Examining the workings of income drawdown

With annuity rates still close to a record low and the flexibility of pension freedoms uppermost in people’s minds, drawdown has become the default for most people with above-average sized pension pots. While almost everybody understands what drawdown is, and advisers are more than confident in explaining the advantages and disadvantages, not all advisers and certainly not many non-advised customers understand what is actually happening under the bonnet.

When advising on annuities, advisers know what success looks like because it is about selecting the right options and getting the highest possible annuity income. But when it comes to advising on drawdown, this is much harder because there are so many moving and interconnected parts that identifying the success factors at the outset is difficult.

This begs the question of what it takes to run a successful drawdown plan. This might seem a simple question, but it is now one of the most important questions in retirement planning and one to which there are no clear-cut answers.

I have identified six separate, but interrelated, factors advisers need to take into account when considering how to arrange a suitable drawdown plan. These include:

• Income strategies
• Sustainable income
• Investment strategy
• Managing sequence of returns risks
• Reviewing
• The effect of charges

Income strategies

It is always helpful to remind ourselves and our clients that the basis for a good drawdown solution is to have a plan. This does not have to be complicated, but without a plan drawdown can easily end up losing money.

Taking the tax-free cash without taking income might seem like a plan, but unless some thought is given to how income is taken in the future, it is just a holding exercise. More and more people are taking tax-free cash and leaving the balance of the pension pot to grow. While this is perfectly understandable and probably suitable, it is still important to plan for the future to ensure the investment strategy is appropriate and give some thought to future income needs. After all, taking the tax-free cash might mark the point when retirement planning changes from accumulation to decumulation.

A useful strategy often used is ‘phased retirement’. There are lots of different permutations, but an essential ingredient is taking tax-free cash in stages and using it to pay income, thereby reducing the tax bill. Some of my best advice has included elements of phased retirement. 

Key points

• Drawdown has become the default for most people with above-average sized pension pots.
• More and more people are taking tax-free cash and leaving the balance of the pension pot to grow. 
• 3 per cent is too low a sustainable income for many people because they need a higher level of income.

It is worth mentioning that one of the biggest barriers to phased retirement, and the reason many people take cash at the earliest opportunity, is fear the government will take it away. I have heard this threat for more than 25 years. Equitable Life was telling clients this in the 1990s. Although I think tax-free cash is here to stay, it is an understandable that governments are not trusted.

Sustainable income

A lot has been written about sustainable levels of income and I do not have anything particular to add to the debate about whether it should be 3 per cent, 3.5 per cent or 4 per cent, but obviously if income levels are too high, there is a higher risk of running out of money.

There is an interesting academic debate about sustainable income and I think it helps to take a practical approach. The lower levels of sustainable income – for example, 3 per cent – is too low for many people, especially those with modest financial wealth. In some cases it makes sense to consider taking income in excess of the sustainable level if needed, providing there are other sources of income available in the future.

If we keep strictly to the sustainable income levels, this would put drawdown out of reach for many clients.

Investment strategy

If an annuity is an insurance policy that guarantees retirees do not run out of income, drawdown is an investment solution from which income withdrawals are taken. This is stating the obvious, but the success or failure of drawdown lies with investment performance.

There is not one best way, but there are a range of investment strategies depending on various factors such as the client’s circumstances and the advisory firm’s approach to drawdown. It is a well known fact that investing before retirement is different to investing after retirement. 

What separates pre-retirement and post-retirement attitudes to risk are time and money. Before retirement clients have time to recover from a period of poor returns and they do not need to withdraw money. After retirement, time is not on their side and money is needed to meet income requirements. Getting the wrong sequence of returns can have devastating consequences.

There are many different investment strategies for drawdown, including: 

• Investing in managed or multi-asset funds and selling units when income is needed.
• Investing in high yielding funds and take the running yield as income.
• The bucket approach – short-term cash – mid-term safety and long-term growth.
• Guaranteed funds and structured products.
• Combination of annuities and drawdown.

The more you think about investing for drawdown, the more complicated it can become, especially when balancing the need for income certainty with flexibility and investment control. 

It is easy to underestimate the risks associated with drawdown. Chart A compares the income from annuities, gilt yields and the returns from the FTSE 100. This acts as a good reminder that shocks to the system, such as the Dotcom bubble crash in 2000 or credit crunch in 2008, have a negative impact.

Managing sequence of return risks

Sequence of return is the new buzz phrase for drawdown and by now all advisers should understand this concept. However, understanding is not enough, we must have strategies to actually reduce sequence of return risk. Most advisers will be aware of this risk, but it is easy to make the mistake of considering it purely theoretical. 

If an explanation of sequence of returns risk is needed for clients it can be explained as follows: “It is the risk that investment returns are lower than expected or negative in the early stages of drawdown, resulting in capital being eroded quicker than anticipated.”

This means that unless investment returns are higher than expected in the longer term the drawdown fund might not be able to sustain future income payments or there is increased risk of lower income and, in the extreme, of running out of money.

The classic way to demonstrate sequence of return risk is to show a drawdown fund over a given period where the returns rises in the early years, but falls in the later years. This is compared to the situation where the returns are reversed, that is, fall in early years, but rise in later years. The second scenario produces a lower fund value compared with first scenario one.

This example might seem too abstract, so it is helpful to look at a real life example. Chart B shows the sequence of return risk in practice over the period 1 May 2012 to 1 August 2017.

A total of £100,000 was invested in May 2012 and income equivalent to 3.5% of the fund value and increasing by 2.5% per annum. The fund was invested in a typical pension fund, which had 60 per cent equity content.

Chart B shows the value of the fund each month. 

Although this is a short and perhaps untypical time period, it shows that sequence of return risk is real, not just something in text books.

There several ways of investing in order to reduce or eliminate the sequence of returns risk and these include: 

• Paying income out a cash fund and topping up the cash in good years. 
• Investing in "smoothed returns" funds. 
• Using guaranteed funds and structured funds. 
• Reducing (or stopping) drawdown when returns are negative.

Reviewing

In many cases, the success or failure of a drawdown plan hinges on the quality of the review process. This means reviewing the investment strategy to make sure it is on track to achieve the required returns in line with the client’s attitude to risk and is meeting the stated objectives. Reviews should take place at regular intervals and advisers should keep a watching brief to make sure the investment strategy reflects any changes in the economic and financial outlook as well as any changes in personal circumstances.

The point I make about reviews, especially as I am practising what I preach, is to keep a regular watching brief once a quarter and be clear of the parameters of the review. For example, reviving income requirements, any changes in attitude to risk and health.

The effect of charges

My view is drawdown is a premium product and so although price is important it is not the main driver. For most advisers it is more about quality than quantity. When looking at the costs of running a drawdown plan, the charges between the main Sipp providers are competitive and there is downward pressure on fund management fees. In practice, one of the biggest costs of running a drawdown is adviser fees.

For advised drawdown, the adviser should do their own shopping around for the most cost-effective solution and charge an appropriate fee for their advice. 

The case is different for non-advised drawdown or where a client rolls over into their provider drawdown plan. As there is no adviser to identify the best solution, the onus is on the customer and they will benefit from clear information about both product costs and investment options. The FCA’s intervention in this area is most welcome.

It is worth making two comments about costs. The first is that if someone can reduce their running costs by 1 per cent, for instance from 2 per cent to 1 per cent, this does not have to be an invisible saving. In the right circumstances it could be taken as extra income. A 1 per cent saving on a £ 100,000 pension pot is £1,000 and who would not want an extra £1,000 a year? Secondly, the biggest impact on the returns is investment performance, which means a low-cost drawdown, but with unsuitable investment will produce a worse outcome than a higher cost drawdown with suitable investments.

Shopping around for the best drawdown plan is important, but as there are so many moving parts it is more complicated than shopping around for the best annuity but equally as important.

One of the paradoxes of drawdown is that it is a very easy thing to understand; you invest the pension pot and take regular income payments and when you die you can leave the money to the family. But it is a very complex thing to manage properly because a good adviser will be watching fund performance and any changes in attitude to risk or personal circumstances as well as monitoring annuity rates.

This is now probably one of the most difficult areas in personal planning, which means that advisers must constantly brush up on their skills and market intelligence while non-advised customers need all the help they can get.

William Burrows is Retirement Director of Better Retirement