By Mike Morrison, November 2012
I have spent a lot of time on the road in the last few weeks, seeing advisers and speaking to them about market issues. Apart from the obvious subject of the retail distribution review, some of the most popular questions have centred on retirement income, and what I think about the possibilities of future reform to the income drawdown market.
The background is pretty clear. Quantitative easing and other macro-economic pressures have resulted in falling gilt yields, putting continued downward pressure on annuity rates and, of course, the benchmark gilt yield used for the calculation of income from drawdown.
Add to this the problem of investment performance that is often flat (at best), the revised Government Actuary’s Department rates in 2006, and the removal of the 20 per cent uplift in 2011 (implemented when the new GAD rates were introduced), and the result is that many people are now facing a massive reduction in income.
It has always been the case that income drawdown is an investment product with a degree of investment risk, and that individuals who want absolute certainty may find that an annuity is, perhaps, a more suitable product. However I would imagine that the investment risk that most advisers had made their clients aware of is that of underperformance by the chosen investments, and not the risk of GAD rates falling so dramatically.
As I mentioned before, the generally accepted alternative to drawdown has been an annuity but falling gilt yields have also meant falling annuity rates. When you add to this the often spoken about, but rarely quantified, effects of Solvency II, the vagaries of the Test-Achats ruling, and the growing take up of ‘enhanced’ annuities, the prognosis for annuity rates seems poor.
This means that drawdown has probably been used by more and more people, pending that elusive increase in annuity rates. Increases in longevity have been much publicised and retirement is now no longer a one-off date, but is potentially a 25 to 30-year period. Would people really lock into annuity rates that are at an all-time low?
We have reached a point where, in many circumstances, the maximum income available under capped drawdown is lower than the equivalent annuity, and yet it seems that people are not currently buying annuities. This suggests to me that the choice depends on more than just income levels.
The GAD rates for drawdown still rely on an annuity-based benchmark. This was all right when annuity rates were at a higher level and there was some ‘compulsion’ to buy an annuity, but is it now time to move away from this?
So far it appears that the official response from the Treasury has been a rejection of any review of the rules, due to the concern that funds could be depleted too quickly. This raises an interesting question: if gilt yields had not gone down and we were still at around, say, 4.5 per cent (a rough estimate of the average for the past few years) then would there have been issues with fund depletion?
As an industry we tend to be very good at articulating the problems, but are often accused of not putting forward ways to solve them. So, with a view to offering up a possible solution, the rest of this article provides what we feel could be a real alternative to the existing rules.
Any pension policy must be designed from an objective point of view, taking into account the individual client’s needs, while also balancing the needs of the exchequer and prevailing public policy.
The combination of the drawdown rules introduced from April 2011 and the continued reliance on 15-year gilt yields as a means of calculating maximum drawdown income have caused an imbalance between the need for risk mitigation and the flexibility which drawdown is perceived to offer. This seems to have been a consequence of the rapidly falling gilt yield, which could not have been foreseen and which is, to some extent, an unintended consequence of current economic policy.
The introduction of flexible drawdown in April 2011 gives us an indication that, from a public policy perspective, the government’s intention is to minimise any risk of individuals needing to fall back on state benefits because of excessive fund depletion.
The minimum income requirement is deemed to be sufficient, with the option to draw down any excess at the prevailing rate of tax. In theory an individual could draw down and spend the whole fund but, in reality, this seems to be a rare scenario and most of the inquiries I have had look at tax-efficient retirement planning.
Under capped drawdown, has the risk of fund depletion been overstated?
In 2011 research carried out by the Pensions Policy Institute highlighted the risk of fund depletion. It warned there was a real risk of fund depletion if individuals took out 100 per cent of GAD. However in ignoring the protection offered by triennial and annual income reviews, the research was fundamentally flawed. The moral hazard in these groups is unlikely to lead them to spend all of their fund and, subsequently, fall back on the state.
One possible solution, or a starting point, is based on the simple premise that there is an increased risk of individuals falling back on state benefits if they hold pensions valued below a certain figure. When they hold pensions above this value, the risk decreases and greater flexibility in drawdown income can be afforded to them. If their pensions fall below this value, then the additional flexibility is removed and they fall back on the basic rate.
In theory, an individual could draw down and spend the whole fund but, in reality, this seems to be a rare scenario, and most of the enquiries I have had look at tax-efficient retirement planning.
While these rules could operate in tandem with flexible drawdown, they could also offer a simple alternative to it.
This is a broad framework and there will be a few administrative issues to be considered, including, but not limited to:
From a political perspective this could well lead to enhanced tax revenues and increased spending as it seems that pension savers want to draw more taxable income than they can at the moment, and it normally only makes sense to draw funds if they are to be spent.
Retirement income is becoming increasingly important and must work for all concerned. For many people drawdown will not have worked on an investment basis due to poor investment performance, but it will have maintained flexibility and control. Annuitisation might be the end of the retirement journey but people must be able to, and want to, get to that end.
Mike Morrison is head of platform marketing for AJ Bell
Any solution must meet the following criteria: