Drawdown Strategies The right solution for your clients

Transcription

1 Drawdown Strategies Drawdown Strategies The right solution for your clients 34% For financial adviser use only 1

2 Introduction The retirement income market has changed out of all recognition from just a few short years ago, but have the solutions offered by providers and advisers kept pace with these changes? That was the question we wanted to answer with this report. In a world where drawdown is the most common solution for most clients, what are the strategies that work best for the myriad of clients who are likely to have many and varied needs? This isn t just about fund choice. It means understanding the risks of using different investment strategies and also understanding the key goals of clients in being able to recommend the most suitable strategy for each. This report isn t about finding the one solution that is best for any given client. It s about suggesting for different clients there are different best solutions and the key is really understanding what clients want and then being able to advise on how they can get it. There has been much talk over the last couple of years about the risks that clients are taking by using investment solutions rather than annuities. In my view, this misses the point. The real debate is how best to arrange a client s investments to deliver the result that they want. We hope this report is a useful addition to that debate. Peter Carter Product and Marketing Director Retirement Advantage October

3 Drawdown Strategies Many advisers suggest you need at least 100,000 to make drawdown viable. The Guardian, How has a product only considered suitable for people with at least 100,000 become the new normal in less than three years? Three out of four people who take drawdown these days have funds worth under 100,000. How could this have happened so quickly? The question is largely rhetorical. Anyone involved in this market would point to the new pension freedoms as the primary catalyst. In 2013, 90% of people bought an annuity and only 5% chose drawdown. Now drawdown sales are roughly double the volume of annuity sales. In fact, they ve increased eight-fold over this period (around 5,000 new drawdown sales were made in each quarter in 2013 compared with 40,000 drawdown sales in the third quarter of ). Of course, many people have simply taken their tax-free lump sum without taking income. These people may annuitise when they eventually decide to take income. If so, this cohort inflates the situation artificially, but it is difficult to deny that there has been a seminal shift from annuities to drawdown since the new freedoms were introduced and this could have profound consequences. A perfect storm? Britons have never really had to worry about running out of money during retirement. The mainstays of retirement income in the UK: State pensions, defined benefit schemes and annuities all remove longevity risk. Even the introduction of drawdown in the mid 90s didn t expose people to significant risk of running out of money. Limits were imposed on how much income could be taken and the requirement to buy an annuity at 75 shielded people from spending too much too quickly. That has all changed. We now have unfettered drawdown. People can take what they want, when they want and stay in drawdown for life. So how likely is it that they will run out of funds? The evidence from around the world isn t promising: 40% of Australians have exhausted their pension savings by age 75 Americans withdraw 8% each year and make their savings last for 17 years on average (still 5 years before the average life expectancy for a 65 year old 3 ) Retirement Outcomes Review Interim Report, FCA, July Britons.html 3

4 55% Pension funds can be depleted even quicker by poor returns in the early years (so called sequencing risk ). Research by AEGON revealed that someone retiring in 2000, withdrawing an amount equal to the income from an annuity, would have seen their fund halved in value after a decade (despite some strong returns after the falls in the first three years from ) 4. Even the ubiquitous 4% safe withdrawal rate has been questioned. A Morningstar report suggests that for UK retirees this figure should be nearer 3% than 4% 5. Against this background, why are financial advisers choosing drawdown for so many clients and turning their back on the conventional wisdom that drawdown isn't suitable for those people with small pots? No one need ever buy an annuity again George Osborne The Chancellor s remarks encapsulated the prevailing sentiment at the time. Rates were at an all-time low and the wisdom of compulsory annuitisation looked questionable. A few years before the Chancellor made his pejorative remarks, drawdown restrictions were abandoned for flexi access drawdown: No limits on withdrawals and the option to stay in drawdown for life. This also coincided with reductions in the minimum premiums imposed by providers, which made it possible for people with smaller funds to take their tax-free cash easily from 55 without taking income. This suggests a major U-turn in adviser attitudes and recommendations. The reality is much more nuanced. Firstly, there has been a strong rise in non-advised drawdown sales. Only 3% of drawdown sales were written on a non-advised basis in By 2016, non-advised drawdown sales increased to 42% 7 and there is every likelihood that this trend will continue. By 2020 estimates suggest more sales of drawdown will be non-advised than advised. 11% Safe Withdrawal Rates for Retirees in the United Kingdom, Morningstar, May FCA Review of Outcomes 7 Professional Pensions

5 Drawdown Strategies Non advised sales likely to exceed 50% by Source: FCA/ABI data 2013, 2015 and midpoint taken. Estimates for supplied by Making Sense of Retirement Limited The majority of non-advised sales are for smaller funds. Indeed for funds less than 50,000 more people act now without advice 8. Secondly, many advisers may still plan to recommend that their clients annuitise, but have chosen to defer the decision. The low interest rate environment may be coming to an end which should mean that annuity rates will start to rise in the coming years. Delaying the decision could also mean more clients are eligible for enhanced rates. And the longer annuitisation is deferred the greater the impact of mortality cross subsidy. Annuities are still the most effective solution for people who want the peace of mind of knowing that their income will be paid for life. Advisers may be recommending drawdown tactically as a stopgap in anticipation of better annuity rates in the future. It s not surprising therefore, that a recent Retirement Advantage survey suggests that for clients with a pension pot worth 100,000 and no other provision (except for the state pension), over 70% of advisers are more likely to recommend drawdown than an annuity in the current economic circumstances 9. A further piece of research suggests that investors need at least 100,000 to justify using an adviser for drawdown 10. Retirement can be an unforgiving environment There are stark differences between the investment strategies that work successfully during the accumulation phase and the investment strategies required for the decumulation phase. This is hardly surprising given that the objectives are almost polar opposites. In the accumulation phase, people are saving from income to build capital usually over a fixed term (though retirement is more fluid these days). The objective is to grow capital and make regular savings, which benefit from pound cost averaging. 83% 8 FCA analysis of distribution channel charges data collected from 55 providers 9 Opinium Research for Retirement Advantage, August

6 In the decumulation stage, capital is being reduced and converted to income. The time horizon is unknown and the opposite of pound cost averaging, commonly called pound cost ravaging, can be devastating. Accumulation is very different from decumulation Accumulation Converting income into capital Fixed term horizon Investing for growth Increasing capital Pound cost averaging Converting capital into income Unknown time horizon Investing for income Reducing capital Pound cost ravaging Decumulation The search for a silver bullet With more and more people choosing drawdown, and with the barriers to protect people abandoned, it s important to understand how different investment approaches might perform. We asked respected independent consultancy, EValue, to stochastically model a range of different strategies to explore if there s a particular strategy, or a combination of strategies, that consistently produce a better outcome. We tested five distinct strategies The strategies were stochastically modelled to give a robust range of outcomes. Unit cancellation Unit cancellation with cash buffer Living off the natural yield or income Longevity tail risk Annuity The core analysis is based on a 65 year old, with a pension pot of 200,000 (after tax-free cash has been taken), investing in a mixed portfolio of 60% equities and 40% bonds, taking an income of 10,000 each year (where a strategy deviates from these assumptions this will be highlighted). The results are also net of assumed charges. 6

7 Drawdown Strategies Stochastic forecasts Stochastic modelling is a method for predicting outcomes that involve a certain degree of randomness, or unpredictability. Such forecasts determine not only which outcomes are expected to happen, but also show those that are less likely to occur. Two types of model commonly used are the Mean Variance Covariance (MVC) models and the Economic Scenario Generator (ESG). The ESG model is the more suitable model to use because it allows for the sequencing of returns and the risk of a run of poor returns in the early years of drawdown (known as pound cost ravaging ). An ESG model has been used in this analysis to capture the randomness of markets, by running 10,000 possible future scenarios. This large collection of future forecasts not only shows which outcomes are most likely, but what range can be expected as well. In this report we have shown the outcome at the 25th, 50th and 75th percentiles. The higher the percentile, the better the outcome. So 75th percentile means that only 25% of simulations delivered a better result. 25th percentile means that 75% of simulations were better. 50th percentile means that half of simulations were better and half were worse. Let s explore the effectiveness of each strategy in turn: Unit cancellation Strategy 1 Fund 100% invested (net of charges) Units encashed to provide income Income Using this approach units are cancelled when income is required. In this example, enough units are cancelled each month to provide an annual income of 10,000 or 5% of the initial fund. The benefit of this approach is that the fund is fully invested. In rising markets this should be an efficient strategy, but there is no flexibility to mitigate the impact of market falls. If markets fall, more units must be sold to generate the required income, giving rise to sequence of returns risk. In short, there is no wriggle room. 35% 15% 7

8 Chart 1: In only 50% of the simulations does money last for 25 years or more The probability of living this long 75% 50% 25% 75 Money runs out in 40.6 years Percentile years 25.8 years Years Looking at Chart 1 above, our stochastic model suggests that there s a 50% chance that the fund will last around 25 years to age 90. Mortality statistics tell us that 50% of men aged 65 will live to 90. Most people wouldn t feel reassured knowing that there is a 50% chance they could live to age 90, but only a 50% chance that their pension fund would last this long. And if they do live this long, there is unlikely to be much of a legacy to leave behind. In 25% of the simulations, the money could last for 40 years, which would create potential for a legacy or the ability to increase income over time to combat inflation. Conversely, in 25% of cases, the money could run out in around 20 years, at which point there is a 75% chance that our male aged 65 would still be alive (and an even greater chance that a woman would still be alive at this age). Overall, there is a reasonable likelihood that the fund could last a lifetime, but there is unlikely to be a significant legacy to leave behind in most cases. Of course, in practice an adviser may make changes to this, or other strategies to adapt to changing circumstances. This could include reducing income, changing the investment strategy or annuitising part or all of the fund. Feature Unit cancellation* Fixed income Longevity of income Combat inflation Access to capital Legacy potential Score 0-5 (5=high) *We have rated the effectiveness of each drawdown strategy across five features which correspond to client needs. Scores are between 0 (low) and 5 (high). 36% 8

9 Drawdown Strategies Unit cancellation with cash buffer Strategy 2 Fund 100% invested (net of charges & minus cash buffer) Cash buffer (2 years income) Income The obvious problem with the first strategy is the rigidity of the process. Units are cancelled regularly to provide income, but without any flexibility to ride out or manage periods of poor or negative returns. To try and combat this, we tested an alternative strategy that used cash to mitigate the impact of poorer years. Two years worth of income is held in cash ( 20,000). This means that units are only encashed every two years, which should reduce the volatility. Holding two years worth of income as cash is intended to provide ballast to bring greater stability to the process. Unfortunately, the results were poorer than the previous strategy (though not by much). Chart 2: The results are poorer using the cash buffer The probability of living this long 75% 50% 25% years Percentile years 55% years Years Intuitively, using cash to manage volatility seemed sensible, but the results often produced poorer outcomes. 83% 9

10 The key lesson from this is that while some form of cash buffer could help protect the fund when markets are falling, significant market falls without a relatively quick recovery are rare. This strategy involves holding cash, which currently delivers low returns. In the first strategy, all of the money is fully invested until it s required for income, so this strategy delivers better results in most cases. Keeping money in cash mostly has a detrimental impact on the fund s ability to sustain income. Of course, there are particular circumstances where the cash reserve could prove worthwhile, but our analysis suggests that overall it is a sub-optimal strategy in terms of maximizing returns. Nevertheless, if the objective is to eliminate volatility, and the client would rather forego the potential for a higher return in exchange for the flexibility to manage unit cancellation in falling markets, this is an invaluable strategy. And there are many people who would feel very comfortable with this proposition. As the money is likely to last for fewer years there will be a smaller legacy if any to leave behind, whichever of these strategies is adopted. Feature Unit cancellation + cash Fixed income Longevity of income Combat inflation Access to capital Legacy potential Score 0-5 (5=high) Living off natural yield/income Strategy 3 Fund 100% invested (net of charges) Income payable from natural yield Income 9% 10

11 Drawdown Strategies Next we explored solely living off the interest, dividends and income generated by the fund. This has the advantage that sequencing risk is almost entirely eliminated because income isn t being taken from capital (although capital values can be eroded by market falls). The key attraction of this strategy is for people who want to leave as much as possible after they die. It s also one of the few strategies where an income is virtually guaranteed to be paid for life (though the amount of income isn t guaranteed). Chart 3: The capital value is significant even after 40 years 350, ,000 Fund value 250, , ,000 25th percentile 50th percentile 75th percentile 100,000 50, Years At the 75th percentile, the capital value increase steadily, even though all of the dividends or any interest paid has been stripped out to provide income. And in 50% of cases, the capital value isn t eroded significantly. Chart 4: Income is linked to performance 30,000 Annualised monthly income 25,000 20,000 15,000 10,000 5,000 25th percentile 50th percentile 75th percentile Base annuity Years The key drawback with this approach is that the income is less than the previous examples and will vary from year to year. It s also less than the income provided by a guaranteed annuity represented by the horizontal line (though eventually income does exceed the amount payable from an annuity in many of the simulations). If the amount of income is important - and needs to be a regular amount each year, this strategy is unlikely to appeal. 11

12 Feature Living off natural yield/income Fixed income Longevity of income Combat inflation Access to capital Legacy potential Score 0-5 (5=high) Longevity tail risk Annuity pot Strategy 4 Fund (net of charges) Circa 15-20% of the fund Income Fund split into 20 pots (minus annuity pot and charges). Investment pots provide income to 85, then annuity purchased. This option is more complex than some of the others but may represent the most balanced approach. A pot is set aside to buy an annuity at age 85. The amount set aside equates to around 15 20% of the fund. This pot will have 20 years growth and will also benefit from mortality cross subsidy which can be considerable at older ages. That means a relatively small amount put aside now can buy a reasonable-sized annuity at age 85. An assumption is made about how this money will grow over time. The balance of the fund is then split into equal parts to provide income each year over the 20-year period. The income received each year is variable depending on the performance of the fund. The starting assumption is an annual income of 7,500. An important point to note, is that it is easier to manage a fund over a fixed period of time than over someone s life expectancy which is unknown. The key risk with this strategy is that investment returns are low over the period and annuity rates worsen, so the fund set aside to buy the annuity fares badly. There are ways to mitigate this. Using a protected fund can provide some degree of reassurance that, whatever happens in investment markets, there is protection against significant market falls. For example, the Protected Index Portfolio protects money so that it can never fall below 80% of the highest value it has achieved. 12

13 Drawdown Strategies Chart 5: This strategy ensures a guaranteed income for life 30,000 Annualised monthly income 25,000 20,000 15,000 10,000 5,000 25th percentile 50th percentile 75th percentile Base annuity Years Interestingly, this strategy starts with a lower income than an annuity bought at outset (which is represented by the horizontal line), but in most simulations exceeds the income from an annuity bought at outset in around years. When the annuity is eventually bought at age 85, it also provides an uplift in income in most cases (though it remains level after this period). Feature Longevity tail risk Fixed income Longevity of income Combat inflation Access to capital Legacy potential Score 0-5 (5=high) Annuitisation Of course, one alternative is to buy an annuity from the start. Annuities provide peace of mind, a guaranteed lifetime income and far greater flexibility these days to protect family and leave a legacy through a greater range of options on death. The disadvantage of buying an annuity is the inability to access capital or vary income. The legacy potential of an annuity can be improved by extending income guarantees for up to 30 years, and income can be escalated each year to combat inflation, but both of these options will reduce the initial income. Feature Annuity Fixed income Longevity of income Combat inflation Access to capital Legacy potential Score 0-5 (5=high)

14 14

15 Drawdown Strategies Conclusion There is no silver bullet. No one strategy that combines the best of all worlds. There are, however, strategies that excel at meeting different needs. The composite table (chart 6) demonstrates the efficacy of alternative approaches. If you re looking for a secure guaranteed fixed income for life, nothing compares with an annuity. If a higher income is your requirement, and you are prepared to take risks, then unit cancellation may work. If leaving a legacy is your number one concern, living off the natural yield or income is the best option. Longevity tail risk may provide a balanced approach offering a reasonable prospect of an income for life, that may increase over time, as well as the prospect of leaving a legacy. Of course, people s needs are rarely that straightforward. Some will want the highest income they can get plus access to their money and the potential to leave a legacy when they die. Other people may want a fixed guaranteed income, but also want to access their funds from time to time and protect their loved ones after their death. The answer in any particular situation may depend on the weighting or relative importance people assign to different objectives. Chart 6: Objectives can be met by using the right strategy Fixed income Longevity of income Combat inflation Access to capital Legacy potential Unit cancellation Unit cancellation Longevity tail + cash Live off yield risk Annuity Note: Scoring 0-5, where 5 equals high 15

16 To give an indication of which strategy is likely to be most successful in meeting each objective, the chart below illustrates the most effective solution. Chart 7: Different strategies work well for different objectives Objective Fixed income Longevity of income Combat inflation Access to capital Legacy potential Combination Solution Annuity Annuity Unit cancellation or Live off yield Live off yield Live off yield Longevity tail risk This suggests a single objective. In many instances, clients will have multiple objectives. Someone who is interested in longevity of income, an income that is fixed income and the potential to leave a legacy may well consider longevity tail risk. It competes well on these three features. Independent research we recently commissioned showed that advisers use many of these strategies to produce optimal outcomes for their clients. For example, two thirds use a cash buffer of some sort frequently, over half use a natural yield strategy to produce income and around a quarter of the advisers we surveyed use longevity tail risk and annuitisation often for their clients (see chart 8). It s also important to consider that it may not be possible to provide the oversight required to manage these strategies for people with smaller funds. For these people, some form of packaged solution or protected funds that require much less monitoring and managing are likely to be more economic. Chart 8: Advisers often use a variety of strategies for different needs 75% 66% 66% 53% 31% 24% 23% Fixed monetary amount taken as income Low volatility funds Cash buffer Natural yield Fixed number of units taken as income Keep money aside to buy annuity later Annuitisation 16 Source: Decumulation Strategies, Opinimum, August 2017

17 Drawdown Strategies Finally, we looked at the rate of sustainable income under each of these strategies that would provide a 95% level of certainty that the income would last for 25 years to age 90. The results are shown below. Interestingly, they are similar to the Morningstar report on safe withdrawal rates published in This report concluded that the 4% rule, which was based on US data, isn t borne out using UK data. Unfortunately, safe withdrawal rates in every case fall short of the 4% rule (ignoring the annuity of course). Living off the natural yield comes closest followed by longevity tail risk (though this does rely on partial annuitisation at 85). Chart 9: Only the annuity is 95% certain to pay an income over 4% Income Unit cancellation 3.31% Unit cancellation + cash Live off yield Longevity tail risk 3.32% 3.82% 3.75% Annuity 5.19% As more people choose drawdown, it s important that we learn the lessons from Australia and the US if we are to avoid a retirement crisis. Relentless improvements in the treatment and diagnosis of otherwise terminal medical conditions means life expectancy is likely to continue to increase. In less than 20 years from now estimates suggest there will be over 100,000 people aged 100 or more in the UK 11. Increasingly, people should start to consider planning for a retirement that could last over 30 years. It is our hope that this analysis contributes to the work in this area to deepen our understanding of how different strategies meet different needs. We owe it to the people who rely on us as an industry to do all that we can to make retirement as comfortable as possible. One day it will be our turn. 11 Number of Future Centenarians by Age Group, April 2011, DWP 17

18 Stochastic Modelling We hope that the illustrations presented here shine a bright light on some usually obscure features of retirement plans and demonstrate how stochastic modelling can transform retirement planning. They highlight the important differences between approaches, allow subtle comparisons and, most of all, give straight answers to sharp questions like Will I run out of money? We think there should be more stochastic modelling in retirement planning. To be fair there is lots already: any modelling that involves or allows for uncertainty is stochastic modelling. But we think a bit more ambition could help everyone. Much of what gets done is too limited in how much of reality it tries to take into account and too narrow in what it seeks to show. For example, projections at high, medium and low rates of return are a form of stochastic modelling. The modelling that goes into setting the representative rates must be quite elaborate and up to date if the results are to have any relevance. However, the rates are usually fixed so such projections are silent on the effects of asset allocation for instance. The good news that there are well tried tools that allow the extension of stochastic models far enough to usefully address retirement planning issues. Models which address more features are inevitably bigger and calculating with them is more work but that work comes with a bonus. Calculating with big models usually involves Monte Carlo simulation and that in turn usually involves building an Economic Scenario Generator or ESG (Monte Carlo simulation is a bit like averaging outcomes found by rolling a dice and an ESG is a big electronic dice). Once you have an ESG you can use it to answer many more natural questions and draw pictures that raise and answer questions that would otherwise not have been asked. Known but hard to pin down issues like pound cost ravaging are easily addressed. The projections in this report are a taste of what can be done with stochastic modelling. With the right tools, it can deliver clear answers to natural questions and give investors a fuller understanding of their situation. If you re interested we can help. Jack Evans Asset Consulting Director EValue 66% 18

19 Drawdown Strategies Appendix I We surveyed advisers to find out their attitudes to drawdown and what methods they used. The results are shown below. How likely are you to recommend an income drawdown solution (rather than an annuity)? 120% 100% 80% 60% 40% 46% 73 % 98% 98% 98% Likely Unlikely 20% 0% -20% -2% -2% -2% -40% -27% -60% -54% -80% 50, , , ,000 1,000,000 Size of pension pot How often do you recommend the following in an income drawdown portfolio? 120% 100% 80% 78% 94% 72% 60% 40% 40% 20% 20% Often 0% -20% -40% -22% -6% -28% Not often -60% -80% -100% Low risk funds Medium risk funds Managed/ governed portfolios -80% Protected or guaranteed funds -60% Cash 33% 19

20 What proportion of active and passive funds do you typically recommend for drawdown clients? 60% 50% 49% 40% 30% 20% 10% 0% 2% 9% I don t use this 2% 6% 10% 0% 1-25% 13% 23% 26-50% 34% 8% 51-75% 39% 5% Over 75% Active funds Index funds How often do you use the following methods when deciding on a withdrawal rate in drawdown? 120% 100% 80% 60% 40% 20% 75% 66% 53% 23% 24% Often Not often 0% -20% -40% -60% -25% -34% -47% -80% -77% -76% -100% Unit cancellation Cash buffer Natural yield Annuitisation Longevity tail risk 20

21 Drawdown Strategies How often do you review client portfolios? 3 yearly 1% 2 yearly 3% 6 months 14% Annually 82% 65% 21

22 22

23 About Retirement Advantage Drawdown Strategies Retirement Advantage is a well-established company that can trace its roots back to We provide those who are in, at or approaching retirement with a range of simple, secure and flexible products to suit their needs. Every year thousands of retirees rely on us for their income. We have over 2billion of funds under our management, and a heritage dating back over 160 years. In January 2018 Retirement Advantage became part of the Canada Life Group (UK) Limited. Canada Life shares a similar heritage, and just as importantly, places the same emphasis on providing outstanding service to customers. Canada Life has operated in the United Kingdom since Today the Group offers life insurance, critical illness cover, retirement planning, annuities, investments and inheritance tax planning, looking after the needs of thousands of individuals and companies. Canada Life is itself part of Great-West Lifeco, with over 30 million customers worldwide and 760 billion in assets under administration. As part of Canada Life, Retirement Advantage has more capability than ever before to help customers feel better equipped to make the most of their retirement. Our awards The Retirement Account, our leading solution for customers who want to take control of their income in retirement, is the most innovative retirement product to appear in recent years. That s why Retirement Advantage has swept the board in industry innovation awards. But we re not just about innovation Retirement Advantage also scooped the Financial Adviser 5 Star Service award for Life and Pensions, recognised throughout the industry as the gold standard measure of service. And over the last ten years, our Equity Release products and services have been recognised time and again for their innovation, quality and value for money. The Retirement Account In 2015 we launched the pioneering Retirement Account. It combines a Guaranteed Annuity, a Pension Drawdown facility and a Cash Account, all held within a single tax-advantaged wrapper written under Pension Drawdown rules. Contact us To find out more about The Retirement Account, or our range of other products you can contact us on or alternatively us at sales@retirement-advantage.com 23

24 Telephone calls may be recorded for training and quality monitoring purposes. Retirement Advantage is a trading name of MGM Advantage Life Limited. Registered no Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Retirement Advantage and the Retirement Advantage logo are trademarks of MGM Advantage Holdings Limited. Registered in England and Wales. Registered office 110 Cannon Street, London EC4N 6EU /18 24