What are the risks of unadvised drawdown?

A blended solution – whereby a portion has been set aside to provide a stable income stream – can act to help minimise risks to the whole pot, but there are no guarantees.

While having such a stable element in the retirement income can increase certainty, removed from the vagaries of the stockmarket, there is no absolute guarantee that the drawdown element of the portfolio, which remains invested, will not be hurt by any sudden, steep and protracted market drop.

Complication

Wrapping one’s head around stock market performance, sequencing risk and portfolio performance can be pretty complicated. 

So the first risk to consider is just how much an uninformed individual can understand their own pension plan, and how it will be affected by exogenic shocks and personal circumstances.

Add to this complexity the fact there is no guarantee the individual will not live longer than expected, suffer a dramatic change in circumstances, take out too much money or incur a tax event, and it is clear there are a lot of factors to assess.

Creating a suitable, blended solution for retirement, and ensuring it remains suitable through all the changing scenes of life, is complicated enough even for a qualified financial adviser, let alone an unadvised pensioner unfamiliar with the intricacies of pension planning.

Assessing how much income to take in a given year is a complicated decision, and most people will not have a clear view on what a sustainable income rate might be. Steven Cameron

William Burrows, retirement director for Better Retirement, explains: “Drawdown is a complicated thing to manage properly because a good adviser will be watching fund performance, any changes in attitude to risk or personal circumstances, as well as monitoring annuity rates.”

He adds: “This is probably one of the most difficult areas in personal planning and customers without advice simply cannot spin all these plates in the air without the fear of them crashing down.

“Non-advised customers need all the help they can get.”

Tax risk

Femi Folorunso, senior consultant for Mattioli Woods, warns clients could potentially face the hazard of taxation. 

He explains: “For clients with substantial personal wealth, in some cases, it may be more tax beneficial to drawdown on personal funds initially before accessing their pension, because of the inheritance tax treatment of pensions.

“For others, drawing down income may create higher income tax liabilities than anticipated, or limitations on how much they can contribute into a pension scheme as a result of the money purchase annual allowance (MPAA).”

Mr Folorunso says as a result, this could make it less possible for individuals to manage earned income tax liabilities through pension contributions.

Too much too early

“The greatest consumer risk of not taking advice when entering income drawdown is running out of money too soon,” according to Fiona Tait, technical director for Intelligent Pensions.

She comments: “The removal of income limits, while very useful in supporting changing income needs, means individuals are no longer given any indication of sustainable income levels, even at the fairly broad level of the previous Government Actuary Department (GAD) rates.”

According to Ms Tait, very few people outside of the pensions industry would be able to assess accurately how much income they can withdraw, without draining their fund between retirement and death.

This is all the more pertinent given the latest mortality data from the Office for National Statistics, which shows life expectancy has improved drastically over the past 30 years.

Its latest statistics show a male born in 2014 to 2016 had a 21 per cent chance, and a female a 32 per cent chance, of surviving to at least age 90.

Although improvements in life expectancy for both sexes has now slowed by a few weeks, the percentage of people living to 90 and above has risen significantly since the 1980s.

Kim Lerche-Thomsen, founder and chief executive of Primetime Retirement, says: “Some retirees fail to appreciate the dangers of taking out too much income from their drawdown pot in the early years of retirement.

“This can leave them vulnerable to the possibility of not having enough pension in later life, particularly if fund values fall sharply during this period.”

Steven Cameron, pensions director at Aegon, agrees there is a significant risk that people will end up outliving their pension pot.

“Assessing how much income to take in a given year is a complicated decision, and most people will not have a clear view on what a sustainable income rate might be”, he comments.

“Add onto this considerations, such as people’s desire to spend more in early retirement when they are healthy and active, and you have a potentially very complicated decision on your hands.”

Longevity and sequencing risk

According to Andrew Tully, pensions technical director for Retirement Advantage, the most “significant issue” with drawdown is longevity risk.

He explains: “People do not know how long they will live, which means making decisions with one crucial piece of information unavailable. 

“That can be compounded for those taking an income if the value of investments fall in the early days. This is often referred to as ‘pound cost ravaging’ and can have irreversible consequences.”

Mr Tully adds if investments have several bad years at the start, there is a big risk people can run out of money very quickly, instead of it lasting their whole retirement. This is known as sequencing risk. 

In a guide for financial advisers, Royal London has explained how those people taking income out of their pension pot could find the effect of investment returns can have a far greater effect on their money than those still in the accumulation stage would face. 

In the examples, two portfolios with the same average return can have very different outcomes, depending on when the pot suffers a steep investment loss.

Both examples are for a person with a £100,000 pot, taking 5 per cent out a year, paid in monthly instalments.

Example one, where there is a huge investment loss in the second year, but a big gain in the third year, shows how the pot would be worth £79,580 at the end of year nine.

However, example two, where the large gain is in year seven, followed by a steep loss in year eight, shows the pot would be worth £88,018 in year nine.

As Mr Tully adds: “Some people going into drawdown may not have a suitable risk appetite or capacity for loss for drawdown. 

“Drawdown is sensitive to volatility in the stock market and therefore can produce a higher income but there is a risk income could fall, or in the worst-case scenario, run out.”

Mr Lerche-Thomsen adds: “Retirees need to assess their capacity for loss, especially as any pension savings invested will be exposed to fluctuations in the investment market.”

This is where a blended solution could help to mitigate the volatility of the markets and the effect a protracted downturn could have on the drawdown portion of the pension, as the annuity element can help provide a stable income stream.

Without advice

Data from the Association of British Insurers (ABI) has shown recently that 94 per cent of non-advised sales have been made to existing customers.

This came after the Financial Conduct Authority’s Retirement Outcomes Review, which revealed the proportion of people buying without advice has risen from 5 per cent before the freedoms to 30 per cent today.

For Lorna Blyth, pension investment strategy manager for Royal London, this could lead to several dangers. She highlights these as:

•    Whether their pot can meet their income needs for the length of time they need income for.
•    Attitude and capacity for loss.
•    They may live longer than they think they will.
•    The impact of charges on their pot.
•    The impact of market falls on their pot.
•    How to cope with changes in personal circumstances.

Ms Blyth comments: “We would always recommend customers seek financial advice to understand the risks and benefits of the different options at retirement.”

Scams 

There is also the risk that some people may be at risk of scams. Earlier this year, the City of London Police warned of the rise of financial fraud, with £42m being lost from pension pots to scams within two years of it coming into force.

Then in August this year, the Serious Fraud Office warned of yet another investment scam involving storage units, which has taken £120m out of people’s savings, including their pensions. 

Intelligent Pensions’ Ms Tait comments: “Unadvised individuals are more likely to be taken in by a pension scam, which could result in their lifetime savings being unsuitably invested or even lost.”

This is why she advocates using advice, to help people get put into an appropriate structure, such as a blended solution, that will match their income needs and, with the adviser’s keen eye, be able to “recognise the danger signs when an investment is simply too good to be true”.

In September, pension provider Just suggested pensions advice should be automatically defaulted to Pension Wise, so that every single person at the point of retirement would automatically at least have to have information from the government service. 

According to a spokesman for LV=, this is not such a bad idea. The spokesman says: “We believe for those choosing not to take advice, taking guidance from services such as Pension Wise should be the default option.

“Non-advised products must be sold within a framework that ensures consumers taking this route fully understand the product and risks associated with it.”

simoney.kyriakou@ft.com