Planning for life after drawdown

It was a huge victory for individual choice, however greater freedom has introduced an element of risk, that, without proper preparation and advice, threatens to leave people with little or no income to carry them through their later years.

People were already facing the prospect of a longer and more varied retirement, putting greater strain on financial, physical, social, and cognitive resources, but the freedoms have added further complexity to the task of ensuring retirement is well provided for.

Today, the decision to retire comes at a time of economic change. The UK’s decision to leave the EU introduced a further round of financial instability, while the prospect of rates rising sharply soon appear remote. 

The low interest environment has spurred pensioners to look for riskier options in retirement. Drawdown is likely to continue to emerge as the more popular source of pensioner income for the foreseeable future, particularly for those who want both capital growth and regular income.

This alternative route, brought to the foreground by the 2015 pension freedoms, is an attractive one for a couple of reasons. First, allowing an individual to decide how much to take from their pot each year gives that person the flexibility to adapt their income to suit their changing financial needs in retirement.

Second, it does not close the door to investment returns, so strong investment performance could lead to a larger pot and the availability of yet more income.

However, there are some quirks of income drawdown that can make living off investments in retirement challenging. They place a huge amount of emphasis on market performance for determining future income potential and are amplified by the impact of regularly withdrawing money from a pot in the form of retirement income.

Financial markets are volatile, and are subject to both falls and rises. The very effect of market volatility will likely mean a person’s portfolio will have to work harder. For example if a £100,000 pot falls by 10 per cent in the first year of an investment, that £90,000 needs to grow by 11% to return back to £100,000. If that person is withdrawing money at the same time, it makes it even harder for the pot to climb back up to its previous highs.

The very same goes for market timings and the order, or sequence, in which market fluctuations occur. For example entering the market just prior to the fall seen in 2001, and then again in 2009, would reduce a pot to such a  level that any subsequent market climbs wouldn’t have the same positive impact retirees would have enjoyed if the market climbs occurred prior to the falls. Again, the effect of withdrawing money serves to amplify this, so a protracted fall in early retirement, coupled with an unsustainable rate of income withdrawal, could derail an entire retirement plan

Source ONS

Therefore, when looking at this option, we need to focus not just on attitude to risk, but also the customer's capacity for loss. The FCA describes capacity for loss as: “The customer’s ability to absorb falls in the value of their investment. If any loss of capital would have a materially detrimental effect on their standard of living, this should be taken into account in assessing the risk that they are able to take.”

To put it simply, if you invest in something and it drops in value, can you withstand the fall?

Those with substantial assets, that could withstand falls in value and still provide an adequate income, could be deemed to have some capacity for loss.

However, where a pensioner's capacity for loss is minimal or non-existent, where their assets are smaller in size, a fall in the value of these assets could mean the client will run out of money if they continue to draw an income. 

So, we need to seek solutions that offer some sort of benefit or upside potential, but with the comfort that a market dip or heightened levels of volatility will not devastate income levels over the entire retirement span, or force a retiree to take a haircut on the amount of income they can afford to take.

Currently the UK blue chip index is on a bull run, recently surging past the 7,000 milestone, and this benefits those with drawdown plans. However, the real issue is being able to safely protect retirement income when the markets fall.

For example, analysis shows that a 65-year-old entering drawdown when the new pension freedoms launched in April 2015, could have had two whole years of retirement income wiped off his saving pot as a result of volatile markets in the 12 months that followed. Markets have recovered and the outlook is rosier for those in drawdown, but it is a demonstration of the impact market falls can have on people’s savings.   

With this in mind, it is vital that those relying on their savings for income are able to adjust the amount they withdraw in such an environment. For example, a 65-year-old retiree with a £250,000 pot, advised to take a sustainable retirement income rate of 2.53 per cent a year at the time, would now have to adjust this down to 2.44 per cent, or risk running out of money up to two years earlier than expected.

The new era of pension freedoms also calls for more innovative retirement options for people. Drawdown with guarantees is emerging as a more popular option – providing the opportunity to participate in market performance and a guaranteed income for life that will never go down irrespective of what happens in the market.

Recent figures from Willis Towers Watson revealed that the drawdown with guarantees market bounced back to strong growth in the second quarter of 2016, rising 20 per cent. It is a strong indication that the market is finding sure footing following the greatest pension reform this country has seen for a century.

These figures suggest pensioners are waking up to the new options available and realising they do not have to lock in their pension pot for the whole of retirement with no prospect of any income growth, and no access to cash. Instead, thousands are turning to ‘best-of-both’ solutions such as drawdown with guarantees, which offer income certainty alongside growth of funds on the stock market, locking in the gains.

At a very basic level, these solutions offer the ability to invest through funds and are tied to market performance. The upswing in a pensioner's fund value is locked in and this increases subsequent income levels. A bit like a watermark: once the mark is reached, the income level is set from this high level and will not ever decrease.

We as an industry need to manage expectations in what is the new retirement reality of increasing longevity, low medium to long-term interest rates and market volatility, against the backdrop of the pension-freedom generation’s ability to self-determine. The complexities of planning for retirement in this environment are stark, and drawdown alone is simply too risky for many looking to preserve income. 

According to the Office for National Statistics, a 65-year-old man has an average life expectancy of 83  – it is 86 for a woman – but improving mortality means the average should be much higher; 88 for a man and 90 for a woman. This gap of five years for a man or four years for a woman can have big implications on financial planning.

A man with a pot of £250,000 would need to save £62,000 more to cover this further five years in retirement if he wanted to maintain a sustainable income of £9,772 every year. A woman would need to save £31,000 more to cover the four further years.

With life expectancy on an upward trajectory, the ability to preserve income for a retirement that could last between 20 to 40 years, will be the main priority for people and their advisers.

Yes, pension freedoms have shaken up the industry, but many people are still keen to receive a guaranteed income for life. Yet traditional annuities that were already offering meagre returns before the Brexit vote are too unattractive for a large proportion of the population. 

Where a pensioner's capacity for loss is minimal or non-existent, mainly for those approaching and in retirement, we need to seek other solutions to meet their later-life needs. Drawdown alone is too risky an option for many pensioners in this new era.

However, certain products, like guaranteed drawdown, are emerging as a solution, marrying people’s appetite for risk with their capacity for loss.

Barry Cudmore is managing director of Aegon Ireland

Key points

By allowing an individual to decide how much to take from their pot each year, a person gets the flexibility to adapt their income to suit their changing financial needs in retirement.

A big market fall early in retirement would reduce a pot to such a  level that any subsequent market climbs would not have the equivalent positive impact.

We need to manage expectations in what is the new retirement reality of increasing longevity.