall resources that they will have and need in retirement. They must consider the rate at which income is likely to be taken from the fund allowing for market conditions, the likely investment performance of the portfolio and the charges levied by the product provider.
What do you think are the biggest misconceptions people hold about income drawdown and what can the industry do to overcome them?
I am not convinced the problem today is about misconceptions, it is more about concerns that come from the reality of the risks. Volatile market conditions make recognising the risks real.
Previous regulatory work highlighted concerns because it was difficult to determine whether clients were being provided with a satisfactory explanation of the inherent risks of opting for income drawdown rather than the other options available. It was suggested that the risks were often described superficially and in terms the investor would not have been likely to understand. Particular areas highlighted:
- High income withdrawals may not be sustainable during the deferral period.
- Taking income withdrawals may erode the capital value of the fund, especially if investment returns are poor and a high level of income is taken. This could result in a lower income when the annuity is eventually purchased.
- The investment returns achieved may be less than those shown in the illustrations.
- Annuity rates may be at a lower level when the annuity purchase takes place.
As an industry, we are now better at explaining what these risks mean to the end client. Ultimately, we can't influence annuity rates but we can influence the other three areas. Managing expectations is crucial, we can adjust income levels and we can decide on the appropriate acceptable level of risk alongside a sensibly structured investment strategy with regular reviews.
Where do you see product innovation occurring in the income drawdown market?
Two important areas involve the nature of charges and allowing for the ever-changing nature of the underlying investments and markets.
Over the last 14 years you will have come across products with bid offer spreads, policy fees, up front allocation percentages, single charges, multiple charges, the list is endless. Products of choice today will clearly disclose the nature, impact and timing of any charges.
Looking at charges, some may question the logic of SIPPs applying a charge when a client takes income at retirement. To understand whether this represents good value you must first identify the cost of the SIPP wrapper. Using Sippcentre as an example, the SIPP wrapper has a cost measured by a reduction in yield (RIY) of 0.17% per annum. In essence, it is structured so that the client is only paying for benefits and features as they use them. In traditional products, you could argue the cost is smoothed across all clients irrespective of whether you use this feature.
A simple example shows the historical scale of change and varying investment trends. The most popular funds by sales over the last 10 years have covered sectors that include technology, North America, healthcare, commodities, UK income, property and absolute return. Investment strategies are evolving beyond the use of more traditional external fund links to include things like exchange traded funds and discretionary investment managers.
How do you think recent developments in the variable annuity market will affect income drawdown going forward?
Two areas worth considering here are longevity risk and the impact of a guarantee. From a product manufacturer's view, the risk and potential cost, if you get it wrong, is huge. Globally, this is why history shows that for every successful product there are many that have proved to be financial suicide for the provider.
The problem with longevity is few of us are in a position to predict our lifespan. The longevity risks in income drawdown are all about what happens to the residual fund if I die early and what is the chance of exhausting my fund if I live to a ripe old age. Variable annuity products tend to market the benefits of a guaranteed minimum income, guaranteed income for life and protection against market falls. If this is the case, longevity is often the enemy of the provider.
Over recent years I have been approached by many organisations willing to provide the underlying mechanism for guaranteed income, a key ingredient in a variable annuity. Few, if any, have been willing to carry the financial implications attached to the longevity risk.
Many products will market the potential for upside alongside a guarantee. In understanding the potential for upside you must consider the impact of the cost of the guarantee. For every product that can clearly display a track record for delivering upside in all market conditions, you will have many that can't.
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