Securing a positive outcome in a post-annuities world

As from April anyone aged 55 or over will no longer face restrictions on the amounts they can withdraw from their defined contribution (DC) pension pot. “No caps. No drawdown limits...No one will have to buy an annuity”, is how the Chancellor so decisively outlined his measures (1).

Despite meeting with a rapturous welcome from most corners of the pensions industry there are a number of commentators warning of those who may be tempted to blow their entire pension pot on an exotic mid-engined Italian sports car and then fall back on the State for support.

While expressing such concerns is laudable, the evidence from the other side of the globe, where pension freedoms have been the norm for two decades, suggests that few diligent savers become spendthrifts overnight. In Australia, where the average pensioner retires at 65 on a pot of around £100,0002, most retirees pay off their debts before securing a steady income stream from income drawdown-style products and/or buy-to-let property. Although annuities are readily available in Australia, they only account for about 3% of the £39bn per annum Australian retirement market (2). Furthermore, many accept a relatively modest income in retirement, recognising that their pension pot may need to last 25+ years.

Given that “There’s nothing to suggest that the Poms are any more stupid than Australians”, to quote one Australian industry commentator (3), evidence would suggest that the average Briton can be trusted with their own cash in retirement. Even if some can’t, the UK income tax system of marginal tax rates will act as a first line of defence in preventing most from adopting reckless behaviour. In addition, government plans to abolish the 55% tax levied on unused portions of income drawdown policies on death could result in investors preserving their pension pots for IHT purposes.

Annuity purchase in the UK has not been compulsory since April 2011, but despite their poor value in the current low interest rate environment, their lack of transparency and poor fit with typical retirement spending patterns, annuities are still bought by more than 90% of the 400,000 or so who retire each year, with an average pension pot of £26,0003. Less than 10% take the drawdown route. With the introduction of the new pension freedoms, industry projections suggest that this c.90/10 split for the UK’s £11bn per annum retirement market will potentially move to 80/20 in favour of drawdown.

This new approach to managing a DC pension pot exposes these newly empowered investors to a myriad of risks that would otherwise have been assumed by the annuity provider, including volatility, inflation and potential drawdown risks that are similar to those assumed by DC pension savers during the accumulation phase. These risks, collectively termed ‘real capital preservation risk’, threaten the preservation of the investor’s capital, and therefore its ability to generate returns to finance spending. In addition, there is of course the unknown longevity risk. Together, these risks effectively translate into the biggest risk of them all – that the pensioner will run out of money.

Furthermore, the “advice gap” between the mass market and the mass affluent looks destined to widen further in a post-RDR world. This is concerning, as most of those who previously took advantage of the freedoms following the introduction of drawdown in the mid-1990s, and the more recently introduced freedoms of flexible drawdown, were in receipt of financial advice. Hence the very real concern is that some poor investment decisions will be made and unsuitable products and solutions will be sold into this nascent market.

As the new DC pension freedoms naturally play into the hands of the asset and wealth management industry, these institutions are ideally placed to provide tailored, flexible solutions which, through highly individualised asset allocations, actively manage the key risks faced by these newly empowered investors seeking positive outcomes in the post-annuities world. At the very least these solutions should, through the provision of intelligently constructed, well diversified and actively managed absolute return bond funds, diversified growth funds with specific CPI plus return targets and high yielding multi-asset income funds, offer the genuine prospect of real capital preservation, real investment returns and a real long-term income stream.

Chris Wagstaff is Head of Pensions and Investment Education at Threadneedle Investments

1 Source: Budget 2014: Pension reforms offer freedoms to savers. FT.com, 19 March 2014

2 Source: Budget 2014: Australians dismiss fear of pension profligacy. FT.com, 20 March 2014

3 Source: Budget 2014: Pensions revolution casts pall on insurers. FT.com, 20 March 2014

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