May 2007

Reaching new heights

Unless you have been in hiding recently, you will have heard that the UK is facing a crisis due to the ageing population and that unless something is done soon, pensioners will have some fairly stark choices about if/how they fund their retirement.

While this is welcome attention on the future it does overlook the dilemma facing those retiring today. How do they best provide for their retirement? For those who have saved in a pension scheme or been fortunate enough to accumulate benefits from an employer's scheme - the question of how to turn this into retirement income also seems to present some stark choices.

For many, an annuity remains the most popular choice - despite the fact that many will claim, rightly or wrongly, that they represent poor value for money. Perhaps one reason for the continued popularity is the lack of a credible alternative. The only real alternative to annuity purchase is income drawdown/unsecured income.

This lack of choice may be one reason why we are now hearing many more discussions about, and some recent launches of, so-called 'third way' products. These products attempt to bridge the gap between the security and certainty of an annuity and the greater flexibility, but additional risk, associated with income drawdown.

Although we can expect this market to grow over time, initial attitudes from financial advisers towards these new products have been lukewarm for a variety of reasons, ranging from concerns about the cost of the guarantees provided by these products, to a lack of clarity over how the products actually work.

Interestingly poor understanding/complexity were often cited as reasons for shunning drawdown when it was first introduced. More than ten years on have things changed? Is drawdown getting a fair hearing?

A recent survey of financial advisers, in conjunction with IQ Research identified the main issues with drawdown as:

- More risky than an annuity

- Need a large pot

- Difficult to understand/complex

- Need to be an investment specialist

On the face of it nothing has changed since this product was first permitted under legislation in 1995. So how do these perceptions actually play out in reality today for those seeking a viable alternative to annuity purchase in today's market?

Risk

Investment risk and mortality risk are the two common risks associated with income drawdown (incidentally the new name of unsecured income hardly helps to dispel any fears around potential risks so I'll use the old name here!). When drawdown was first introduced in 1995 the actuarial profession went into overdrive calculating 'mortality drag', in other words the additional investment return required to compensate for the absence of the mortality cross subsidy that annuitants enjoy. Since then, there isn't a year that goes by without predictions of life expectancy increasing. Much of the comment focuses on the resultant downwards trend in annuity rates. But a corollary of greater life expectancy is a lower mortality cross subsidy, and hence a lower return required under drawdown.

Relatively small changes in the degree of out performance required over gilts can have a very significant impact on investment strategies and the investment arena has moved on considerably since the early drawdown plans were sold (many on a with-profits basis). The range of investment options and tools that can be used within the drawdown 'wrapper' has become much more sophisticated. The emergence of regional equity tracker funds provides the opportunity for cost effective diversified access to equity markets. The development of stochastic modelling techniques is ensuring advisers and clients alike are better informed of the potential range of outcomes rather than simply the expected or average, and the recognition that the investment timeframe in retirement may be as long as the pre-retirement period is leading to greater acceptance that a degree of investment risk is appropriate. More recent developments include the launch of so called absolute return funds. These funds target an explicit rate of return and while it may be a little early to judge their success, they could potentially fit well with a drawdown investment strategy that is targeting a fixed return over gilt yields.

For those lacking the requisite skills or confidence to structure or advise on investment portfolios in this area, then the potential to outsource via a discretionary manager should not be overlooked.

For advisers citing risk or investment complexity as barriers to drawdown there are genuine reasons to revisit these issues - this would appear to be even more relevant given the increasing appetite for investment-backed annuities to provide potential income upside.

Complexity

Although the recent strength of equity markets has undoubtedly helped to boost sales of income drawdown plans over the past 12-18 months, it is likely that much more significant forces are at work to explain the growth during 2006. The removal of some of the complexity - for example the minimum income limit - associated with income drawdown plus the introduction of alternatively secured pensions providing the capability to continue drawdown beyond age 75 has undoubtedly meant an increase in sales. The reduction in the age limit for protected rights benefits being taken has also contributed to the increase.

The greater simplicity, aligned with other changes such as the move to quinquennial (five yearly) rather than triennial (three yearly reviews) provide an opportunity to simplify the proposition for customers, advisers and providers alike. This, aligned with greater competition should provide positive forces to reduce costs in this market - often cited as another potential barrier to growth.

Given that flexibility is one of the major benefits of income drawdown, it is not surprising that the product is often seen as more complex than a simple annuity. For many the potential upside - including the ability to plan beyond age 75 using ASP and the benefit of retaining the adviser/client relationship beyond retirement - merit serious consideration of the drawdown option.

It is likely to remain the case that the small size of many pension pots will dictate annuity purchase as the only viable option, but advisers should not look at this in isolation. Other assets and potential income sources (including equity release) should be considered as advisers look at holistic retirement planning and avoid the knee jerk reaction.

Returning to the sales figures, it appeared that income drawdown sales had plateaued in 2005. If positive equity markets and A-Day changes have provided drawdown with the potential to reach new heights this is welcome news, it also means that some of the new breed 'third way' products may need to learn carefully from the 'old kid on the block'.

Ray Chinn
Head of Pensions
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