It's time for advisers to look more seriously at blending drawdown and annuity income as retirement needs change and income guarantee requirements compete with the desire for exposure to higher growth asset classes, writes Adrian Boulding
One of the major impacts of pension freedoms over the last three and a half years is the increasing percentage of people moving into retirement who have elected to use an income drawdown policy as their primary pension decumulation vehicle, rather than purchasing an annuity which was the default choice for pension savers at retirement age pre-pension freedoms.
We saw a dramatic plunge in annuity sales from 89,000 in Q2 2013 - about a year before George Osborne went public on pension freedoms, to 17,000 in Q4 2016 at the notional annuity market bottom. Back in 2014, many predicted a 70% to 80% decline in the annuity market and that was pretty much borne out as a healthy £11bn market in 2013 became a more ‘bijou' £4bn one by 2016.
Pension freedoms' strong "you no longer need to buy an annuity at retirement" message was, unfortunately, being trumpeted via multiple newspaper headlines across the land at exactly the time when annuity rates were operating at all-time lows, as rising longevity rates, prolonged periods of low interest rates and QE-inflated gilt prices all worked together to suppress annuity rates - thereby pushing down the retirement incomes that annuity purchasers could hope to secure from the same sized pots a few years before:
Changing Outlook
However, what's interesting is that today the tide is turningfor both annuity rates and their sales. A combination of factors is running in favour of annuities. Firstly, interest rates are slowly rising as are underlying long-term bond prices. These two factors have been pushing up annuity rates for the last two years. Somewhat less expectedly, longevity gains have apparently stalled. We've now banked the easy gains from marginalising smokers and the next big challenge - improving air quality - will not come easily or quickly.
The resulting outlook for annuity rates continues to look positive right through until 2025, according to RBC Capital Markets. The annuity market is rebounding, even seeing investment in product innovation by providers.
Furthermore, the outlook for equities, we're told by market observers, is headed for a period of greater volatility, so would-be retirees may be well-advised to search for guaranteed income certainty that annuities offer.
Market pricing speculations aside there are other very good reasons why retirees should, in fact, be considering blending annuity with drawdown policies to meet their income and savings needs in retirement.
Let's dig into this idea a little more. Firstly, it's worth thinking about what your plans and needs are in retirement. Ideally, in discussion with your adviser, think about what ‘essential' income you need to pay for your day-to-day expenses. That's not just the standard monthly bills for electricity, TV, water, heating, shopping, council tax and keeping the car running; but also needs to cover other items that you really need to regard as important and necessary for your sanity like a good holiday each year. Once these have been added up, you might want to see if you can fund these essentials out of an annuity to ensure the basics are definitely covered.
Level annuities cost a lot less than inflation-protected ones. So, combining a level annuity to cover today's essentials plus a drawdown plan with the balance is a good mix. The real growth assets in the drawdown will cover future cost increases in the basket of essentials as well as providing for ‘lifestyle' spending in retirement.
Among these lifestyle items, there may be some big-ticket things which you may not be able to put an immediate timeline or budget on. It may be likely that within the next 10 years your daughter will get married. But who would have predicted she would want to stage that wedding in Costa Rica, more than doubling any estimated bill you might have factored in?
Drawdown policies are ideally placed for irregular drawing as these items come up. They also offer the exposure to higher growth funds, so a good deal of your lifestyle expenditure could be paid for from investment growth in the good years. You'll need to arrive at a notional annual maximum drawdown amount that you are limited to in order to ensure that you do not run dry before you reach your dotage.
Ideally, within your drawdown policy, there is scope to leave a target amount for inheritance purposes as well. An adviser can help you navigate these tricky decisions, determining how much you need to live on, how much of a lifestyle cushion you feel comfortable with and how much you would like to leave for your family, charities and others.
Sustainable Withdrawal
Advisers have access to some pretty sophisticated tools to help ensure your drawdown policy doesn't run out of funds early. FinalytiQ's Timeline App is one such ‘sustainable withdrawal rate' calculator which has a strong following in the adviser market. Don't tell the Financial Conduct Authority - who believe that past performance is no guide to the future - but it uses masses of historical data to predict what your percentage likelihood is of running out of money is, given pot size, retirement date, health and income level you are looking to take annually.
Advisers can also help you in your natural desire for greater income certainty as you get older. We now know that, as we get older, our cognitive abilities diminish. Frankly, we are more likely to make poor financial choices without realising that we are exposing ourselves to greater risk as we get older. We are more vulnerable to pension liberation scams, for example. It's also a well-known fact that in later retirement, perhaps over the age of 85 today, retirement income needs tend to level off and begin to reduce - perhaps as mobility issues begin to play a factor in holiday plans, for example.
In later life, clients don't want to fret about the price of their weekly shop, or indeed the state of the prospects for their FTSE-100 or Nikkei shares. After all, we've had 13 major declines in stock markets as defined by more than 10% losses in value (and within than five 20%+ drops) since 1926. It would be terrible if the next decline wipes 10% to 20% off your drawdown-based assets when there is no other flexible income source to turn to for lifestyle and inheritance funding or even your day-to-day essentials.
Remember, there is no magic age to turn the rest of the drawdown into an annuity. A much better approach is to start with some annuity and to buy a series of further top-up tranches of annuity throughout retirement. That avoids the timing risk of major switches from drawdown to annuity. And the prompts for the next slice could be to take unrealised capital gains; seize a sudden lift in annuity prices; or simply that worsening blood pressure which will improve a fully-underwritten annuity quote.
Used in this way, a gradually shifting combination of annuity and drawdown provides a valuable de-risking service to the client. After all, in retirement, it's not limiting volatility of capital values that really matter but limiting volatility of retirement income. Securing a stable income is the key thing to work on retaining once you leave the world of paid work behind.
Adrian Boulding is director of retirement strategy at Dunstan Thomas