Branch out for an income

The pension reforms were widely welcomed, and their first anniversary provides a good opportunity to take an early view on their success.

Along with the benefits of pension freedom come the risks – in particular, the investment risk associated with big falls in the stock market index, inflation risk, and, of course, longevity risk. We should not forget that the primary purpose of a pension scheme is to provide life-long retirement income security for however long the scheme member lives and, when there is no requirement to buy an annuity, there is no guarantee that the member will not run out of money before they die.

These risks are now borne directly by scheme members. Unfortunately, many people do not understand these risks, even with improved financial education. Some risks have to be experienced before they can be genuinely understood. Also, many people will have problems understanding the full range of product choices that are now available. All this makes it difficult for many people to be in a position to make sensible ‘informed’ choices.

How do we deal with this and make pension freedom a success? We should begin by recognising that most people should not be expected to manage retirement risks themselves. This was one of the conclusions raised in the report of the Independent Review of Retirement Income (We Need a National Narrative: Building a Consensus around Retirement Income) published earlier this month.

Instead, pension scheme providers should be designing products and solutions that effectively manage these risks. We also need to remember that one of the important lessons from behavioural economics is that too much choice is a bad thing. This means that people need to be shown only a limited number of well-designed default pathways using decision trees that deal holistically with the scheme member’s total assets and liabilities, health status, family circumstances, tax position, and risk appetite and capacity.

The decision tree will help people decide the best retirement financial strategy for their pension pot. This comprises an investment strategy, a strategy for investing the pension pot during retirement, a withdrawal strategy, a strategy for withdrawing cash from the pension pot to finance expenditures, and a longevity insurance strategy.

A good product for delivering retirement income needs to offer accessibility, a degree of flexibility to withdraw funds on an ad hoc basis, inflation protection – either directly or via investment performance, with minimal involvement by individuals who do not want to manage investment risk – and longevity insurance. No single product meets all these requirements, but a combination of drawdown and a deferred (inflation-linked) annuity does, for example. So a well-designed retirement income programme will have to involve a combination of products.

If any product satisfies these conditions as part of a hybrid solution, it might be considered a safe harbour product. Any adviser recommending such a product, having assessed suitability, cannot subsequently be sued for poor advice. So far ,the FCA has refused to grant safe harbour status to any UK investments.

Drawdown has three components – the fund in which the pension pot is invested according to an agreed investment strategy that reflects the member’s preferences and risk attitudes, the arrangement for delivering the pension (for example, a self-invested personal pension scheme), and the withdrawal strategy. But drawdown could not by itself be classified as a safe harbour product, since it does not hedge longevity risk. It can also be expensive if sold in the retail market.

An alternative to drawdown sold in the retail market is scheme drawdown. The scheme itself provides a withdrawal facility together with an institutional asset management solution to meet the decumulation needs of members in early retirement, that is, until longevity insurance kicks in. It is a natural extension of the default fund used by modern multi-trust, multi-employer schemes for the auto-enrolment accumulation stage. Scheme drawdown has the potential to be much cheaper and deliver more consistent results than retail drawdown, due to economies of scale, trustee oversight, and the use of a well-designed institutionally managed fund. Unfortunately, very few companies have so far offered scheme drawdown to their members. This contrasts with Australian superannuation schemes which are beginning to offer group annuities to their members.

A particularly critical issue is the withdrawal strategy. If too much is withdrawn too soon, there is a risk that the scheme member will run out of money while they are still alive. If too little is withdrawn, there is a risk that the scheme member dies with a large chunk of pension pot unspent and could have enjoyed a much higher living standard in retirement.

The US financial planning community developed the concept of a ‘safe withdrawal rate’ (SWR), as exemplified by the ‘4 per cent rule’. The individual withdraws 4 per cent of the fund in the first year and the same amount adjusted for inflation in subsequent years. If the individual is prepared to accept a 10 per cent probability of failure (that is, a 10 per cent chance of running out of money before 30 years), the SWR increases to 4.17 per cent. A 5 per cent withdrawal rate results in a failure probability of 27.5 per cent.

So there is, in fact, no safe withdrawal rate with drawdown. An important reason for this is ‘sequence-of-returns’ risk: if the fund experiences a sequence of poor returns in the early years of retirement – as has happened over the last year − and a fixed amount is withdrawn from the fund, then the fund can become so depleted that no amount of good subsequent performance can compensate and the fund will run out of money very quickly.

Another critical issue is the longevity insurance strategy. It is essential for ensuring the pension scheme serves its primary purpose of providing a lifelong income. But when should longevity insurance be purchased and when should it come into effect?

This essentially boils down to the choice between buying an immediate annuity when it is needed, and buying a deferred annuity at the point of retirement, with the deferred annuity beginning to make payments when it is needed. Most experts believe that for a normally healthy individual, longevity insurance should come into effect some time between age 75 and 80.

Charges for drawdown vary considerably and in total could have up to four components: the charge imposed by the scheme provider to cover operational costs (such as administration), the investment management charge, the platform charge (0.25 per cent to 0.50 per cent a year), and the charge for advice (0.50 per cent to 0.75 per cent a year). Even for a simple fund structure from a low-cost provider, the annual charge might be 1 per cent, plus an administration fee of £250 a year (to cover the cost of income payments and income amount reviews). A more common total cost is about 2 per cent a year. High charges can be as lethal as poor investment performance in reducing the value of the pension pot over time.

So we are still a long way from pension freedom being the long-term success everyone wants. We do not yet have companies offering a low-cost, well-designed scheme drawdown that delivers flexible access, inflation protection and longevity insurance. We do not have a well-developed deferred annuity market. Indeed, we do not have any safe-harbour products. Instead, too many people face the prospect of investing in unsuitable high-risk, high-cost products that could well run out of money before they die.

David Blake is professor of pension economics at the Pensions Institute of Cass Business School

Key points

Along with the benefits of pension freedom come the risks, including the investment risk associated with big falls in the stock market index.

An alternative to drawdown sold in the retail market is scheme drawdown.

Another critical issue is the longevity insurance strategy.