Article 2 / 5

Combine harvest
PensionsMar 23 2016

How to avoid the drawdown downside

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by

Before pension freedoms, the conventional wisdom was that drawdown was only suitable for those with funds of more than £100,000.

There were obviously exceptions as some advisers pointed out that it was not necessarily the size of the pension fund that determined suitability but personal circumstances. This meant that clients with more modest funds were advised to take the drawdown route, but only after going through an in-depth advice process which included a proper risk assessment.

However, pension freedoms removed the annuity handcuffs and opened the door to drawdown for the mass market because certainty went out of fashion and flexibility became the new norm. But nearly one year after ‘freedom day’, many of the new drawdown investors may be having second thoughts as the recent turmoil in the global market has resulted in lower fund values. Over the past 12 months (to 1 March 2016) the FTSE All Share index has fallen by around 9 per cent, and consequently, the value of drawdown funds (where monthly income has been taken) have fallen in value by a much greater amount because of the ‘sequence of returns risk’.

For many people, sequence of returns risk is something they may be aware of as a concept, but have little appreciation of what it means in practice. The purpose of this article is to show how sequence of returns risk actually impacts on a drawdown plan using the actual market experience over the past 12 months. It goes without saying that one year is too short a period of time to analyse the long-term benefits of equity investments, but it does help focus on the impact of this important risk.

In conjunction with Partnership, we modelled some examples of drawdown over the past year using actual market returns. The idea was not to suggest that an annuity purchase or drawdown was a better option than the other, but to highlight the effect that falling stock markets have on pension drawdown. We compared the income from an annuity with the same income being taken from a drawdown. We assumed a man aged 65 purchased an enhanced level-term annuity on 1 March 2015 with a pot of £100,000, and that his medical conditions included diabetes, high blood pressure and high BMI. With the drawdown, one example assumed the pension pot was invested in a FTSE UK All-Share Index fund and the second example assumed a fund with a 60 per cent equity content.

Fund values

The results from the two examples should come as no surprise; the All-Share index fund was the most volatile and resulted in a lower fund value of £84,496 whereas the 60-40 fund was less volatile and consequently cushioned the fall in the fund value to £91,404. Obviously in a rising market we would expect the reverse with the All-Share fund showing bigger returns.

These results are obviously time-sensitive over such a short period, and when the numbers were done to the end of January 2016 the fund had fallen to £83,605 and £89,916 respectively.

So what can we learn from these two simple examples?

In the UK, many advisers and their clients have been tempted to take the same income from a drawdown as they could have taken from an annuity. As the examples show, these relatively high rates of income withdrawals expose the drawdown pot to significant levels of risk if investment returns get off to a bad start. Those wanting a high income, especially those who qualify for an enhanced annuity, may be better advised to consider an annuity.

A better approach is to work out the sustainable level of income. There has been a lot of academic research into this and it is generally agreed that an income between 3 per cent and 4 per cent of the fund value (increasing with inflation) should be sustainable over the longer term without significant risk of running out of income.

One of the problems with the matching annuity income strategy is that we are not comparing like with like. Annuity payments include an element of repayment of capital as well as interest and some mortality cross-subsidy premium. A good way to explain the benefit of mortality cross-subsidy is to think of it as an ‘invisible force’ that gives annuities an income advantage over drawdown.

Advisers who have been involved with drawdown will know only too well the importance of implementing the appropriate investment strategy. Although there are many different strategies, successful drawdown plans all have one thing in common, and that is some mechanism for reducing the exposure to sequence of returns risk.

There are many different strategies for reducing this risk, and professional advisers should make sure their own drawdown proposition has a clearly defined approach to investing drawdown funds.

Future expectations

Experience shows that the clients who complain the least when things go wrong are normally the ones who understand the risks they are taking and have a reasonable expectation of future investment returns. Therefore, it is vitally important that all the risks are explained and understood at the outset. In short, clients need to understand that although drawdown may appear to be a better bet than an annuity, it is not always the case.

People retiring at the moment are between a rock and a hard place: low interest rates and volatile stock markets. This means that the binary choice between a single annuity and a single drawdown plan is a difficult decision in the current economic climate. It is probably true to say the ‘annuity or drawdown’ decision is one of the most difficult in retirement planning.

Often, there is a strong case for annuities as well as a strong case for drawdown, and this can easily be translated into a strong case for a combination. The new combination plans make arranging a combination of options much easier.

One of the dilemmas in retirement planning is that annuities are a complex product to price and construct but provide certain outcomes, whereas drawdown is a relatively simple product but produces uncertain outcomes. One of the keys of reducing the uncertainty of drawdown outcomes is to understand and manage the sequence of returns risk.

Billy Burrows is director of Retirement Intelligence

Key points

Pension freedoms removed the annuity handcuffs and opened the door to drawdown for the mass market.

Many advisers and their clients have been tempted to take the same income from a drawdown as they could have taken from an annuity.

People retiring at the moment are between a rock and a hard place: low interest rates and volatile stock markets.