DrawdownApr 11 2019

A drawdown history and the consequences for investment pathways

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A drawdown history and the consequences for investment pathways
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It has been described in multiple ways and, even on a practical level, the market has also developed in different ways.

In the traditional insured pension market, drawdown has typically developed as a standalone product which customers must ‘buy’ when moving from accumulation to decumulation.

It was natural for drawdown to be packaged in this way by insurers, as it was a neater fit with the packaging of the annuity products that insurers had offered long before drawdown even existed.

In the self-invested personal pension market, drawdown generally developed differently. 

As most Sipp providers did not offer their own annuities, instead offering access to annuities as an option, drawdown was also positioned as an option to those customers – not as a distinct product.

The FCA’s proposed solution is to allow the whole Sipp to go into the pathway investment when someone partially crystallises, not just the drawdown pot.

This distinction in the market between a new drawdown product being sold, and a drawdown option being offered inside a single Sipp created an important division in how investments were treated as held where partial drawdown was concerned.

In “drawdown product” schemes, it is more typical for individual investments and cash sums to be treated as ring-fenced within either the non-drawdown or drawdown pot. So a particular unit trust or insured fund will belong to one or other pot.

In “drawdown as an option” schemes, it is more typical for investments to be split notionally across drawdown and non-drawdown pots.

This notional split is updated behind the scenes whenever further benefits are crystallised into the drawdown pot, paid out as drawdown, or when contributions are added to the uncrystallised pot.

Both options are accepted by HM Revenue & Customs from a tax perspective. Each has slight positives and negatives in terms of the management of investments, though for most individuals this will be marginal.

As a result, this distinction has largely slipped under the radar for the 20 plus years since drawdown was introduced.

The Financial Conduct's Authority’s proposed introduction of investment pathways has the potential to change that.

The FCA is proposing that when non-advised individuals put further funds into drawdown they will be offered a pathway investment for that pot. They do not have to take up this investment option but, if they do, it creates significant problems from a notional split perspective.

Consider an individual who has opted for a pathway investment with £50,000 in a drawdown pot and £50,000 in a non-drawdown pot under a “notional split” scheme. We will say they have £10,000 in cash and £40,000 in other investments held outside their £50,000 pathway investment.

In our “notional split” scheme, if that individual chooses to take £1,000 as drawdown, the administrator will not disinvest anything from the pathway investment.

The notional split means there’s no need. They just pay out from the cash and the notional investment split is updated.

This creates problems with pathway investments. Our individual now has a drawdown pot worth £49,000, but still has a pathway investment worth £50,000 – which the FCA’s proposed rules insist is labelled in such a way that it is directly associated with the individual’s drawdown plans.

The potential for confusion is obvious, and this is just a basic example.

When you consider that similar issues are created by multiple other events (e.g. further contributions, or even later crystallisations where the individual chooses not to go into the pathway investment on that occasion) the value of the drawdown pot and the valuation of the pathway investment will potentially become seriously out of whack very quickly.

The FCA’s proposed solution is to allow the whole Sipp to go into the pathway investment when someone partially crystallises, not just the drawdown pot.

However, from a customer outcomes perspective this does not work – it cannot be right for all of a £500,000 pension to be put into a pathway investment because that option has been deemed suitable for the £30,000 of that pension which has been put into drawdown.

Issues are also created as soon as the individual decides to sell some of the pathway investment for purposes other than taking benefits.

So let’s just tell providers they have to move away from the “notional split” option? Easier said than done when you consider back office systems, some provided by external parties, have been developed for two decades to work in a fundamentally different way.

Re-engineering those systems will take a long time and cost a lot of money.

It is also unlikely to be possible to use multiple systems for different groups of drawdown customers, which potentially means tens of thousands of existing drawdown customers, and their advisers, getting used to a new way of investment allocation.

It will be interesting to see how this challenge is addressed when the rules currently being consulted on are finalised.

Gareth James is head of technical at AJ Bell