Mike Morrison discusses the issues advisers and their clients need to bear in mind when taking advantage of the new flexibility around retirement income
One key element that cannot be factored into a financial plan is the exact date of death – which is probably just as well!
This necessitates the need for assumptions about life expectancy in order to arrive at some idea of how long income will be required.
Before 1995, when annuity purchase was pretty much compulsory, this was less of an issue as annuities would pay out for life, however long that may be. Following pensions simplification, annuity purchase was no longer compulsory but the other options at age 75 meant that it was still used by most.
From April 2011 the need to annuitise is to be totally removed with the option to utilise income drawdown throughout retirement.
As we all know, income drawdown involves managing the pension pot to fund the client’s required level of income and/or leaving a surplus to be passed on if so required. The removal of the requirement to annuitise in effect makes the investment period open ended.
The statistics show that we are all living longer and there is research to suggest that generally people underestimate how long they will live – this does not make investing in an income drawdown portfolio easy!
The strength of income drawdown is its flexibility and the ability to take advantage of investment growth. However, its weakness is the fact that the retirement fund is subject to investment risk. In this respect, assessing an individual’s attitude to risk is an inherent part of the decumulation advice process.
In my mind, I have always segmented income drawdown broadly into the following – funds below £100,000 normally would suggest annuity purchase (although it depends on other assets). Funds in excess of, say, £300,000 (again subject to other assets) could be income drawdown clients who are able to withstand fluctuations in investment markets. In between there are fund sizes where individuals feel they could be too big to lock into annuities, but not able to withstand too much loss in their fund values.
As annuity rates have fallen, and with a prognosis to possibly fall further with Solvency II and the possibility of unisex annuity rates, the perception is that they are poor value for many and inflexible, particularly on early death. This could well influence the attraction of income drawdown to people who are realistically too risk averse to accept investment risk.
As well as the investment risk, it must not be forgotten that an income drawdown product is likely to cost more as the financial advice and investment management involved has to be paid for.
So, imagine the pension client who chooses income drawdown but needs to maximise the income that he draws – so in effect replicate an annuity, if maximum GAD represents the annuity equivalent. Not only does the client have to achieve investment growth to match the underlying rate of return of the annuity but extra to cover the management charges of the investments and more still to cover any trail remuneration taken by the financial adviser.
This disregards any initial charge taken by the adviser which, coupled with poor investment performance, could immediately damage the chance of the fund meeting its investment target. As the client gets older and the mortality cross subsidy inherent in annuities increases, it is likely to be even more difficult to achieve annuity replication.
Another factor to consider is the volatility of the investment market and funds and the effect this can have on an income drawdown portfolio, particularly if there is the regular encashment of units. Cashing units in a falling market – the reverse of pound cost averaging – can have a devastating effect on a retirement portfolio.
As income drawdown becomes more popular it will be important to understand the investment issues in question, from how to assess the client’s attitude to risk and to put this into practise, to how to develop a robust and repeatable investment process to manage the money. As time goes on I am sure that there will be funds that are specifically designed to cope with the problems that income drawdown raises.
For many people annuitisation is likely to be the ultimate landing place but at an age they can choose, when mortality cross subsidy is at its highest and the peace of mind induced by the guarantee that an annuity brings is most valued.
Mike Morrison is head of pensions development at AXA Wealth
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