Drawdown is the new default for those taking income from their pension pot so, on the second anniversary of pension freedom, William Burrows lifts the bonnet and takes a look at what is powering the engine.
There are many different ways of arranging a drawdown plan. Different levels of income, investment strategies and charging structures all mean it is very hard to compare drawdown plans and begs the question: How can advisers and their clients judge whether a drawdown is good, bad or indifferent?
Working out what is happening inside a drawdown plan may be harder than first imagined. In the days before pension freedom, it was good practice to benchmark drawdown against annuities – for instance, over the long term, would drawdown pay out more income than an annuity? This comparison might have been crude but at least there was something to aim at.
A more sophisticated analysis would consider the trade-off between possibly lower income during retirement but a lump-sum legacy to the family on death. Today, the comparison with annuities is less prevalent and it is therefore appropriate to consider other ways of judging if a drawdown is delivering a good outcome.
There are arguably three ways in which a drawdown plan can be judged:
* Is it meeting the stated objectives and expectations?
* Is the chosen level of income sustainable over the longer term?
* Is the investment strategy suitable?
Let’s consider each of those in turn.
Is it meeting the stated objectives and expectations?
One of problems of judging drawdown against objectives is that many advisers and their clients are not clear exactly what their objectives are. They are plenty of vague objectives – for instance, ‘I want flexibility and control’. However, very few have firm objectives – for example, ‘a sustainable income in real terms, for the rest of my and my partner’s life, with as much flexibility as possible and without taking undue risk’.
In order to have clear objectives, it is necessary to have a good plan. Good advisers will have a plan and many will have a detailed cashflow for their higher net worth clients. I wonder, however, how detailed the planning is for clients with modest-sized pension pots who are taking drawdown instead of annuities …
The point is, if there is a plan, it is easy to see if drawdown is on track but without a plan it is difficult to monitor progress.
Is the chosen level of income sustainable over the longer term?
Much has been written about the debate over the correct level of sustainable income withdrawals. Some say it is 4% for level income, others say between 3 and 3.5% for increasing income.
One of the most interesting contributions to this debate is some work by Copia Capital Management head Henry Cobbe, who has produced a series of sustainable income figures reflecting the client’s risk profile and duration. This shows the sustainable income is lower for longer durations and lower risk profiles. The sustainable level works well for higher net worth clients but not so well for those who need a higher level of income.
Currently, someone aged 65 could purchase an annuity with £100,000 paying about £5,000 per annum gross for a single-life level annuity and about £4,400 for a joint-life annuity. This level of guaranteed income is more than the sustainable income from drawdown.
In practice, this means a discussion about the trade-off between a higher income in the short term compared with a lower income that may increase in the future and may provide an inheritance. At today’s annuity rates, the decision may favour drawdown but if the income from annuities rose to £6,000 for a single life or £ 5,500 for a joint, this might reverse the decision.
In simple terms, the sustainable drawdown income compares favourably with an inflation-linked annuity, which higher net worth clients can live with, but does not compare favourably with a level annuity income, which those with modest financial wealth may need.
Is the investment strategy suitable?
One of the problems in reviewing drawdown is it can be difficult to calculate overall returns if units are being sold to pay income. Also, unlike investing for growth, there are no specific benchmarks for drawdown portfolios as the investment strategy for drawdown is different to growth portfolios. Drawdown investments have to be managed in a different way because of the different risks, including sequence of returns risks, which need to be taken into account.
The traditional ways of investing for drawdown include investing in high-income funds, model portfolios, multi-asset funds and smoothed returns funds. Each has its own advantages and disadvantages and some help reduce the sequence of returns risks while others ignore it.
Whatever the chosen investment strategy, it must reflect the client’s attitude to risk, capacity for loss and income objectives. It can be argued some of the model portfolios being used may reflect the client’s risk profile but do not pay enough attention to capacity for loss and reducing sequence of returns risk.
To date, the discussion about drawdown investment strategies has concentrated on actively managed funds and costs have not been an issue. As the spotlight shines more brightly on drawdown, however, the debate will widen to include the role of passive funds and the cost of running a drawdown plan.
On the one hand, drawdown strategies should be tailored and actively managed to meet the client’s individual circumstances; on the other, they will benefit from passive investments and lower running costs. The use of passive funds such as Vanguard’s LifeStrategy funds or exchanged traded funds such as Copia’s Retirement Income range, may have a role to play in drawdown because not only do they introduce rules-based investment decisions, they will reduce the overall costs.
In conclusion, when drawdown was mainly a high net worth proposition, the solutions were individually tailored to specific client circumstances and the priority was often preserving capital rather than maximising income while costs were not an important element.
The priorities for those with modest pension pots are different and may include maximising income, reducing investment risk and reducing plan charges and the cost of advice. This calls for a different approach to running drawdown plans, which may include looking at new investment options and strategies.
William Burrows runs Retirement IQ and is an adviser at Better Retirement. You can follow the latest annuity trends and see a range of annuity charts at www.retirement-iq.co.uk
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