Mass market drawdown is seen as the solution to fill the hole left by annuities. Emma Wall finds providers grappling with the volatility issue
The average UK pension pot is worth £30,000. It may not seem like much – but imagine if every single person in Britain aged 55 or older decided to take their £30,000 out of their retirement savings scheme this April. Suddenly those thousands multiply at an alarming rate, and start to look like an almighty headache for pension providers.
Of course, it is unlikely that pension savers will request all their cash at once, after all only 25% of the drawdown is tax-free and no one wishes to give HMRC more than necessary. But it is predicted that millions will flow out of pension schemes in three months’ time, and providers have had less than a year to facilitate these outflows. Much like the pension charge cap announced by pensions minister Steve Webb in the autumn of 2013, it is another case of the City frantically playing catch up with Westminster.
Providers looking to get into managing pots through retirement face the challenge of designing investment strategies that have the liquidity to provide their scheme members with large chunks of cash at little notice, while still delivering growth and even income past their retirement date. According to the Office of National Statistics, around 85,000 people aged 60 today are expected to survive until 100 years old. Post-retirement pension schemes are therefore potentially catering to an investment horizon similar to that of a member in the growth stage of pension saving – up to 30 years or more.
Delivering capital growth alongside capital preservation with a consistent level of liquidity is no easy task.
Barclays Corporate & Employer Solutions Head of DC Pension & Investment Consulting Lydia Fearn believes the design of the solution will be entirely dependent on whether each DC member had a final salary pension with a small DC pot and is looking to simply have more flexibility with regards to when and how they draw the cash from their DC pot or whether the member is reliant on their DC pot as their main pension income in retirement.
“Those who fall into the first category will be wanting largely capital preservation with any growth at least maintaining the buying power of their savings – in other words protection against inflation,” she said. “Members in the second category will need their fund to give them a living pension as well as offer growth to maintain longevity. Both these strategies mean very different investment portfolios and objectives and providers will need to consider where there is demand and which they can deliver most effectively. If a mass market drawdown solution aimed at individuals in category two were to be offered it would be a complex strategy to define.”
Nest chief investment officer Mark Fawcett his organisation is currently consulting on how to help their members access suitable retirement solutions – the issue is not so pressing for Nest because it has no members with assets of any size yet for who such a solution would be relevant. “One of the challenges the industry faces is that of balancing what savers might ideally want or expect with what is realistically achievable. Our consultation is looking at whether there are ways of combining some of the security of annuities with some of the flexibility of drawdown products, but you can’t have it all,” he warns.
Fawcett expects the solution to combine elements of volatility management, liability driven investment and even conventional or deferred annuitisation, but admitted that the provider “didn’t have the answers yet”.
“This is an entirely new landscape that requires real innovation,” he continued. “The solutions the industry develops will be of critical importance to millions of people in old age so this thinking really needs to be given the time and consideration it deserves to get it right.”
AllianceBernstein’s Getting Budget Ready report surveyed defined contribution pension savers approaching retirement, finding that three in 10 did not know when they were going to retire. Of those that knew the age at which they would retire almost 60 per cent planned on making lump sum withdrawals on retirement to pay off debts, self invest or treat themselves to a holiday. A third planned to keep their money in their pension scheme and take a reasonably regular income, while 6 per cent wanted to keep their money invested in the pension scheme for growth.
AllianceBernstein head of pension strategies David Hutchins says that for investors seeking an income a multi-asset fund approach where the income paid is from a combination of investment returns and either capital growth, dividends or bond coupons would be the best option. AllianceBernstein’s Retirement Bridge Income Funds offer income-seeking investors a home for the savings accrued in their Flexible Target Date Funds on retirement.
“For someone wanting an annuity like income but without its limitations, a well-diversified fund invested across a range of equity and bonds split broadly 35 per cent equities and 65 per cent bonds would probably make sense,” Hutchins explains. “What we would not recommend is to constrain their investments by seeking only investments that pay high dividends or coupons. This approach will almost certainly lead to the investor taking far more risk than they might be aware of.”
As well as these natural income solutions where the regular is delivered in the form of true income, in the form of equity dividends or bond coupons, Schroder head of investment solutions John McLaughlin suggests that protected drawdown solutions could be suitable for maturing DC members.
“Such solutions might promise a pre-defined level of capital drawdown over a specified time period such as 5 per cent per annum, paid monthly until age 80, while retaining a degree of growth potential with the objective of also delivering a final unguaranteed lump sum to the investor – that could for example then be used to buy a standard annuity at the much more attractive pricing offered to an 80 year old,” he explained.
Aegon investment director Nick Dixon says the insurer also anticipated these types of schemes to be popular, allowing investors to stay invested with potential for market growth, with a guaranteed minimum income, but unlike the old annuity model, investors can easily exit this strategy and invest elsewhere.
Despite this prediction, Dixon says that Aegon has not developed detailed thinking on mass drawdown solutions.
“As a platform provider we enable drawdown through our ARC and One Retirement services but we tend to leave it to advisers and their customers to develop the asset allocation that is right for them,” he said.
However, the insurer did announce last month that the introduction of a new default lifestyle approach, which moves savers into multi-asset investments, rather than gilts, as they near retirement. It is likely these multi-asset schemes will continue run post-retirement for members who choose to stay invested.
Alongside both natural income solutions and protected drawdown solutions, McLaughlin suggest asset managers and insurance companies collaborate to deliver individualised products that deliver a certain drawdown payment for life – combining the protected drawdown solution with the promise to purchase a deferred annuity.
While it is only a matter of weeks before the new freedoms take effect it could be many more months before a broad range of drawdown options targeted at the mass market starts to emerge. Advisers and trustees will, until there is some change in approach from the regulators, still want to keep recommendations of mass market drawdown at arms length, for anything other than on an advised basis, but this looks like an area that is set for rapid development in the coming year.
What Can We Learn from the US?
In America many 401(k) plans are invested in a target date fund that allows them to leave their money in their investment strategy after the member retires. The money is allowed to grow tax free, but the drawdown restrictions differ dependent on the provider.
“The US has a structure of which splits capital into three buckets – growth, income and cash. The growth part is the invested and the individual is aware that this can rise and fall in line with investment returns. The income part is there to provide some certainty of income in a similar way to an annuity and could include a guaranteed product,” explains Fearn.
“The cash part of the strategy is there for short term needs or emergency access should the member require access to capital at short notice. The split could be determined by the risk profile of the member or even based on a required level of income but gives people more flexibility.”
The concern with these types of strategies is the cost – individuals want greater certainty of income in retirement, but these solutions can be expensive to administer and unlikely to comply with any charge cap, similar to that for DC default options. Fearn expects however, that some individuals may be comfortable with higher fees in return for the greater certainty of income.
Fidelity Worldwide Investment head of retirement Richard Parkin expects there will be a range of investment solutions put forward for drawdown and believes some of these will focus on minimising costs. He added that a diversified approach could be best achieved through active management where costs are higher, but investors should expect better performance in return.
“As well as investment costs, the costs of operating income payments are not insignificant and it may be that some firms struggle to operate within DC charge cap levels, particularly where there are fixed fees,” he said. “As always, we believe the focus should be on achieving the customer’s goals not just finding the cheapest product on the market.”