BlendedOct 19 2016

Retirement Month: Blending a cocktail of solutions

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Retirement Month: Blending a cocktail of solutions

Pension freedom has accelerated the use of combinations of annuities and drawdown as part of a balanced solution and two companies, LV= and Retirement Advantage, provide packaged solutions.

Of course, there is nothing stopping advisers and their clients putting together their own combination of options under a Sipp umbrella. Numerous advisers were doing this well before pension freedoms.

Perhaps now is the time to take the discussion about combination solutions one step further and to consider what should go inside the combination solution. Before I do that, let us recap on where we are the moment.

We love jargon in pensions and the option for a combination of different retirement income options has had various different labels: hybrid plans, blended solutions, combination plans and cocktail solutions.

The term hybrid is used for a single policy that allows for a combination of annuities and drawdown from the same provider, whereas a blended solution refers to option under a Sipp wrapper.

Hybrid plan

Blended Solution

✔ A combination of guaranteed income and drawdown options within one policy.

✔ The guaranteed income is for a lifetime annuity or a fixed term plan with a choice of terms and maturity options.

✔ The guaranteed income may be paid into a pension cash account, giving added flexibility as income is only paid out to the client when needed.

✔ This is a flexible pension account structure with numerous features to make it easy to hold a range of guaranteed income and drawdown options within a SIPP.

✔ This solution allows for annuities and investment funds to be purchased from other providers, making it truly flexible.

✔ An important feature of a blended solution is the range of tools and resources available to help advisers determine the best blend of options.

The case for combination solutions

I have set out the reasons a combination may result in better client outcomes. One reason that often gets over looked is that now clients with funds of less than £100,000 are investing in drawdown, the annuity part of the combination reduces the overall risk.

There are several ways of justifying the case for a blended solution, but the strongest cases can be made on the following basis:

    It reduces or diversifies risk in retirement

    It enables clients to meet more than one retirement objective 

    It produces better client outcomes

    It is useful for reducing or diversifying risk in retirement 

A good case for blending can be made by looking at the risks people face at retirement and ways to reduce these risks. Generally speaking, people are not faced with binary risks, for example, income or capital risks, but a multitude of risks including:

    Risk that inflation will reduce spending power

    Risk of living longer than expected and running out of income in the future

    Risk that circumstances such as health or income requirements may change in the future

    Risk that equity prices and or interest rates could rise or fall

There is no single policy that effectively manages all of these risks. For instance, a guaranteed annuity is the only way to protect against the risk of a client outliving their pensions, but they do not provide flexibility if circumstances change.  

Drawdown is the most flexible option, but there is a risk that fund values could fall if future investment returns are less than expected and a risk that income could eventually run out.  

Annuities rates fell to record low levels immediately after the Brexit vote. The 15-year gilt yield, which I use to benchmark annuity pricing, fell from just below 2 per cent before the EU referendum to as low as 1 per cent in the summer.

Annuities have fallen by about 17 per cent over the past year. The benchmark annuity (age 65 and 60, £100,000 joint live 2/3rds with level payments) was £4,818 in September 2015, but is about £4,000 now.

It is possible they could fall lower, but I believe yields and annuities will slowly bounce back – although it may be a long time before they return to their position before the referendum.

Even the most ardent fan of lifetime annuities must agree the case for purchasing lifetime annuities at these levels is not very strong. Not only have the rates changed for the worse, but the optimum time to purchase an annuity has also changed.

While there is probably no specific age, or time, that can be regarded as the optimum, most experts agree the best time to purchase an annuity is when guaranteed income becomes an important priority.

The benefits of mortality cross subsidy increase with age and this means the optimum time to purchase an annuity is probably during a person's late 60s or early 70s, depending on health.

This does not mean annuity purchase should not be considered at early ages, especially for those who qualify for an enhanced annuity or where a guaranteed income is the priority. However, advisers may not want to commit clients to a lifetime of low income if they are relatively young and generally in good health.

It is important to understand how the relative value of annuities changes with age because there are advantages in purchasing annuities (in whole or part) as a client gets older and the benefits from mortality cross subsidy increases.

An annuity is a type of insurance policy and the income for life promise is made possible because they are based on the principle of mortality cross subsidy: those who die before their expected life expectancy produce a notional profit that is used to subsidise the payments of those who live longer than expected.

Drawdown is an investment proposition, not a type of insurance policy, so there is no mortality cross subsidy. Unlike an annuity where the capital is exchanged for income, the money in a drawdown plan remains in the control of the client.

Mortality drag is the term used to explain how the absence of mortality cross subsidy has a negative impact on a drawdown plan where the aim to maintain the annuity purchasing power.

No one option can be described as being the right answer, but it seems fixed-term income plans do have some advantages over lifetime annuities – and this comes from someone who has been critical about them in the past.

Perhaps the biggest advantage is the option to secure a level of income for a set period and then having the potential to review the options depending on market conditions and circumstances. Maybe lifetime annuity rates will have increased.

The case for annuity/drawdown combinations is stronger than ever, but until the rates for lifetime annuities bounce back to levels that are considered ‘value for money’, other options may produce better outcomes.

Finally, just because a client needs an amount of guaranteed income, it does not necessarily follow that this has to be secured by a lifetime annuity. Annuities remain the only policy that can guarantee income for life and so the question becomes: when is the right time to purchase this insurance?

Billy Burrows is director of Retirement Intelligence

Key points

Pension freedom has accelerated the use of combinations of annuities and drawdown.

The term hybrid is used for a single policy that allows for a combination of annuities and drawdown from the same provider.

The case for purchasing lifetime annuities at current rates is not very strong.