INVESTMENT STRATEGIES FOR INCOME IN DRAWDOWN
The pensions freedoms introduced in April 2015 brought rapid changes to the retirement landscape. Perhaps the most noticeable was the sharp decline in annuity sales, as consumers opted for the flexibility of drawdown or chose to withdraw a tax-free lump sum and then defer the decision on what to do with the rest of their savings. But if annuities are no longer the default method of generating a retirement income, what is the best way of withdrawing pension savings? This issue has become a concern for the industry and for the Financial Conduct Authority.
In the Retirement Outcomes Review, the FCA’s study of the impact of pension freedoms, the regulator flagged poor outcomes for consumers as one of its biggest concerns. It found a significant number of people who opted for drawdown did so to access their tax-free cash and then made no further decision on what to do with their remaining pension pot. As a result, just under one third of new entrants to drawdown do not know where they are invested.
The FCA also found a significant number of savers are invested entirely in cash, and determined that moving from all cash to a mixed portfolio of assets could increase their annual income by 37%.1
To tackle poor outcomes for unadvised clients, the regulator has been consulting on whether pension providers should set up decumulation strategies, or investment pathways, to better help meet customer needs in retirement. It is also considering rules to make sure the only way for a customer to end up with all their savings as cash will be to make an active choice.
The problem of decumulation strategies is not just one for unadvised clients. The popularity of drawdown has also soared amongst advised clients. Many people with pension pots below the level traditionally seen as viable for drawdown are opting for the flexibility drawdown offers over the fixed income of an annuity.
There are number of ways of approaching the problem of determining the optimum withdrawal rate for a client in drawdown.
This is usually a trade-off between a client’s desired level of income, their financial situation (including other sources of retirement income), appetite for risk and the desire to pass on a lump sum to their beneficiaries.2
If we ignore clients who have moved into drawdown early to take a lump-sum cash withdrawal and wealthier clients whose use of a personal pension is entirely or mainly for inheritance tax planning, the need for an income is a delicate balance between the maximum income that can be generated given the timescale and outcome that the client is aiming for.
The so-called ‘safe withdrawal rate’ of 4% of the value of the funds invested every year has served as a default withdrawal rate for income drawdown for many years. But this is increasingly seen as a blunt approach that doesn’t take account of an investor’s desire or need for income, the timescale that the client is working to or their attitude to investment risk.
In its place, other investment strategies are increasingly being adopted which aim to produce the optimum level of retirement income. We run the rule over two of the most common strategies to highlight their advantages and disadvantages.
This is perhaps the simplest strategy for investing in drawdown. This strategy involves a client withdrawing only the income generated each year from share dividends, coupons paid on fixed income investments or bank interest.
The main advantage is that no investments are sold to generate pension income. The underlying assets may fluctuate in value in line with general market movements but, barring the complete failure of the investments, the pension fund will be there to provide an inheritance. Leaving the initial sum invested undisturbed also allows a fund to capitalise on any long-term growth in its value, helping to combat the effect of inflation.
Although this is a straightforward strategy and easy to articulate to clients, there are several drawbacks to relying purely on natural income. If a client has no other source of income outside of the state pension, then the drawdown pot needs to be substantial to provide a significant annual income. For example, the yield of the FTSE 100 hit an all-time high of 4.9% in early December but an investor would need more than £200,000 invested to receive an annual income of more than £10,000.
The second drawback to this approach is the variable nature of the income generated by natural yield. Company dividends can and do fluctuate depending on the company’s fortunes. Even if dividends remain the same in percentage terms, if the price of underlying assets drops then the cash value of the income generated also falls. This makes financial planning based on a client’s income needs difficult.
EXTRACTING A SET INCOME FROM TOTAL RETURNS
An alternative approach which provides more certainty of income, at least in the short term, is to make pre-determined withdrawals using a combination of yield and selling down a portion of a client’s assets.
This can allow a portfolio to benefit from greater diversification by avoiding the need to concentrate investments in high income producing assets.
This strategy also provides greater certainty for clients by pre-determining the annual withdrawal to be paid out, regardless of the amount of income generated by the investments.
This strategy allows for clients to receive a larger annual income than can be provided just from the yield generated by a portfolio and is also a relatively simple concept to explain.
This greater certainty for clients comes at the cost of the potential for the fund value to be eroded in years when the investment growth and income generated is lower than the pre-determined withdrawal.
This option also provides for some of the flexibility which has clearly attracted so many people to drawdown since 2015. Unlike an annuity, this offers the ability to vary the level of income taken from a portfolio each year and either increase or decrease the percentage withdrawn from the fund in any given year.
However, investors without other sources of income, or without a cash contingency fund, remain exposed to the risk of depleting their pension fund if markets fall over a sustained period of time.
In addition to the two investment strategies outlined above, there are a number of other strategies for producing the optimum retirement income in drawdown. These include using hybrid strategies such as ‘auto-protection’, which proposes a pre-determined withdrawal rate between 4% and 6% of fund assets, followed by automatic annuitisation at age 80 3. Another option is using a three pot strategy: establishing a cash fund to provide immediate income, then establishing two other investment pots with differing investment profiles to produce a combination of above-inflation growth and yield.
As Thomas Bernhardt and Catherine Donnelly point out in their recent review of decumulation: “There are many ways of solving the problem of how much to withdraw as income and how to invest savings in retirement. There is no solution that is appropriate for everyone and neither is there a single solution for any individual.” 4
Since April 2015, pension savers have shown a marked preference for the flexibility of income drawdown over the certainty of income provided by annuities. Defined contribution pot sizes are likely to continue to increase in size and pension savers are also likely to become more used to the choices available to them, as well as more aware of their income requirements. As a result, the investment strategies available are also going to need to evolve to continue to meet clients’ changing needs.
“ THE INTRODUCTION OF FREEDOM AND CHOICE IN PENSIONS HAS OPENED UP NEW WAYS FOR PEOPLE TO ACCESS THEIR PENSION SAVINGS.
“ HOWEVER, IT HAS ALSO OPENED THEM UP TO NEW CHALLENGES, COMPLEXITY AND RISK. SURROUNDING THE FREEDOMS, THERE HAVE BEEN CONCERNS ABOUT PEOPLE MAKING SUB-OPTIMAL DECISIONS WHICH HAVE THE POTENTIAL TO HAVE A SIGNIFICANT NEGATIVE IMPACT ON THEIR RETIREMENT OUTCOMES.”
The Evolving Retirement Landscape – Pensions Policy Institute,
1 Retirement Outcomes Review – The Financial Conduct Authority, June 2018
2 Evolving Retirement Outcomes – Pensions Policy Institute, July 2018
3 Auto-protection – Michael Johnson, Centre for Policy Studies, March 2017
4 Pension Decumulation Strategies, A state-of-the-art report – Thomas Bernhardt and Catherine Donnelly, Risk Insight Lab, Heriot-Watt University
Investment markets and conditions can change rapidly and, as such, the views expressed in this update should not be taken as statements of fact nor be relied on when making investment decisions. Forecast are opinions only, cannot be guaranteed and should not be relied on when making investment decisions.