Pensions freedom has blown a hole in years of conventional wisdom that assumed and required full annuitisation at retirement for most savers.
This is no bad thing as the state pension age was out of sync with the reality of demographics (most people living longer), while full annuitisation at 65 or so was out of sync with the reality of capital markets (falling inflation and interest rates in the post-war era).
Retirement income provision through mandatory annuitisation was economically and conceptually broke, and it’s great that the government and industry are together trying to fix it.
But that does not spell the end for annuities. Far from it.
Annuities are an essential part of the retirement planning toolkit to do what they say on the tin: provide the ultimate protection against longevity risk.
But this should be at a time when such protection is needed. At 65, full annuitisation is probably too early given average life expectancies. And you don’t always need guarantees to provide a steady income.
So we expect annuities to become part of later life financial planning.
Thinking caps on
Providers, asset managers, advisers and consultants all have their thinking caps on (still), which makes the very public and very considered proposals from NEST, the government-backed workplace scheme for auto-enrolment, all the more interesting.
Reassuringly its findings, published a few weeks ago, read well. They are also streets ahead of much of the industry (so far) with proposals that are sensible, evidenced, and intellectually robust.
When considering NEST’s retirement blueprint it’s worth remembering that this is about retirement income for small pots.
The illustrations they give are for pot sizes of £100,000 – most retirement pot sizes are actually much smaller. In this context proposals such as living off a ‘natural yield’ which may provide a decent retirement income for a client with a £2m pot is simply not relevant here.
For most people provision of an income in retirement necessarily means exhausting the accumulated capital – whether in exchange for an annuity or from regular withdrawals.
Hence, the key risk to retirement savings is ‘shortfall risk’ – the risk of the pot not stretching far enough to make it last throughout retirement. NEST expects its approach “to incorporate a running down of capital as well as generating an income”.
NEST sets out four key features and six principles in its blueprint for a straightforward, value for money, flexible decumulation default for auto-enrolment savers.
The four key features are:
- Simplicity – meeting a range of needs for most people, most of the time
- Value – provide good quality and value for money to deliver good outcomes for the majority with associated economies of scale
- Freedom – savers should be able to opt out
- Clarity – the default option should be within a set of straightforward retirement choices
The six principles for NEST’s retirement blueprint focus on:
- Shortfall risk as the key retirement risk;
- The run-down of capital as the primary provision of income;
- The importance of underlying liquidity to protect against systemic risks;
- The importance of mitigation strategies against sequencing risk;
- The need for management rather than hedging of inflation risk;
- And ideally as much flexibility and portability as possible.
The importance of time
In the same way as NEST uses target date strategy to provide an asset allocation glidepath over time in the accumulation phase, NEST has sketched out preliminary thinking of what a glidepath through retirement might look like.
Naturally given the importance of time not only as a determinant of risk capacity, but also as a key parameter when considering shortfall risk, it’s not surprising that NEST’s proposal for retirement investing is a changing asset allocation over time to address different risks at different phases of the retirement investing journey.
A phased approach
NEST’s blueprint is designed to address flexibility, inflation protection and longevity protection at different stages of the retirement journey which is broken into three phases with changing allocations of the retirement portfolio to three building blocks – an income drawdown fund, a cash lump sum fund and a later-life protected income fund.
This ‘bucket’ approach is popular in the US, where the changing allocations to those buckets can either be separately managed, or more conveniently for default arrangements, delivered within a single target date strategy which provides a through-retirement glidepath for long after the target date. The target date range in the name of a fund marks the turning point between accumulation and decumulation.
In the early years of retirement, the emphasis is on flexibility and NEST suggests a sufficient (10%) allocation to a cash lump-sum fund.
In the later years of retirement, the emphasis is on longevity protection – NEST suggests a sufficient allocation to a later-life protected income fund that could be used at 75 to lock in an income stream from 85 (using a deferred annuity).
This means that longevity insurance is taken out when it’s worth having, and not before.
The asset allocation engine in retirement
The core of NEST’s proposed through-retirement strategy is the income drawdown fund that can be partially switched either into to the cash fund or into the protected income fund at different stages of the journey.
To address the key retirement risk of shortfall risk, any such drawdown fund, in my view, would necessarily have to be a well-diversified in scope, multi-asset in content, and mindful of the key determinants of shortfall risk – inflation risk, longevity risk, liquidity risk and mismatch risk.
This way it is more likely to have a high probability of sustaining a real income for the saver over time, as capital is run down.
The inclusion of deferred annuities in NEST’s blueprint is a bold statement given this type of contract does not currently exist in the UK.
However, the inclusion has merit and we hope it acts as a stimulus to insurers to be innovative when rethinking the retirement toolkit that they offer to advisers.
While some think that deferred annuities will not catch on because few people would want to allocate to future income, that is rather missing the point.
For default decumulation, the allocation is happening anyway as it considered to be in the savers’ best interests.
Theoretically, by deferring annuitisation, the saver benefits from both the pick-up in annuity rates and the fact that their investment portfolio remains invested for longer.
NEST’s retirement blueprint is a useful glimpse of what could emerge as future best practice in the provision of through-retirement investment strategies.
The shape of retirement investing for most savers is likely to evolve rapidly away from a funds-only approach to become multi-dimensional in its challenge, and multi-product in its delivery.
In this ‘blended solutions’ environment ensuring that the approach to risk profiling, outcome modelling, and portfolio and insurance allocations are fit for purpose becomes an urgent priority.
Henry Cobbe is head of research at BirthStar