With a potential explosion in demand for drawdown due to next year's pension changes, Financial Planners must take action to ensure their review procedures are robust and personal recommendations safeguarded from complaints and regulatory action.
Research suggests one area of concern is the calculation of critical yield, a key benchmark that allows clients to compare drawdown against other options, that firms often base on generalised criteria rather than taking into account an individual's own health and lifestyle.
Personalising critical yield calculations using rates based on individually underwritten annuities will ensure clients choose drawdown for the right reasons and help highlight the added value of professional advice.

In this issue of Technical Update, Just Retirement's group external affairs and customer insight director Stephen Lowe, takes a topical look at the changes ahead next year for income drawdown after one of the most dramatic Budgets in recent years.
What will happen when 'pension freedom' arrives? What are the risks for planners and consumers and how will the Financial Planning sector cope with the turmoil? 

Benefits and risks of income drawdown in post Budget environment as new pension freedoms arrive next year

Pension 'freedom' arrives next April with new rules allowing retirees to take the whole of their pension pot as a cash lump sum if they wish. It is what many Financial Planners have been waiting for but, for those without professional help, has it come too soon?

Even given the history of regular tinkering with pension rules, the changes announced by Chancellor George Osborne in the 2014 Budget are a bold step. Ultimately, the changes are designed to encourage people to think carefully about how best to deploy pension money. Annuities will remain the cornerstone of retirement planning because they guarantee the income will keep flowing however long someone lives.

But the new rules will create new options to take lump sums although they may also mean added complexity, risk and cost. To help decision-making, the government has promised 'guaranteed guidance' for all retirees although there are still big question marks about how this will be delivered. In the meantime, it is hoped the changes will persuade more people to seek professional expertise.

The biggest impact may well be among those with smaller pension pots due to more generous trivial commutation rules and the recognition that they have choices beyond buying an annuity from their own pension provider offering poor value. The wealthy and more financially-savvy have always been more likely to take advice, use the flexibility already available and to shop around if they wanted an annuity.

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The main annuity alternative has been income drawdown which, when introduced nearly 20 years ago, ended the requirement to annuitise by age 75. This age requirement was pushed back in 2010 and scrapped a year later. At the same time, drawdown was split into two varieties – 'capped' which imposes income restrictions and 'flexible' which gives unlimited access to pension capital provided the retiree had £20,000 a year of secured income.

Drawdown solutions have therefore been part of the retirement planning landscape for many years. At its heart is the drawdown review which, for those in capped drawdown, must be carried out at least every three years and annually for clients aged over 75. The review is required by pension regulations in order to value the pension fund and to use GAD rates to determine the maximum allowable income level, with the aim of ensuring the fund does not deplete too quickly.

Although we expect the drawdown review requirements to change under the new rules with GAD rates disappearing, it is clear that any client seeking a sustainable income from their drawdown pension will still need formal financial check-ups at regular intervals to ensure the arrangements remain suitable as the retirement years go by.

The Financial Conduct Authority has no specific rules around drawdown reviews but where a client is being advised on a course of action – whether that is to adjust income, buy an annuity or to just leave everything as it is – it will be a 'personal recommendation'. Based on that fact, the drawdown review must meet the same suitability rules as the original recommendation.

Among the relevant circumstances are "state of health" and "attitude to risk", both factors crucial to financial planning generally and retirement planning particularly where clients are older and usually have less ability to recover from financial shocks.

This may seem obvious but research conducted by Just Retirement last year which generated around 600 responses from financial intermediaries raised concerns about how annuities were being considered during drawdown reviews and specifically their application to critical yield calculations, a key benchmark in the drawdown process. Our figures found that 55 per cent said they considered annuities at reviews as part of critical yield calculations, but only using standard rates. A further 12 per cent said they did not consider annuities at all. That suggests just one-third use individually-underwritten annuities as the basis of comparison, with the rest potentially not using a relevant critical yield in their review process.

While it is likely some clients signal at the start that they never intend to buy an annuity so any comparison would be meaningless, we feel many more are actually deliberately deferring annuity purchase but still want to be kept informed of the amount of guaranteed income that would be available should they chose to switch.

This prompted us to commission more in- depth research by David Ingram, president of the Personal Finance Society and founder of support services provider Aim Two Three Consultancy. His review of a number of smaller firms looking after a total of 1,100 drawdown clients found that 40 per cent did include individually underwritten annuity rates in the critical yield calculation. Of the 60 per cent who did not, many simply said it was not part of their process.

Critical yield has a vital role in considering whether the level of income being drawn from a pension fund is sustainable over the long-term. During a review, if the investment returns are failing to meet the critical yield, then the selected level of income cannot be maintained without depleting the fund. This leaves clients in drawdown with a choice of either reducing their income or chasing higher returns by taking on more investment risk. Should those who are not comfortable with either remain in drawdown at all?

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It is essential that the critical yield calculation is as accurate as possible and tailored to the individual's own circumstances, which means the annuity assumption should reflect the annuity a client might purchase in reality. Our research indicates that up to 60 per cent of cases could qualify for enhanced annuity rates and it is only by going through the individual underwriting process, collecting and submitting health and lifestyle information that a rate can be established that reflects an individual's unique circumstances.

There are circumstances in which critical yield is not the most important factor in the drawdown review process and in many cases clients will enter drawdown despite critical yield. However, a process that does not cover the key points mentioned as best practice in COBS 9.3.3 including shortcomings around collecting and using health information will be open to challenge and potential complaints. Failure to include enhanced rates in the critical yield calculation means some clients who could benefit from an annuity may be left in drawdown receiving a lower level of income and taking a higher level of investment risk.

Investment risk looks very different to those relying on a portfolio to generate regular income. During pension accumulation, investors can benefit from volatility where dips in asset prices give the opportunity to buy more at lower prices.

That's not true for retirees who need the money to live on and may find falling asset prices combined with income withdrawal can ravage the value of a portfolio and lead to irrecoverable losses. Two major stock market slumps in the last 15 years are a reminder that investing can be a bumpy ride with outcomes affected by timing.

It is important that clients are fully aware that full disclosure of health and lifestyle can have a positive impact and, with the majority able to secure enhanced rates, intermediaries should assume they will qualify rather than that they won't. [See panel below 'Three steps to a personalised critical yield'].

A client's circumstances can change dramatically between drawdown reviews. Fading health, divorce or the death of a spouse, poor investment returns and a need to pay for long-term care are among the factors that may impact on a financial plan. Attitude to risk may also change, making guaranteed income more important. Pension legislation also changes and, of course, there are the effects of mortality drag that make it harder for a drawdown income to deliver the same as an annuity as retirees get older.

Although firms have a great deal of freedom to create their own review processes it is important to take account of best practice. Our research among firms highlighted a number of steps, summarised in panel 1 [for panel 1 see below]. Reviews need to be frequent, in many cases part of the overall review of a client's affairs. Costs should be explicit. A full financial fact find should be completed.

Firms need to determine the client's attitude to risk, capacity for loss, their current state of health (along with their spouse and any dependents), and any changes in circumstances such as employment or marital status. This information will allow relevant critical yields to be calculated which can then be discussed with clients before recommendations are made.

Are you confident that your drawdown review process is robust and will adapt to the era of pension changes a few months away? If it's making you think, remember that there is a mass of support available to firms who are keen to modernise their processes and reduce the risks of compliance issues. But the silver lining is that putting individual factors such as health and lifestyle at the heart of the process is exactly the kind of personalised service that clients expect and value.

The position can be complicated by existing investments that cannot justifiably be sold. Fortunately it's not rocket science to make recommendations that match clients' risk profiles, investment objectives and circumstances. Advisers have an important ongoing role in maintaining client portfolios as circumstances change and investment time horizons shorten.

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PANEL 1: COBS 9.3.3

"When a firm is making a personal recommendation to a retail client about income withdrawals or purchase of short- term annuities, it should consider all the relevant circumstances including:

(1) the client's investment objectives, need for tax-free cash and state of health;

(2) current and future income requirements, existing pension assets and the relative importance of the plan, given the client's financial circumstances;

(3) the client's attitude to risk, ensuring that any discrepancy is clearly explained between his attitude to an income withdrawal or purchase of a short-term annuity and other investments.

PANEL 2: THREE STEPS TO A PERSONALISED CRITICAL YIELD

A critical yield is an indicative investment return which – if met – would achieve a fund value capable of supporting a certain level of income in the future. There are two types, the first is the return required to match an annuity purchased at outset, the second is the return required to maintain a client's chosen income level. The three steps are:

Step 1 – individually underwrite. Six in every 10 annuity applicants could qualify for an enhanced annuity rate. Underwriting will help establish the correct level of enhanced annuity rate uplift which can then be factored into the calculation.

Step 2 – Shape. Drawdown illustrations often reflect standard assumptions based on a level annuity with no dependant's pension. Consideration should be given to the frequency of payments, escalation, guaranteed periods and dependant's pensions
that a client would actually wish to have built in.

Step 3 – Income. The client needs to consider
how much income they wish to take now and
also in the future and, if they are considering annuitising, at what point in retirement. The critical yield will be much higher for drawdown clients who choose to extract the maximum income.

STEPHEN LOWE DIRECTOR, JUST RETIREMENT

Steve joined Just Retirement in January 2011 and is responsible for customer insight, public affairs and media relations. He sits on the board of the Pension Income Choice Association; the ABI's committees for Retirement
 & Savings; Distribution and the Department of Health's steering group for the development of long term care solutions. He led Just Retirement's RDR transformation programme and more recently was part of the core team that completed Just Retirement's IPO. Prior to joining Just Retirement, Steve was the Marketing & Product Director of Living Time and has worked as Marketing Director for Prudential's UK, Europe and Middle East business. Steve is a Chartered Marketer and holds an MBA from Henley.

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