Andrew Tully discusses income drawdown exit strategies
Nothing lasts forever. And that is true for pensions as well. Drawdown is a popular solution for many, whether they want to access their lump sum but don’t need any income; or they want to retain investment control over their funds; or they don’t want to be locked into an annuity just yet. But clients and advisers have to constantly re-evaluate whether staying in drawdown remains the best strategy.
The majority of advisers are aware that the day to leave drawdown will come. Recent research by MGM Advantage showed 74% of advisers with drawdown clients already have an exit strategy in place. But worryingly, 18% did not.
The reasons advisers gave for not putting an exit strategy in place included clients wanting to retain control of their fund (42%); clients having access to other financial options (for example ISAs) (39%); preferring access to a large choice of funds unavailable in alternatives (31%); and preferring the death benefits from drawdown (31%).
While these are all commendable reasons why drawdown might fit clients’ needs at the moment, we need to be aware of what is possibly around the corner. As clients age, and their lives change, they may need a different retirement solution.
Our research found that the most popular exit strategy is an annual review against other at-retirement options (84%). This could be triggered by changes in the client’s personal circumstances.
For example, deterioration in health would lead 83% of advisers considering enhanced annuities, or a fall in fund value to a level deemed unsuitable for drawdown could signal an exit to annuities for more than half (59%).
A change in family circumstances is also a strong reason to review drawdown’s suitability. And while age alone is not necessarily a trigger for considering an exit strategy, as the client gets older other issues come into play such as lack of mortality cross-subsidy, fading health, and wanting to take on less risk.
Mortality cross-subsidy is a powerful reason why an annuity might be a better option for older clients. Annuities are pooled products, where those who die before their normal life expectancy, subsidise those who live longer than expected.
The investor does not benefit from cross-subsidy in drawdown. Everyone has their own fund – that is the reason why the fund can be returned to the estate on death.
However, those who buy annuities do benefit from this subsidy. So in order for a drawdown fund to provide the same income as an annuity, there has to be an extra investment return each year to compensate for the absence of this subsidy.
When the client is, say, in their late 60s, this extra investment return is small (less than 1%). But as the client ages, the return needed increases exponentially. For example, at age 85, it is less than an extra 4% each year. The burden of maintaining this additional investment return may mean a move to annuity is preferable.
Fading health may be another reason why clients want to exit drawdown. The maximum income available in drawdown is based on Government Actuary’s Department (GAD) rules. But it does not take into account ill health. It is the same income parameters regardless of whether the client is in rude health or whether their health is suffering.
We know up to 70% of annuitants could be in a position to qualify for an enhanced annuity, and that is no different for drawdown clients. Poor health can strike very quickly and transform clients’ financial needs. Drawdown clients may want to secure a higher income through an enhanced annuity to help them make changes to accommodate illness.
A 70 year-old with type 2 diabetes and high blood pressure may be able to use their £150,000 fund to secure an enhanced annuity of £10,674 a year, compared to a 100% GAD drawdown limit of £10,500. If that enhanced annuity was an investment-linked annuity, then the client could receive about 120% of the income level (£12,866).
Of course, more severe ailments will secure a higher income. A 70-year-old who had a heart attack six months ago may be able to secure £13,387 a year in an investment-linked annuity with their £150,000 fund.
A third reason to exit drawdown may be a growing reluctance to hold as much risk, and a growing need to have some form of income guarantee. There are various options for those who decide to exit income drawdown.
Those clients who no longer want to be troubled with investment risk can choose the option of a guaranteed annuity, using enhanced terms if available.
But some clients, while seeing the benefits of moving to an annuity, will want to continue to control their investments, and, importantly, use investment performance to offset the effects of inflation.
By transferring to an investment-linked annuity, investors can take an income equal to 120% of the benchmark annuity, with the ability to change income at any time – giving them the control over income and investments they would have been used to in drawdown.
An investment-linked annuity will also guarantee to pay 50% of the benchmark annuity at outset regardless of the underlying performance of the funds, giving clients a safety net below which their income will never fall.
If the client wants a guaranteed income, but also the potential for growth, an alternative solution may be to split the drawdown fund between an investment-linked annuity and a guaranteed annuity. This gives clients 75% guaranteed income, plus the ability to benefit from future investment performance and flexibility.
Drawdown offers clients many key benefits, but it will be a temporary solution for many. Knowing when it is the right time to move, and where to move to, is where advisers can offer their clients help in adapting to their changing financial needs
1. Source: MGM Advantage research among 200 advisers, conducted by telephone by Research Plus Ltd, fieldwork 29 October to 8 November 2013.
Case study - meet Dennis
Dennis retired from his job as a head office manager for a large retail firm when he was 68, and decided to invest in a drawdown contract as he wanted to retain investment exposure and be able to vary his income level.
Five years later, he is uncomfortable with his level of investment risk, as well as the mortality cross-subsidy he is losing out on while in drawdown. However, he does not want to move everything to a conventional annuity and lose all investment exposure.
Dennis has been diagnosed with high blood pressure and type 2 diabetes. Unfortunately, the diabetes has been very difficult to control and he is now insulin dependent (he also has neuropathy as a result of the disease). He is concerned this factor is not being reflected in the maximum income calculated for his drawdown contract.
At 68, Dennis had a fund of £235,000 (after he had taken tax-free cash). He invested it in a drawdown fund at a time when gilt yields were 3.25% (February 2009). His maximum income was £20,586. He chose to take a yearly income of 100% of GAD which was £17,155.
After five years...
Dennis is now 73 and has developed high blood pressure. His drawdown fund is worth £200,394 (assuming 5% growth, net of charges) and the maximum income he can now take from his fund has fallen to £18,756 (assuming 3.25% gilt yield at February 2014). For comparison, 100% GAD is now £15,630. None of his drawdown income is guaranteed.
He decides to move out of drawdown completely and instead split his retirement fund equally between an enhanced annuity and an investment-linked annuity.
£100,197 buys him an enhanced annuity of £8,640. He invests the remaining £100,197 in an investment-linked annuity, and taking his medical conditions into account his maximum yearly income under the contract is £10,407. This gives him a yearly income of £19,047 and importantly, a guaranteed income of £12,976.
Dennis was keen to maintain some investment exposure, but at the same time wanted an increased income guarantee, hence splitting it between a conventional annuity and an investment-linked annuity.
If Dennis was happy to remain fully invested, he could move 100% into an investment-linked annuity. This would give him a maximum income of £20,280 and a guaranteed income of £8,450.
Andrew Tully is pensions technical director at MGM Advantage
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