Vince Smith-Hughes discusses the difference between fixed-term annuities and annuity products
Income drawdown originated in 1995. Since then, many advisers have used it to good effect. Although it is not without risk, there are many clients who have, over the years, appreciated the flexibility, investment options and death benefits it provides.
Since its introduction, additional guidance has been published to help advisers to establish suitability. The Regulatory Update 55 (RU55) - published in August 1998 - was a key part of this guidance, as it helped advisers to calculate critical yields. RU67 subsequently reinforced the importance of giving specific risk warnings:
- High income withdrawals may not be sustainable during the deferral period
- Taking withdrawals may erode the capital value of the fund, especially if investment returns are poor and a high level of income is being taken - this could result in a lower income when the annuity is purchased
- The investment returns may be less than those shown to clients
- Annuity rates may be at lower levels when annuity purchase takes place.
Interestingly, there have been several variations on income drawdown over the last few years, such as variable annuities, guaranteed drawdown and fixed-term annuities. Confusingly, they are all drawdown products in one guise or another.
Fixed term annuities
Fixed-term annuities, in particular, have become popular over the past few years. These arrangements give clients a guaranteed income (subject to GAD limits) and a guaranteed "maturity" value at the end of the term which can be transferred to another drawdown plan or an annuity.
Now that the Age 75 rule has gone, these could, in theory, be open-ended. But in practice, many are written for short-terms, such as five years. Recently, there have also been launches of plans which include investment elements.
It is not hard to see why many advisers regard these arrangements as attractive - they give the client some certainty over income, while maintaining flexibility at the end of the term.
In addition, there is a chance that clients could benefit from better rates, possibly on enhanced terms, when they come to purchase an annuity.
Opinions differ on whether these arrangements are good value. With bond and gilt yields at very low levels, the actual returns offered by these arrangements have come under pressure of late. Advisers should convey to clients the risks of drawdown which apply here.
Although there is no investment performance risk to most of these arrangements, there is a risk that any income taken will not be sustainable for the whole of retirement. After all, nobody knows where annuity rates will be in five years' time.
In addition, most of these arrangements do not invest in "real assets", such as equities or property. The client, therefore, runs the risk of the fund decreasing in value, and of the real value being eroded by inflation.
There are alternatives available for clients looking for the flexibility of drawdown, with the added benefit of more security.
These options include investing in a smoothed, multi-asset fund which irons out the day-to-day fluctuations of unit price.
They also reduce the risk of income being taken when the value is low, and losses being crystallised. However, the flexibility of drawdown is retained, including the ability to vary income.
For clients looking for a lifetime income, annuities should be considered. Investment-linked annuities are an attractive alternative for many, as a result of current, extremely low conventional annuity rates.
There are many retirement solutions available to advisers. It is therefore important that they consider all of the options available, and ensure that the client understands the pros and cons.
Key considerations for advisers:
- There are numerous guidance papers on income drawdown that must be considered in the context of alternative forms of drawdown - appropriate risk warnings must be given
- Advisers must consider whether arrangements offer attractive returns
- They must ensure that clients are aware of what they are buying, especially if there could be a risk to their future incomes
- It is possible to build a cautious portfolio, or use a multi-asset smoothed fund, as an alternative to fixed-term annuities, for some clients
- Inflation for retirees must be considered - pensioner inflation can significantly erode the future buying power of income
- Advisers must be familiar with recent drawdown changes and all of the regulatory requirements
- Advisers have a range of options to consider for clients approaching retirement, as well as for those who are reaching a drawdown review point
- Clients looking for a lifetime income should consider investment-linked annuities
Vince Smith-Hughes is head of business development at Prudential
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