Andrew Pennie looks at the options available to generate retirement income and some of the key client factors that should influence the recommended strategy
As a result of longer life expectancy and relatively low annuity returns, there has been a significant growth in the number of products available to deliver retirement income.
The three main options are annuities, drawdown or one of a number of different third-way products.
In retirement, clients face a number of key risks, most notably:
- Longevity risk - living too long and money running out
- Inflation risk - inability to maintain standard of living
- Investment risk - failing to generate real returns ahead of inflation
- Flexibility risk - inability to meet a significant change in circumstance
- Capital risk - preserving pension capital for next of kin.
As advisers, we are responsible for mitigating these risks on an ongoing basis in a way that best meets the clients' ever-changing circumstances and objectives. Traditional annuities mitigate longevity risk and, for an extra charge, can also deal with inflation risk.
Avoiding risky options
Annuities, however, do not provide any opportunity for investment growth, and thus this should be seen as an opportunity cost rather than a risk. Traditional annuities do little to mitigate the two remaining risks as they provide no flexibility and limited capital protection options.
Drawdown is considered to be at the other end of the spectrum to annuities. Unlike annuities, they do not completely deal with any of the key retirement risks.
Drawdown is all about managing the risks and an ongoing process of assessing suitability against changing client circumstances and external factors.
If appropriate, and managed in the correct way, drawdown can be an excellent vehicle to manage all the retirement risks and undoubtedly provides the greatest opportunities from a flexibility and capital protection perspective.
Third-way solutions vary dramatically, but generally profess to cover many of the benefits of annuities and drawdown with the drawbacks of neither.
Longevity risk can be partially mitigated, while there is usually an opportunity to beat inflation through investment growth - albeit, investment choice and flexibility is constrained by the need to cover guarantees.
Third-way solutions also normally provide options to address flexibility and capital protection, but again with likely compromise over options and timing.
However, the key to whether this type of solution is suitable or not should largely depend on the cost (or potential opportunity cost) of the underlying guarantee, the likelihood of a client calling on that guarantee, and the impact it would have if they needed to.
Clearly, there are pros and cons for each solution. In some circumstances, particularly over time, a combination of solutions may prove most effective to meet your clients' needs.
Every client is different and has different personal circumstances and aspirations for their retirement. In addition, their circumstances will likely change over time - what was right for them last year may be entirely inappropriate now.
It is highly dangerous to segment retirement income solutions by pension fund value. A host of client factors must be considered to identify and recommend the most appropriate strategy. This would include the clients' age and health, attitude to investment risk, investment horizon available and the degree of dependency on their pension fund, taking into account other income and capital resources.
Once in a position of understanding the client's circumstances and objectives, advisers must continuously advise and avoid pandering to what the client thinks they need. Core examples for retirement income planning would include the following:
- Risk: If the client has absolutely no appetite for risk or is not in a position to take any financial risk, traditional annuities are hard to argue against
- Value: Segmenting solution by fund value can be dangerous. Take a doctor with a high NHS pension and small personal pension, for instance - an annuity producing more taxable income is unlikely to be the best solution
- Guarantees: They can be expensive and unnecessary but in the right circumstances these solutions can be useful, not least as part of a drawdown exit strategy
- Phased drawdown: If a client does not need their entitlement to tax-free cash, advisers should strongly recommend that they don't take it. Phased drawdown is the most effective means of adopting a flexible and tax-efficient drawdown strategy
- Drawdown exit strategies: As well as phasing into drawdown, phased exit strategies to take advantage of higher annuity rates because of increasing levels of mortality subsidy should become a consideration as clients get older
- Health: It is imperative that advisers monitor clients' health and eligibility for enhancements where they recommend a non-annuity solution. Not being aware of eligibility for higher annuity levels is not a defence.
Retirement planning is a growth opportunity for advisers, but it remains a complex area of advice. It is highly likely that it will be an area of increasing claims risk.
Advisers must ensure they have a robust and consistent advice process (in-house or outsourced) that clearly demonstrates initial and, where appropriate, ongoing suitability for their clients.
Andrew Pennie is marketing director at Intelligent Pensions
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