Thursday, 15 August 2013 13:32
Technical Update: Income Drawdown
The annuity market in the US has declined as more people move towards more flexible retirement options such as income drawdown but will the same happen here? Some experts seem to think so. Baby boomers starting to enter retirement in the UK will herald an unprecedented boom in demand for income drawdown, believes Standard Life's Alastair Black.
In this Technical Update, Mr Black looks at the growth in the market and why this generation's high expectations will spur increasing use of more flexible retirement solutions such as income drawdown.
There are a number of things "fundamentally shifting" in the retirement market, which means the future is positive for drawdown, says Mr Black. Among these is that the staple of retirement planning for many years - annuities - will lose their dominance in the years to come.
While he believes annuities will still be the right choice for some, they will not meet the needs of many consumers and more people will start to understand the relative benefits of drawdown. There are some key issues, however, which need to be explored, he believes.
Mr Black takes a sober and insightful look at the pros and cons of income drawdown with an analysis many planners will find useful.
Choosing between annuities and income drawdown to find the best option for funding a retirement plan.
I believe that the number of people entering the drawdown market is set to grow rapidly now that the baby boomer generation is entering retirement. This generation has high expectations and it will be looking to give its finances a work out to get the best out of them – with income drawdown likely to be an attractive option.
There are three things fundamentally shifting in the retirement market which means the future is bright for drawdown.
1. The staple of retirement planning, annuities, will not be as dominant in the years to come. While annuities will still be the right choice for some, they will not meet the real needs of many consumers and more people will start to understand the relative benefits of drawdown.
2. The move from Defined Benefits to Contributions (DC) pensions continues and is starting to shift from DC being a top-up that received little attention to it being the main pension that matters.
3. Income Drawdown previously had a bit of a bumpy ride, but the challenges it faced are being addressed at a fundamental level, as the product becomes more mainstream. Customers can have more confidence looking forward.
So what do customers want from retirement?
We have carried out extensive research into what customers want from their retirement income and it won't surprise anyone to know that number one on the agenda is a sustainable income. People want to know they have an income that will meet basic levels of comfort.
But when you scratch the surface you realise that most people's dreams of retirement are about so much more than this. Some want to adjust their income level when needed; for others it could be about passing on their hard earned wealth to their loved ones. Based on our research, the graphic below (not shown) summarises what people are looking for when it comes to their retirement income, with a sustainable income at the core.
We have also carried out research to help us understand how people's income needs might change as they move through their retirement years. The chart above outlines the different factors that can determine retirement income needs and we have described what we see as the more realistic retirement journey as a 'Retirement Smile'.
The fact remains, however, that everyone is different and nobody knows how or when many of these changes will impact on them. So the real challenge for our industry is to help ensure that people continue to smile about their income in retirement, even when there are so many unknowns. And that requires consideration, planning and flexibility.
An annuity absolutely meets the need for sustainable income. It guarantees an agreed level of income for life. An annuity is probably the right product for many, particularly those who have limited wealth in reserve elsewhere and need an annuity to meet their basic needs in retirement. It also provides a regular income that will continue as long as they live, with minimum fuss.
However, annuity rates have fallen to an all- time low (up to more than 30 per cent in the last five years). People are living longer and guaranteed investment returns have fallen dramatically (due to quantitative easing and the euro crisis among other factors). These rates are unlikely to improve quickly, so if people don't see an annuity as representing good value for money, they will look elsewhere. If you consider the fact that these days many people live for more than 30 years in retirement, you can see why locking into a fixed income for life at current levels may not be quite so attractive. Furthermore, it leaves no chance to adapt when life throws up surprises – whether that's inflation, a change in tax rates, ill health or any other factor outside their control. For those who want flexibility the answer is likely to be income drawdown. Yet drawdown comes with its own risk – ongoing exposure to investment markets. For those who can't afford the risk of any potential income loss or are unlikely to be able to ride out a rough period, then an annuity might remain the right option. But before anyone makes a decision, they need to understand their options and the benefits and risks of an annuity and income drawdown, so they make an informed choice.
How do you compare Annuities and Drawdown?
Calling an annuity guaranteed and drawdown flexible (or risky) does consumers no favours. Annuities carry risks - they are just different.
We carried out some research among consumers who were five to 10 years into their retirement, to look at how they felt about choosing either an annuity or drawdown. These were customers that had a reasonable pension pot at retirement (so they could have used drawdown). This research took place at the start of 2012, when drawdown incomes had started to fall, but most of those in drawdown were still happy with their choice. They had made an active decision to manage their assets and were willing to ride out some rough times. On the contrary, many of those in an annuity seemed less happy with their decision. At the same time, many had not heard of income drawdown - there was a lack of knowledge of the alternative income source to an annuity and some misconceptions about annuities and the risks of that product.
Yes there are also big risks of taking the alternative income drawdown. Not least in theory because your pot could reduce to zero and annuity rates could keep trending downwards. But the important thing is to help consumers look at things in a balanced way. Both solutions carry risks.
We've built a retirement journey at Standard Life that starts 10 years before retirement to help our customers understand their options and what they need to be thinking about. So that by the time they do near retirement, they are well informed and ready to discuss things with their advisers, so they can make the right decisions about their retirement income. It also means they can make decisions about drawdown in a timely way. In the future, we believe that more people are going to realise they need advice and alternative solutions in order to achieve their retirement goals. Let's hope with education we can work together to help all of them so people do not regret their decisions.
Pension: Top up or Main source of Income?
For many baby boomers retiring just now, the main sources of pension are probably the State Pension and a Defined Benefit Pension, providing that valuable guaranteed underpin they wanted. Any DC pot could well be seen as just a top-up that they didn't think they needed advice on. That is going to change. They say you can't predict the future. But we can look at other markets that have been through this change already. If we look internationally, for example at the US, it's probably around 10 years ahead of us in the move from Defined Benefits to Defined Contributions. So what happens in the US, where people have "owned" their pension assets for much longer?
In the US around 95 per cent of retirement income is drawdown rather than annuity. The cultural mentality has shifted with people believing that having owned their assets and benefitted from investment growth for 30 years in accumulation, why would they not want to do the same in decumulation? While we might not go this far in the UK, the trend suggests we will certainly start to catch up.
But drawdown hasn't been an easy ride for people has it?
Last year retirement incomes were falling by up to 50 per cent (or even more). But there were reasons for this and importantly, thanks to the powerful pensions lobby, these issues are being resolved. The reasons why drawdown was bumpy for some are being addressed at a fundamental level. As a result, there are three main improvements and it is to be hoped they will see users' income limits start to rise – but more importantly - stabilise. Let's look at each in turn.
1. The Government has reversed its decision to reduce how much income could be taken from the relevant GAD table (roughly equivalent to current annuity rates) increasing the amount back up to 120 per cent from 100 per cent. The Government's original intentions in reducing the limit to 100 per cent were good, based on sustainability of income. Taking a maximum of 100 per cent would reduce the likelihood of running out of money.
However the change back to 120 per cent was welcome news as a key benefit of drawdown is to meet flexible income needs. It might be the right thing to take 120 per cent in some years and less in others as part of an integrated Financial Planning strategy worked through with their adviser.
2. Financial institutions have woken up to the fact that those in retirement need to adopt a new approach to their investments when taking an income. It's well accepted that pound cost averaging means that volatility can actually improve returns through buying on the downside. The reverse is true in decumulation. Selling on the downside is equally bad (or even worse) as you can't recover any losses once made.
More providers are offering a range of investment funds (often around reducing volatility) that have been specifically designed to help provide a long-term sustainable income - helping people in drawdown.
3. Chancellor George Osborne announced in the Budget in March 2013 a request for the Government Actuaries Dept (GAD) to review the link between maximum drawdown income (GAD tables) and Gilt yields. Basing drawdown income on Gilt yields was designed as a proxy for changes in annuity rates. However annuity rates fell by nothing like the same amount as they invest in Corporate Bonds. Drawdown customers were faced with a reduction in the maximum income that could be taken beyond what was intended.
We welcomed the Chancellor's call for GAD to review the link. It should bring maximum drawdown income back up into line. But more importantly once it has it should avoid the risk of them moving out of line again so rates should be more resilient. Sitting beneath all of this is the need for financial advice.
Given the number of people approaching retirement and the amount of money they have it looks like the potential for an advice boom. But how will the industry respond? It's estimated there may be something like 20,000 qualified financial advisers now we are into the post-RDR world. Unless we can find a way to educate consumers I am just not sure there will be enough advisers to go round.
Published in Insight & Analysis