Blending Drawdown and Annuity Income for better retirement income management

It’s time for advisers to look more seriously at blending drawdown and annuity income as retirement needs change and income guarantee requirements compete with the desire for exposure to higher growth asset classes.

One of the major impacts of Pension Freedoms is the increasing percentage of people moving into retirement who have elected to use an Income Drawdown policy as their primary pension decumulation vehicle, rather than purchasing an annuity which was the default choice for pension savers at retirement age pre-Freedoms.

We saw a dramatic plunge in annuity sales from 89,000 in Quarter 2, 2013 – about a year before George Osborne went public on Pension Freedoms, to 17,000 in Quarter 4, 2016 at the notional annuity market low point. Back in 2014, many predicted a 70-80% decline in the annuity market and that estimate was not far wrong as a healthy £11bn market in 2013 became a more slimline £4bn one by 2016 and 14 annuity providers fell to about six today.

Pension Freedoms’ strong “you no longer need to buy an annuity at retirement” message was unfortunately being trumpeted via multiple newspaper headlines across the land at exactly the time when annuity rates were operating at all-time lows, as rising longevity rates, prolonged periods of low interest rates and QE-inflated gilt prices, all worked together to suppress annuity rates.

People have mistaken low annuity rates as meaning poor value. No, if they are going to live longer and interest rates and inflation remain low, then their annuity income later in life gains value. So, the resulting fall in the starting level of income from an annuity is entirely consistent with this:

Source: SharingPensions.co.uk

Overall, standard annuity rates have fallen by about a quarter since March 2003. Lower interest rates and rising life expectancy remain key drivers behind falling annuity rates, despite slight rallies in recent months:

Source: Hargreaves Lansdown’s annuity quote tool.

Since the Pension Freedoms, the FCA has been keeping a tally of how many customers choose each decumulation option at retirement. The saddest thing about the chart above is that full ‘cash out’ withdrawal is by far the most popular option. Continuing to call ourselves the ‘pensions industry’ is fast becoming a misnomer.

Furthermore, the outlook for equities, we’re told by market observers, is heading for a period of greater volatility, so would-be retirees may be well-advised to search for greater exposure to the guaranteed income certainty that annuities offer.

It’s worth noting that right now 63% of Drawdown sales are advised, whereas only 28% of annuities sales are preceded by financial advice. Market pricing speculations aside, there are other very good reasons why retirees should in fact be advised on how to blend annuity with drawdown policies to meet their income and savings needs in retirement going forward. 

Let’s dig into this idea a little more. Firstly, it’s worth thinking about what your clients’ plans and needs are in retirement. Work with them to determine what essential income they need for day-to-day expenses in retirement.

That’s not just the standard monthly bills for electricity, TV, water, heating, shopping, council tax and keeping the car running; but also needs to cover other items that really need to be regarded as vital for one’s sanity - like a good holiday or two each year. Once these have been added up, you might want to see if these essentials can be funded out of an annuity to ensure the basics are definitely covered.

Also consider the type of annuity available. Level annuities cost a lot less than inflation-protected ones. So, combining a level annuity to cover today’s essentials with a drawdown plan to pay for the occasional bigger expenses makes sense. The real growth assets underpinning drawdown policies should also cover future cost increases in that basket of essentials as well as providing for lifestyle spending in retirement.

Amongst these lifestyle items, there may be some big ticket items which your client may not be able to put an immediate timeline or budget on. It may be likely that within the next 10 years your client’s daughter will get married. But who would have predicted she would want to stage that wedding in Costa Rica, more than doubling any estimated bill they might have factored in?

Drawdown policies are ideally placed for irregular drawing as these items pop up. They also offer the exposure to higher growth funds, so a good deal of lifestyle expenditure could be paid for from investment growth in the good years. You’ll need to arrive at a notional annual maximum drawdown amount that you recommend your client limits themselves  to in order to ensure that they do not run dry before their dotage.

In its March 2018 Policy Briefing, The Institute and Faculty of Actuaries recommended a sustainable annual drawdown rate of no more than 3.5% of the entire pot value, assuming decumulation starts at the current State Pension Age of 65. In this scenario, a £100,000 pot in Drawdown could deliver an income of £3,500 per year. In our Annuity AND Drawdown model, would £3,500 be enough to cover your client’s lifestyle expectations assuming they have £100,000 to put into an income drawdown plan after they’ve purchased that annuity to cover agreed essentials?

If they plan to start drawing their pension early, at say age 55, then the recommended maximum drawdown level drops to 3%. However, the actual sustainable income on an individual level depends on age, gender, life expectancy as well as investment type and performance. Therefore, advisers need to do a good deal of fact finding before deciding on each customers’ drawdown-based annual budget that they should try to work to. Aegon has previously proposed drawdown rates on a sliding scale of between 1.7 per cent to 3.6 per cent a year, depending on the risk profile and time period.

If the client has secured their essential income through a combination of State Pension, final salary pensions and annuities, then their remaining drawdown funds can adopt a higher risk profile than they could otherwise.

However, the reality right now, based on the FCA’s latest numbers, is that the average withdrawal rate from drawdown pots has increased from 4.7% in 2016/17 to 5.9% in 2017/18. More positively, the average pot entering drawdown has also risen from £105,000 to £123,000 over the last year.

If financial discipline and over-drawing down is a real concern, advisers might want to consider putting a large percentage of pensions savings into an annuity at the start of retirement – specifically enough to cover those standard essentials mentioned earlier.

Ideally, within your client’s drawdown policy, there is scope to leave a target amount for inheritance purposes as well. An adviser can help navigate these tricky decisions, determining how much is needed to live on, how much of a lifestyle cushion is comfortable and how much might be left on death for family, charities and other beneficiaries.

Advisers now have access to some pretty sophisticated tools to help ensure a drawdown policy doesn’t run out of funds early. FinalytiQ’s Timeline App is one such ‘sustainable withdrawal rate’ calculator which has a strong following in the adviser market. Don’t tell the FCA as they believe that past performance is no guide to the future! However, it uses masses of historical data to predict what the percentage likelihood of running out of money is - given pot size, retirement date, health and income level being extracted annually.

Advisers also need to be aware that clients tend to want greater income certainty as they get older and the prospects of going back to work to top up income shortfalls recedes. We also now know that, as we get older, our cognitive abilities diminish. Frankly, we are more likely to make poor financial choices without realising that we are exposing ourselves to greater risk as we get older. We are more vulnerable to pensions ‘liberation’ scams for example. In later life, clients don’t want to fret about the price of their weekly shop, or indeed the short-term prospects for their FTSE-100 or Nikkei shares.

So, as clients get progressively older, advisers ought to be suggesting steadily converting a larger percentage of the remaining pot into an annuity. At older ages annuity rates are of course more favourable. If any ill health has shown itself by then, full underwriting may well lead to an enhanced annuity with even stronger retirement income prospects.

Remember, there is no magic age to turn the rest of the drawdown into an annuity. A much better approach is to start with some annuity and to buy a series of further top-up tranches of annuity throughout retirement. That avoids the timing risk of major switches from drawdown to annuity. And the prompts for the next slice could be to take unrealised capital gains; seize a sudden lift in annuity prices; or simply that worsening blood pressure which will improve a fully-underwritten annuity quote. 

Used in this way, a gradually shifting combination of annuity and drawdown, provides a valuable de-risking service to the client. Remember, in retirement it’s not limiting volatility of capital values that really matters but limiting volatility of retirement income when clients are most dependent on that income in later life. Securing a long term stable income is the goal to achieve for clients once they’ve left the world of paid work for good.

Adrian Boulding is Chairman and Chief Innovation Officer at Spire Platform Solutions