More consumers are opting for income drawdown without advice, a study has warned.
Post-pension freedoms savers are increasingly choosing ‘DIY drawdown’ with relatively small pension pots and exposing themselves to a new range of risks, the report from Retirement Advantage said.
The pension specialist commissioned risk modelling firm EValue to model five drawdown strategies to see how different approaches perform and what levels of risk consumers are facing going it alone.
The report considered whether a particular strategy, or combination of strategies, consistently produces a better outcome and concluded there was no single investment strategy that could work for the duration of retirement.
Seeking financial advice was crucial for consumers to avoid “heading for the rocks”, they warned.
EValue and Retirement Advantage concluded there was “no silver bullet” for people looking to DIY plan their retirement.
Andrew Tully, pensions technical director at Retirement Advantage, said: “Drawdown is a complicated business and our modelling work proves there is no magic solution or silver bullet. No one strategy combines the best of all worlds to create the ideal outcome and it may well be that a combination of approaches through retirement will work best.
“Given the complexities involved (...) seeking professional financial advice is a critical first step. Not only will an adviser create the most effective drawdown strategy for [a person’s] individual circumstances, but reviewed regularly as [they] go through retirement will ensure [they] can sleep at night.”
The FCA's retirement outcomes review found consumers are increasingly accessing drawdown without taking advice. Before the freedoms, 5 per cent of drawdown was bought without advice compared to 30 per cent now.
In its research eValue considered the strategies: unit cancellation, unit cancellation with cash buffer, living off the natural yield or income, longevity tail risk and an annuity.
Its analysis was based on a 65-year-old man with a pension pot of £200,000 (after tax-free cash has been taken), investing a mixed portfolio of 60 per cent equities and 40 per cent bonds, targeting an income of £10,000 a year.
On unit cancellations - where units are cancelled when income is required - it found there was a 50 per cent chance the fund would last about 25 years to age 90, alongside a 25 per cent likelihood it would last for 40 years, and a further 25 per cent chance it could run out in 20 years' time. At this point there was a 75 per cent chance the fictional male aged 65 would still be alive.
Retirement Advantage said: “Overall, there is a reasonable likelihood that the fund could last a lifetime, but there is unlikely to be a significant legacy to leave behind in most cases.”
To adapt to changing circumstances an adviser might make changes such as reducing income, changing the investment strategy or annuitising part or all of the fund, it added.
Given the rigidity of the process, which made it difficult to manage periods of low returns, eValue tested its second strategy which used cash to mitigate the impact of poorer years.
As part of this, two years’ worth of income was held in cash (£20,000), meaning units are only encashed every two years, which should reduce the volatility, the firm said.
The firm found the results were poorer than the previous strategy.
Retirement Advantage said: “Keeping money in cash mostly has a detrimental impact on the fund’s ability to sustain income. Of course, there are particular circumstances where the cash reserve could prove worthwhile, but our analysis suggests that overall it is a sub-optimal strategy in terms of maximizing returns.”
In the third option the fund remained fully invested and provided income in the form of a natural yield, such as interest and dividends.
This has the advantage that sequencing risk is almost entirely eliminated because income is not being taken from the capital but the drawback was that the income was less than the previous examples and would vary from year to year.
According to Retirement Advantage it is also less than the income provided by a guaranteed annuity, though eventually it does exceed the amount payable from an annuity in many of the simulations.
The firm said: “If the amount of income is important - and needs to be a regular amount each year, this strategy is unlikely to appeal.”
With the approach ‘longevity tail risk’ a pot of about 15-20 per cent of the fund is set aside to buy an annuity at age 85. This pot will have 20 years’ growth resulting in a relatively small amount put aside buying a reasonable-sized annuity at age 85.
The balance of the fund is split into equal parts to provide income each year over the 20-year period.
The key risk with this strategy, Retirement Advantage said, is that investment returns are low over the period and annuity rates worsen, so the fund set aside to buy the annuity fares badly, although there are protections that can be put in place for this.
The firm found that although this strategy started with a lower income than an annuity bought at outset in most simulations it exceeded the income from an annuity after about 10-15 years.
The alternative to the above scenarios is to buy an annuity from the start but the disadvantage of this is the inability to access capital or vary income, Retirement Advantage said.
Dobson and Hodge financial services director Paul Stocks said: “There are many different approaches to ‘at retirement’ advice and my fear is that providers facilitate clients moving into drawdown without the client understanding that there are a whole range of providers and approaches which are likely to be better suited.
"Existing providers should be signposting the client to Pension Wise and where advice is needed, Pension Wise should likewise be signposting accordingly.”
Mr Stocks added: “Many advice firms will meet potential clients without immediately incurring a cost on the client and therefore, for the sake of an hour, I’d suggest anyone about to move into drawdown should set that time aside because getting it wrong could see them regretting it for 30+ years and whilst guidance no doubt helps, taking that additional step of discussing how advice could help based on the individual's needs and circumstances should ensure the outcome is appropriate.”
carmen.reichman@ft.com
