Steve Lewis: Probability-based or safety-first? The retirement income conundrum

A probability-based approach to retirement income still has its place, but pension freedoms mean a safety-first model is more important than ever says LV= head of sales and market Steve Lewis

Steve Lewis LVThe advent of the freedom and choice reforms has radically changed the pensions landscape and presented new challenges and opportunities, both for advisers and consumers. Many of the safety nets inherent in the previous regulatory system have been removed and so it is important that we all now recognise that what was long accepted practice for retirement planning may no longer be appropriate.
The market needs to engage in a rigorous debate about the different approaches that can be taken to meet client needs and provide retirees with a safe, secure retirement income. There are different approaches to retirement income planning, and everyone should be aware of what these are and let the client know which path is being taken.
The two main approaches to retirement income planning are the traditional probability-based approach and the safety-first approach. While neither approach is right or wrong, the role of safety-first has grown in importance since the freedom and choice reforms were introduced and the risks of advisers making the wrong recommendation have increased.
Last week we published a paper that highlights the pros and cons of the two approaches.
Our concern is that advisers may not have been able to adapt their processes quickly enough to keep up with the rapid pace of change. From our conversations with advisers, we know that many continue to follow the long-established probability-based approach. While some advisers will be using safety-first, our research with advisers found some gaps in people’s knowledge. Less than one in five advisers said they are confident they know the meaning of safety-first and 46 per cent had never even heard of it.
As the vast majority of advisers will be aware, the traditional probability-based approach bases the chances of running out of money in retirement on historical statistics. Using the Monte Carlo models, it’s about estimating the chances of running out of money in the face of market and longevity risks, and planning accordingly.
In contrast, the safety-first approach focuses on the individual and aims to remove, or significantly reduce any risk to essential income. It has its origins in the actuarial profession and so focuses on eliminating or mitigating risks of an individual outliving their income in retirement. This approach is based on the assumption that retirement income planning should focus on individuals and not on the historical data or group statistics. It distinguishes between essential expenses and discretionary expenses and aims to eliminate any risk to the essential income.
Historically, the UK pension system had an in-built safety-first mechanism in its legislation and regulation. Prior to the introduction of the freedom and choice reforms, Government Actuary’s Department rates and the minimum income requirement on drawdown were essentially designed to provide a baseline income that would last a lifetime. In addition, most clients had some sort of defined benefit pension and guaranteed annuity as part of their income mix.
Now, we are in a completely different environment and advisers will be reviewing their retirement processes to ensure that they can use the right approach with each client. Using only a single method could have negative consequences for advisers’ businesses, as well as their clients. Indeed it may be appropriate to use the probability approach today, with a shift to safety-first in later years, or the shift to safety-first happening as market volatility risk increases.
I believe a safety-first approach should be considered for all clients as the basis for gaining flexibility without losing the security of essential income, including through the use of a blend of products. However, the probability-based approach may be right for those with more capital where there is also a clear preference and appetite for investment risk. Therefore, it is important advisers are aware of the different philosophies and can explain to clients when and why they have decided to take a particular approach.
As an industry we need to review how it is that two years after pension freedoms we are seeing individuals with relatively small funds entering into income drawdown or UFPLS arrangements. Previously, many advisers would not have recommended a client with less than £100,000 to enter drawdown but now we see this as a common occurrence. We believe this needs action now as, with thousands retiring each week, it’s clear we have months, not years, to get this right.