Cherry Reynard explores hybrid products that combine drawdown and a guaranteed income, and compares them to the alternatives.
Taking an income in retirement is often seen as a binary choice: either opt for the security of an annuity or choose to stay invested in financial markets through a drawdown product, thereby sacrificing security for greater growth potential. However, neither in itself may be appropriate for a recent retiree whose financial needs may vary considerably over the course of a 20-30 year retirement.
Moreover, neither may be appropriate for the prevailing investment environment. Annuity rates have moved a little higher over recent months (a 65-year-old could expect to buy a level annuity of around £5,190 from a £100,000 pension pot), but they are still at near-record lows at a time when rising inflation is eroding purchasing power. Bonds still look expensive and may suffer as interest rates rise. Meanwhile, the stock market is risky, although it can at least provide an income and some inflation protection.
The dilemma facing retirees has not gone unnoticed by the insurance companies, who have tentatively been launching guaranteed drawdown or ‘third way’ products. These are designed to combine the flexibility of drawdown with some element of guarantee, thereby giving investors – in theory at least – the best of both worlds.
Fiona Tait, a pensions specialist at Royal London, says: ‘The two main types of product sit somewhere between an annuity and full drawdown. There are annuities with flexibility, and there are drawdown products with a guarantee of some kind.’
Guaranteed drawdown products are also called unit-linked guarantees – the guaranteed income is linked to unit (investment) growth. The mechanics are fiendishly complicated, but in essence, there is drawdown functionality with guarantees built in. This type of product is currently being offered by Aegon, MetLife and Prudential.
The guarantee used to be available on any underlying investment, but Richard Parkin, head of pensions policy at Fidelity International, says most providers have pared this back in recent years, and guarantees are now only available to overlay a relatively conservative investment strategy.
The other main option is a third-way annuity. This is where ‘naked’ (non-guaranteed) drawdown is mixed with either an annuity or guaranteed drawdown within the same product. There is flexibility and connectivity between the two. For example, the guaranteed income can usually be paid into the drawdown account. These are offered by Aegon, MetLife (guaranteed drawdown plus drawdown) and Retirement Advantage (annuity plus drawdown).
The problem with all these products is that the guarantee comes at a cost. Tait says: ‘There will be a trade-off. As soon as a guarantee is added, the management cost of a product goes up, because there is more work to do to manage the guarantee. There is also an indirect cost: the provider needs to invest in such a way as to not lose too much money.’ This means investing in lower-risk, lower-growth assets.
Tait adds that Royal London has looked seriously at introducing a product of this type, but has consistently found that the cost of the guarantee is too high to do so.
A recent report by consultancy the Lang Cat assessed the various options in terms of the return on investment they would have produced over the past 25 years. An annuity would have produced a total return of £116,000, compared with £336,000 from drawdown. The guaranteed drawdown and third-way products would have returned £259,000 and £226,000 respectively.
It is worth noting that in terms of income alone, guaranteed drawdown produced the highest payout (£167,000), compared with £116,000 from an annuity and £135,000 from drawdown. Third-way options produced £125,000.
Whether investors will deem this a good return or not will very much depend on their perceptions. Some will feel they have done better than they would have done with an annuity in one of the blended products and are therefore up on the game; others will look longingly at what they could have got from drawdown.
A substantial chunk of the return from drawdown in the Lang Cat’s study was left in the pot at the end to be inherited. Again, retirees may or may not be pleased about this, depending largely on whether or not they have children.
As every investor knows, past performance is no guarantee of future returns. The relative merits of each type of product will depend on the performance of stock and bond markets. If stock market performance in future is similar to performance over the past 25 years (high returns with the occasional crash), drawdown will probably provide better returns. If the stock market goes nowhere, annuities will turn out to be the better bet.
PRICE WORTH PAYING
The cost of the guarantee that comes with third-way products will vary. Parkin says: ‘Guarantees tend to cost more when interest rates are low. Many third-way providers will vary the guarantee rate in line with the prevailing interest rate, so the rate will reflect what is going on in the broader annuity market.’ If interest rates go up – which is plausible in a climate of higher inflation – these products may look more compelling.
The Lang Cat report recognises that for some retirees, whatever its cost, the guarantee will be worth paying for. It says: ‘When we kicked off [the paper], it was with a reflexive “meh” – guarantees are expensive, and clients wouldn’t go for them if they saw the cost. After the exercise, we still think they’re expensive, but once you get in and start doing the modelling across economic cycles, you can start to see how they work. There is no reason why guaranteed drawdown shouldn’t form an ever-greater part of the retirement planning landscape.’
The report concludes: ‘Unless a client is aggressive in their attitude to risk (and has a high capacity for loss), we believe an alternative to full naked drawdown exposure has to be considered. That includes guaranteed drawdown, which is designed to offer potential for capturing market growth.’
It makes the point that retirement is not just about the final monetary outcome, but also about how people feel along the way. Some people are unconcerned by market volatility, while others want security for at least some of their income. There will be those who want a bit of both and those views change in retirement.
It’s tempting to wonder whether investors might be able to achieve a third-way outcome without paying for an explicit guarantee. Indeed, Tait argues that much the same outcome can easily be achieved by combining an annuity and drawdown.
She says: ‘Many retirees have several pensions – the average person has around seven jobs in their lifetime. They could use one of their pensions to buy an annuity, which is still the cheapest form of guaranteed income. They can then use their other pensions to invest flexibly.’
Those lucky enough to have a defined benefit scheme can use that and the state pension to secure what they need to live and pay bills, while keeping their options open with their remaining income for different periods of their life. Advisers often suggest retirees have a greater need for income at the beginning and end of retirement. At the beginning they have plenty of energy to splash out on exotic holidays and take up expensive hobbies, while at the end they may need costly residential care. Tait points out that drawdown income can be switched on and off to meet these needs.
Parkin’s rebuttal is that investors retain access to their funds with a third-way product. With any annuity, the money is lost the moment someone dies (except in exceptional circumstances). Someone buying an annuity and drawdown still loses half their pot if they die early. ‘With a third way fund, you still have access to all of your outstanding fund should you wish to cash it in.’
Parkin points out that these are complex products. He says it is therefore right that they are only available through advisers, rather than mainstream investment platforms such as Fidelity FundsNetwork, Interactive Investor or Hargreaves Lansdown. The mechanics of how the guarantee is provided are also complex and require a skilled adviser to untangle. There are few third-way products on the market, a sign perhaps that the skills required to put them in place are too specialist for most.
At the moment the third-way market is a niche one, and many retirees are achieving a similar effect with a combination of drawdown and annuity. However, as pension freedoms bed down and investor preferences become clearer, third-way options may become more commonplace. Ultimately, it may not be money that matters most to retirees, but peace of mind.