With the decline in guarantee products following the onset of pension freedoms, we are now seeing a widening gap in the product landscape. This gap could leave retirees increasingly exposed to investment risk, at a time when volatility is returning to the investment markets. Customers are therefore in great need of new products or strategies to meet their financial requirements in retirement.
Many clients have two main financial concerns in retirement: income security and flexibility. Unfortunately, few retirement products on the market can offer both at an affordable price.
Value for money
In the UK, annuity sales have fallen as customers commonly think they offer poor value for money and are not worth the loss of flexibility. On the other hand, drawdown sales continue to grow in the post-pension-freedoms landscape.
Despite this, UK retirees consistently express that a key concern for them in retirement is running out of money, which conventional drawdown products do not guarantee against.
This suggests that while customers do value income security in retirement, the current product landscape does not provide it to customers at an appealing price.
In theory, drawdown with an embedded guarantee (one of the products under the variable annuity umbrella) offers retirees the best of both worlds. These products allow customers to remain in the investment markets, so they offer potential investment growth and retain flexibility in early retirement. Certain product designs include a guarantee later in retirement in case retirees live longer than they expect to.
Unfortunately, for customers who want to retain the flexibility offered by income drawdown but want a guaranteed underpinning, the choice of products available on the market has almost disappeared.
In March this year, Aegon withdrew from the guaranteed drawdown market, which follows the departure of Axa and MetLife from the market in 2016 and 2017, respectively.
Prudential is the last provider offering guaranteed drawdown products to customers. Prudential’s head of business development, Vince Smith-Hughes, believes the key to its success is that it has lower costs for this product. He is quoted as saying: “Providers pulled out of guaranteed drawdown because they were reliant on third parties to provide the guarantee. We have a fund structure to provide the guarantee ourselves. There isn’t a third party risk.”
Sales of variable annuities never took off in the UK to the extent that they did in the US and Japan as they are often perceived as complicated and expensive. In particular, the explicit charge for the cost of the later-life guarantee was considered to be too expensive.
Milliman and Royal London have produced a white paper, entitled Retirement Guarantees: Are They Worth It?, on the value of retirement income guarantees – based upon a review of actual products available in the UK market at the time of study. The paper concluded that, while guarantees offer valuable protection for customers in certain circumstances, they can be expensive, and that customers need to be careful not to over-insure themselves. The research showed that, particularly in the low interest rate environment, hard guarantees can be too costly for some customers.
Modelling
The stochastic modelling results revealed that a drawdown with guarantee can return around 30 per cent less over the average retiree’s lifetime compared to a drawdown with no guarantees. Some customers may not be aware of this trade-off.
Key points
• Many clients have two main financial concerns in retirement: income security and flexibility.
• There remains a need for alternative product designs.
• Embedding a risk control strategy within a drawdown fund may be such a solution.
Given the clear gap in the market, there remains a need for alternative product designs. The Financial Conduct Authority, in its Retirement Outcomes Review Interim Report, has been vocal about the need for more product innovation when it comes to combining flexibility with an element of income security.
Customers are in the tricky position of wanting a guaranteed income for life in retirement with complete flexibility at a low cost. Clearly the market does not have the magic wand to design a product that completely satisfies all these requirements. Something needs to give and compromises need to be made.
For many, reducing the risk of running out of money, rather than eliminating it entirely, may be the most cost-effective course of action. If such a solution could be accompanied by flexibility, ease of understanding and a reasonable price, it may fill that gap in the market.
It is imperative that customers fully understand that under this product type their risk of running out of money is reduced rather than eliminated. Transparent and open communication from the provider and adviser will be key. Embedding a risk control strategy within a drawdown fund is a softer approach which may be such a solution. A degree of income security can be given, flexibility is retained, the costs are currently lower than for annuities and variable annuities and the concept can be communicated with some ease (certainly more easily than the complexity of variable annuities). Market research studies have shown customer feedback to be very positive.
For example, the strategy objectives of ‘smoothing’ and ‘cushioning’ are particularly appealing to those in retirement and approaching retirement. Starting to take a retirement income when investment markets are experiencing severe falls can be particularly damaging on the sustainability of a drawdown fund due to sequencing risk. Investing all or part of a retirement fund in one of these funds will help to cushion the customer from this effect.
While it does not eliminate the risk of running out of money in retirement altogether, this approach does give downside protection at a more palatable price.
Some of the latest retirement products released in the UK are going down this route. This year, Scottish Widows released new drawdown funds, which aim to manage significant volatility to help customers’ pension pots last longer. The embedded ‘managed volatility mechanism’ in the funds helps make taking an income less susceptible to the ravages of the market, and so makes it more likely to sustain an income for longer.
Absolute guarantee
While customers do not receive absolute guarantees that they will not outlive their retirement funds, they do not face the high financial costs of an absolute guarantee.
We also see this approach becoming increasingly popular in international markets where there have been recent launches of products which incorporate embedded risk control strategies. These launches are timely, as there is much talk of the return to volatility in the markets and customers may start to see the effects of this on their retirement funds.
There were some big falls in the equity markets earlier this year, on the back of fears of a global trade war. While the markets have since stabilised, this provided a welcome reminder about the potential risks in the investment markets. We anticipate that more providers will launch products in this space to meet customers’ needs and to fill the gap in the market.
Beatrice Male is a consulting actuary and Neil Dissanayake is director of European trading at Milliman
