What is the “nastiest, hardest problem in finance”? The challenge of calculating how much someone could take from their retirement portfolio without running out of money, according to Nobel prize-winning economist and inventor of the eponymous ratio Bill Sharpe.
Now it seems the FCA has weighed in on the question of how to solve this problem — at least indirectly.
You can see the FCA’s thinking on the issue from its Defined Benefit Advice Assessment Tool instructions. It’s all about the various things to consider when advising on DB transfers, but there is a very clear read-across to its thinking on taking income from pensions.
The instructions say advisers assessing whether a client should transfer funds from a DB pension must find out their “attitude to transfer risk”. This is “the client’s behavioural and emotional response to the risks and benefits of giving up ‘guaranteed’ benefits (or safeguarded benefits) for those which are flexible and not guaranteed”.
Trade-off
The read-across to the choice between buying an annuity and taking drawdown is clear. It is almost the same trade-off between wanting a guaranteed lifetime income and wanting flexibility. You might call it ‘attitude to drawdown’. With so few advisers now doing DB transfers, this is the main significance of these instructions to the wider advice community.
An annuity provides a guaranteed set lifetime income regardless of how long you live, uncorrelated with the stockmarket and not normally requiring any investment management, bother or expense. But an annuity is inflexible and indeed irreversible.
In contrast, drawdown allows you to have access when you need it, scope for investment growth depending on how the market goes and possible freedom from inheritance tax. But it involves the bother and expense of managing the process and the investments, possible losses and the chance you will run out of money before you die.
This isn’t to say an annuity and DB pension income are exactly the same. Plainly they aren’t. For example, unlike most annuities people are likely to buy, the income from a DB pension is more or less protected against inflation. But there is an obvious analogy.
What is more, many DB transfer decisions turn out to be all-or-nothing choices — the whole transfer value has to be transferred, or none of it. The options are nothing like so binary with the annuity-versus-drawdown decision and clients can choose some of both solutions.
The obvious strategy is to analyse clients’ expenditure between core and discretionary — at least at its most basic — and consider annuitising the income to cover core spending and using flexible drawdown for discretionary needs.
The FCA is keen for advisers assessing the merits of DB transfers to probe their client’s attitudes very carefully and methodically. The same would be true of the drawdown-versus-annuity question.
The regulator is especially keen for advisers to ask a good balance of questions that would elicit a range of responses from different clients, and that they don’t ask the sorts of question that would lead clients to answer in a particular way.
Simple tick-box questions about flexibility and tax efficiency are unlikely to pass muster. The adviser should challenge their client to think clearly about what they really want. Why does the client need such flexibility to meet essential spending patterns? What about the chances of losing out towards the end of their life? Will the client want to manage their money over the whole of a very long retirement?
Flexibility and certainty are competing needs — clients must think about their priorities.
The key risks to think about with DB transfers — and they are broadly the same for deciding on the balance between drawdown and annuity solutions — are:
- Investment risk — clients will have less income in retirement than they expect because of lower-than-anticipated investment performance
- Longevity risk — clients will run out of money before they die because they have previously drawn unsustainable amounts
- Inflation risk — clients will find rising prices erode the value of their capital and therefore their sustainable withdrawals.
There is also the risk they are no longer able to cope with managing their affairs.
It is hard to see how clients and advisers can evaluate these choices and have meaningful discussions about retirement without some kind of cashflow modelling. It won’t give a precise forecast of the future, but it will get both parties to think about the probable outcomes of their choices and make better decisions.
Danby Bloch is chairman of Helm Godfrey and head of editorial strategy at Platforum
Ultimately, how does the adviser know what is in the client’s head.
Secondly, the adviser does not have a crystal ball.
Thirdly, the more detailed and complex the FCA make things, the more expensive advice becomes. Not all clients are UHNW.
Has the FCA bothered to undertake or commission any historical analysis to establish how many properly constructed and regularly reviewed portfolios have ever burned out as a result of drawing down 4 or even 5% p.a. of their value? I’ve never seen it and I think it highly unlikely that any competent adviser would recommend a higher rate.
The consequences for those who select a higher rate without taking advice are not with the FCA’s purview so it shouldn’t be wasting its time and other people’s money fretting about them, other than perhaps to lobby for a change in the law mandating that those who wish to draw down at a higher rate than 5% p.a. must take advice (or prove impaired life expectancy).
To David Bennett’s post above, I would add: How does the FCA expect ever to achieve the objectives of the FAMR which, after five years of fruitless and costly messing about, has to date achieved absolutely nothing?
Well it all hinges on the definition of risk, doesn’t it?
Is it a risk to the income in drawdown?
Is it a risk to capital in drawdown?
It can’t be a risk to capital otherwise annuities would be banned.
Looking at the risk to income, the FTSE has never failed in any year to deliver a positive income return. One might suggest that the stockmarket’s past income returns are indeed a fairly good indicator of future returns.(Yes, we’re not suggesting a single equity as a suitable portfolio).
Proctor & Gamble has not failed to pay a dividend each year since 1892. The UK government has defaulted on gilt obligations twice in that period.
It’s not one-size-fits-all solution, however for many retiree investors the demonstration of income flows – without guarantee – goes much further to aid real client understanding than the continued error of conflating income and capital returns.
As a proportion of global share capitalisation, the UK stock market, by value, represents just 4.1% and although most of the companies that comprise it (esp. the FTSE 100) have, overall, always delivered a dividend, the picture when it comes to capital values is very much less rosy.
This is Money (albeit almost a year ago) suggests that, over the preceding two decades, the collective value of the companies that comprise the FTSE 100 index is/was down in value by 20%.
And what about Bonds? They surely need to make up a fair slice of any income-generating portfolio.
Far too many investors are far too focused on and thus weighted in the UK. Anyone investing in a FTSE 100 UK tracker fund in the expectation of achieving long term growth are almost certainly likely to be disappointed. Even allowing for Virgin having reduced the AMC of its FTSE 100 tracker fund to 0.6% p.a., it’s still way over-priced for what it delivers. It trades largely on its name.
When it come to this debate I talk less about risk and more about sovereignty..
You see
Buy an annuity and sovereignty over your pension funds passes to the insurance company AKA “the provider”
Drawdown you retain sovereignty over your funds ….
Now look at this from a clients perspective …when you and your spouse die…your hard earned cash passes to the provider, if there is any left ? odds on there will be. The alternative is when you die most if not all your funds remain in your estate, well upto 75 anyway.
Now the only risk is the totally inadequate barrier of 75 which either needs to be extended to 100 or removed altogether !
This is not the only reason that annuities are a practical choice, but it is a big one !
Hi Danby,
What I think is lacking in this discussion is the relative value of the investments underlying the options and the risk/reward ratio in relation to that relative value.
You and I can remember when gilt yields were 15%. Of course inflation was high. But a return to “normal” gilt yields (where the Bank of England is no longer artificially depressing them) would swing the balance much more in favour of annuities. As a retired IFA living on drawdown, I would certainly look again at purchasing an annuity.
However while gilt yields are artificially depressed – and it looks as though financial repression is here for the foreseeable future – the theoretical attraction of annuities is much reduced by the practical consideration that they produce a very poor return.
Annuities now don’t look great value compared with annuities taken out 20 or 30 years ago when interest rates were much higher – along with inflation – and we lived rather shorter lives. But that’s the wrong comparison. You need to look at the current alternatives. It costs quite a bit more to use any other investments to provide the same guaranteed lifetime income as an annuity.