Broadening the retirement toolkit

Innovations from other markets where annuities are not the norm give clues to where our market should go, says Birthstar head of research Henry Cobbe

The new pension freedoms mean that investment objectives have changed. In most cases, it’s unlikely to be a simple choice between cash, drawdown or annuity but more of a combination to match a member’s needs, requirements and aspirations.

The freedoms mean that proposition design and choice architecture within and without the workplace pension context needs to be refreshed. For corporate advisers wishing to offer individual advice, this creates a tremendous opportunity.

Instead of considering accumulation to an annuity, financial advisers must now consider retirement outcomes – income replacement and adequacy rates, sustainable withdrawal rates, life expectancy and legacy decisions. This means creating a ‘life cycle’ framework for combining future income, current portfolio, life insurance and annuity choices to optimise asset allocation over time and consider not only investment risk but mortality and longevity risk too. While none of these considerations are new to advisers, the responsibility for managing them is. Innovations from other markets where annuities have long ceased to be the mainstay of retirement income are increasingly relevant in the UK.

We are moving from ‘to’ to ‘through’. Lifestyling pensions are managed to a retirement date typically targeting annuity conversion. Target date funds can be managed through retirement, targeting sustainable withdrawals from a balance of stability and growth.

The target date is not an end date but a start date for the drawdown phase; it is the turning point where investors move from making regular contributions to making regular withdrawals. The investment objectives gradually pivot from making a pot grow before retirement to making it last in retirement, sustaining a durable income. They are not a silver bullet but form part of the retirement toolkit alongside cash, the state pension and other guaranteed income.

Partial annuitisation will become more prevalent. Annuities’ key feature is to provide guaranteed income in old age until death. That was generous in 1928 when the pension age was 65 and the average age of death was 67; now it’s a stretch as, happily, we are all living longer.

Partial annuitisation may have a role to play to top up other guaranteed incomes, like DB benefits and the state pension, to help cover a client’s essential spending in retirement. So while most retirees in the UK take 25 per cent cash/75 per cent annuity, about 19 per cent of retirees in the US take some form of annuity, with optimal allocation considered to be 25 per cent annuity/75 per cent drawdown on average.

Traditional annuities and enhanced annuities would both be termed in the US as ‘immediate’ annuities because they start paying out at point of purchase. What we don’t have yet in the toolkit are ‘deferred’ annuities, which start in the future to do what annuities were originally meant to do: form a perfect hedge to longevity risk.

By combining target date funds with a progressive purchase of deferred annuities, there is scope to get the best of both worlds: a managed portfolio to draw down over time and a longevity hedge for later life, when longevity risk is an insurance worth having. We encourage UK insurers to offer deferred annuities to broaden the retirement toolkit.

In the trust-based market, we are already seeing the emergence of glidepaths, pathways and signposts to help navigate the new freedoms. Glidepaths represent the investment strategy over time; pathways represent the product journey over time. A default pathway might mean owning a target date fund until aged 65-70, then using it as a self-managed or trustee-managed drawdown solution for income until aged 70-80, and then offering partial annuitisation from 80 onwards, ensuring that a residual legacy pot passes tax-free to the next generation.

The key aspect is that both the glidepath and the pathway are appropriate for a scheme membership that does not want to engage in active choice. Over-reliance on engagement and active choice as cognitive ability declines is noble of providers but unhelpful to members, as large-scale studies show.

What is essential is that for those who want active choice there is very clear signposting to appropriate and properly governed options, whether on an advised or non-advised basis and whether within a scheme or outside it. Corporate advisers have a key role to play in working with providers – asset managers, insurers, master trusts and platform providers – to bring those innovative solutions to market.