Pension freedoms were exciting. Giving people the potential for using their pension pot to draw down money as and when they need it. But with the new freedoms came new responsibilities.
A few years in and the evidence is that far more people than before are plumping for drawdown to provide a retirement income. But until fairly rcently many would have been cautioned against drawdown, as the risky option. In our post pension pension freedom world, the risks haven’t really changed. Anyone wanting drawdown to provide them with an income in retirement has to deal with the challenges of drawing too little money, and therefore not using the pot to its fullest potential; or drawing too much and running out of pension pot way before death. Given the average life expectancy is increasing, this can be a big ask.
So, how do you make a pension pot last a lifetime?
The SMF (Social Market Foundation) issued a report on this. For inspiration they looked abroad at other countries that have been living with the pension freedom reality for a while. In Australia they found it was a game of two halves. 40% spent the drawdown pot too quickly leaving nothing by age 75. But in contrast a significant proportion eeked out the pot by spending only 1% a year.
Sounds like a frugal existence to me.
The SMF also found the typical American spent the pot at a startling 8% a year.
Making sure the pension pot can last a lifetime is definitely achievable. Research from the ILC (International Longevity Centre) and Cass Business School found that with careful management a pot of £100,000 shouldn’t run out before death. They found the secret is flexibility, rather than following a set investment strategy.
And the best defence is having a good adviser working for and with you.
In this brave new world, the adviser immediately starts to add value by setting the right assumptions for the client’s drawdown strategy. Cashflow modelling is invaluable to map out the future projection of the drawdown fund, and is determined by three key factors:
- The investment returns
- The rate of withdrawals, and
- The longevity of the client
Part of the process is establishing the right investment portfolio suitable to the client’s ambitions and the amount of investment risk they want to undertake. But the investment mix has to be capable of sustaining the withdrawal rate. One option may be to take the ‘natural yield’ of, say, 3-4%, by withdrawing from capital of high yield bonds.
The subjects of catastrophe and failure should be brought up. If the client can accept some margin of failure – some risk that their money will run out before they die – then they will be able to increase their withdrawal rate. If they can’t, then they will be restricted to a low withdrawal rate, as well as seriously asking themselves if drawdown is the right option for them! Advisers can also use cashflow modelling to show the effects of a ‘catastrophe’, such as a significant fall in investment markets, on the client’s drawdown strategy. The client has to ask themselves if they are comfortable with the outcome. Again, if the risk is too great, now is the time to be questioning the suitability of the option.
Date of death
Another key assumption will be date of death. Many times people will take into account the average life expectancy. But for all those who don’t survive to that age, there will be another lot who will survive beyond it, possibly by some years. A man aged 65 today has a 50% chance of living until 89, and a 25% chance of living to 95, while a woman the same age has a 50% chance of living to 93, and a 25% chance of living to 97. One of the key benefits of annuities is taking on that longevity risk, and many may want to build into their retirement income strategy the option of buying an annuity in later life. Another alternative is to use a different source of income – for example releasing the equity within a property.
An assumption for inflation should also be built in. In a retirement spanning 25 or 30 year, it’s safe to say the buying power of income today will not be the same as tomorrow.
Regular reviews
Regular reviews are a necessity to make sure the drawdown strategy keeps on track. The ability to be fleet of foot and change the strategy according to current circumstances could make a significant difference to ensuring the pension pot doesn’t run out too quickly. Part of that is addressing sequencing risk, the danger that too much income is withdrawn when markets are down, crystallising losses, which then have a greater impact on the remaining saving. This is the reverse of pound-cost averaging (which is why it has also been termed ‘pound cost ravaging’). A spread of investment assets should help mitigate the risk of withdrawing income from saving at the wrong time. But advice at the right time will also help avoid this pitfall. Another strategy is to have a blend of products, and rely on the annuity income in time of trouble rather than withdrawing from the drawdown pot. The client should also consider keeping some fund invested in cash to access to avoid the need to sell assets in bad times.
Managing a drawdown fund through later life is a tricky business. And with more people reluctant to annuitise – either initially or in later life – to maintain flexible death benefits, more are going to have to take on the challenge. A few key rules are going to be essential – take advice, set the right assumptions, use cashflow modelling, and review review review.
Please note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of Sense Network Limited. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author.
