When pension freedoms were introduced almost two years ago, they welcomed in a new era of flexibility and autonomy. But, by allowing retirees to do as they please with retirement savings, they also introduced a new level of risk and complexity, not only for retirees themselves, but also advisers.
Annuities subsequently fell out of fashion and instead retirees opted to invest in drawdown in droves. The Association of British Insurers calculated that in the first year since the new reforms £6.1bn was invested in drawdown products, greater than the £4.2bn invested in annuities.
Furthermore, the reformed landscape opened the door to a new breed of retirement income products, those that offer the benefits of drawdown: that is flexibility and investment growth hand in hand with the benefits of an annuity, such as security and income certainty.
Yet, this nascent market faces a challenge. There is a need to drive greater consumer and adviser awareness so that people at the point of retirement know all the income options they can choose from. Advisers have a key role informing and educating retirees about the many options available, including these best-of-both solutions.
One of the core solutions can be called drawdown with guarantees. This drawdown product allows retirees to be invested in the stock market and have access to capital as needed, but also has the added security of a guaranteed income for life. I believe advisers can identify with this terminology and in turn find it a useful way to talk about the products with their clients.
Drawdown is good for several reasons. It allows retirees to remain wedded to the stock market and benefit from any investment gains. In January the FTSE 100 closed at the record high of 7,275 points, which is good news for retirees in drawdown who may be benefiting from a rise in the value of their pension pot. Drawdown also offers flexibility as retirees are able to withdraw money from their pot as and when they need it with no limits.
However, there are risks of investing purely in drawdown. As anyone with money in the stock market is constantly reminded, the value of investments are subject to both market rises and falls. While retirees are currently enjoying the good times, things can change quickly and there is always the possibility that market falls will cause the value of a pension to decrease.
Life expectancy is also on the up. By 2039 there are forecast to be 1.5m people aged 90 or older in the UK, which means the money used to fund retirement will need to last for longer. At a time of greater personal responsibility for pension provision, there are likely risks that people will either overspend, underestimating how long they will live for and be left with little to get by on, or underspend, living in fear of running out of money.
Before pension freedoms, the only way to protect oneself from these risks was to purchase an annuity, which would provide an income for life, but came with its own drawbacks. Firstly, with interest rates at record lows, annuity pay-outs are poor value compared to the other retirement income options currently on offer. Secondly, opting for an annuity is an irreversible decision, and retirees will have to forgo any flexibility, which can be difficult to bear when care costs or sudden illness require large lump sum costs to be met.
It is in this environment, between the uncertainty of pure drawdown and the inflexibility of annuities, that the option of adding a guarantee to a drawdown product has emerged as a genuine option for those wanting to mitigate these risks. It removes the fear of outliving savings and, by providing a minimum level of income that can be increased or decreased as necessary, means retirees are able to budget more easily. The drawdown element also allows retirees to meet lump sum payments or unexpected expenses and the guarantee can be managed to secure an income for the whole of retirement.
Despite the clear upsides, one of the biggest hurdles these products face is the associated cost. A report by the lang cat consultancy found some advisers question the cost that comes with the addition of guarantees to drawdown, with the perception that this may be expensive for the client to absorb.
The lang cat suggested this was suppressing the popularity of products such as drawdown with guarantees. However, when we consider that the cost of a guarantee is only about 1 per cent and the additional security can offer real value to those considering their retirement options, it is important that advisers speak to their clients about whether they would be willing to shoulder the cost for the certainty it provides.
In many respects purchasing a guarantee is similar to buying insurance. People insure their homes, contents, pets and lives in the hope that the thing they are insuring themselves against will never happen.
However, the value is that they are protected if something should happen and this gives peace of mind. As far as retirement income is concerned, a guarantee ensures that a person will never run out money, even if market movements result in reductions to the value of their pension pot, and offers the security that they will have an income for life.
The truth is that we do not know what is going happen to markets or our own life expectancy. What is important is that people who are retiring are happy. This happiness is highly personal and depends on several factors: what they think the economic future holds, their personal circumstances, concerns about market crashes and their own capacity loss.
Determining these traits will help inform advisers if a guarantee is the right option for their client and unless someone has a very high risk appetite, alternative options to pure drawdown, such as drawdown with guarantees, should be discussed. At the very least advisers must highlight the varying options and their benefits to clients and let them consider it, and make their own decision about whether the benefits of extra security are something they are willing to pay for.
Aegon Ireland's research shows this is precisely what people want in terms of their retirement income; flexibility to access their money with the knowledge that they will be able to meet costs throughout their whole life.
As more and more people enter retirement in the post pension freedoms world and an era of greater personal responsibility, I expect there to be a growing appetite for solutions like drawdown with guarantees, especially with an uncertain time ahead of us.
Barry Cudmore is managing director of Aegon Ireland
Key points
Drawdown with guarantees allows retirees to be invested in the stock market.
By 2039 there are forecast to be 1.5m people over the age of 90 in the UK.
Adding guarantees to income drawdown can help reassure clients.
