A flexible retirement portfolio is key to changing income needs

A range of drawdown or annuity options are available to cater to the changing income needs and tolerance for investment risk of clients over the different stages of their pension lifecycle, writes Fiona Tait (pictured), Business development manager at Scottish Life.

A lot of attention has been given to the introduction of legislation allowing flexible drawdown from pension savings, but this is only one of the options available. What do the choices look like after the 6 April 2011 changes, and how do they fit together?

There is a strong argument to suggest an annuity should be the last option. This is because annuities sit at the far end of the risk/reward spectrum. As savers get older, they will generally seek to reduce investment risk to protect their remaining (and probably dwindling) assets.

In this context, a shift from equities towards gilts can be achieved not just by altering the balance of the overall investment portfolio, but also by a shift from equity-based to gilt-based products.

By considering the annuity first, the retirement option decision becomes annuity versus other options. If the annuity is an end point, the decision is no longer whether to buy an annuity but when.

For the majority of clients, this may still be at the point they retire, but as longevity increases, more will seek to put off this commitment, or at least to spread it out over a period of time. 

The retirement process: early years

For many people, retirement is no longer a one-step process. They do not go from working full time one week to not working at all the next, but may reduce their hours over a period of a few years. During this period of partial retirement, their income may be made up of a mixture of salary and pension income. It is also likely that they will be spending more than in later years as they remain in good health.

Middle to later years

As individuals move into middle retirement age, their income needs become less. Those who reach their 90s are likely to face long-term care costs, leading to a sharp increase in their income requirements.

This creates an m-shaped pattern of income requirements over time.

Income drawdown

Income drawdown is suitable for those who are looking to take income but either do not need the maximum possible amount, or who wish to be able to vary their pension income to suit their circumstances. This makes it ideal for the early years of retirement.

Clients with the possibility of spending 30 years or more in retirement will find it increasingly difficult to predict how their income needs will change over the years. Income drawdown allows clients to choose, within limits, the amount of income they wish to take each year, and to vary this amount when their circumstances change.

Because the pension fund is still invested, there is the opportunity to improve the income that can be taken, providing the client is prepared to accept investment risk. Once again, this makes it more suitable for younger retirees. 

Pension unlocking

For some, the first stage in retirement is not about income at all. Legislation allows clients to access their pension commencement lump sum (PCLS) from age 55 without having to take any income. They are then able
to pay off debts and/or give financial support to their families if it is needed.

Capped drawdown

Capped drawdown is the 2011 equivalent of the income drawdown option. There is a maximum income limit, based on the Government Actuary’s Department (GAD) drawdown tables. This limit is designed to stop individuals who do not have a guaranteed income of £20,000 to fall back on (see flexible drawdown below), from taking too much income and running down the value of their pension fund too quickly. On 6 April, the income limit was reduced from 120% to 100% of GAD limits, partly to help funds last longer.

Capped drawdown is suited to providing ongoing income over the longer term, but with some flexibility to adjust income levels to suit the client’s changing needs. 

Flexible drawdown

Since 6 April, it has been possible to access a form of drawdown that does not have an upper income limit, providing the minimum income requirement (MIR) can be met. The MIR has been set at £20,000 and is designed to ensure individuals who withdraw large amounts from the pension plan have enough income left to live on without resorting to state support.

Flexible drawdown can be used to provide greater amounts of income during the years when expenditure is greatest, in the early days of retirement or when long-term care fees are needed.

The lack of any upper income limit means the client can withdraw the entire pension fund. Some clients will find the prospect of having their whole fund back to spend as they like irresistible.

This freedom will have to be weighed up against the requirement to pay income tax on the non-PCLS part of the fund.

Delaying annuity purchase

Both flexible drawdown (assuming the whole fund is not withdrawn) and capped drawdown allow the client to delay annuity purchase until a time when their income needs might be more predictable, for example, when they know whether to purchase a spouse’s pension or when they qualify for better or even enhanced annuity rates.

After death, the pension fund survives and may be passed on to financial dependants in the form of an income or a taxed lump sum. The income option allows a taxed lump sum to be passed on to the next generation on the second death. The rise in the recovery tax charge from 35% to 55% will make this less favourable but, where a lump sum is the priority, it is still a benefit worth having. 

Annuities

Where a client depends on receiving the maximum income possible, an annuity is more likely to be suitable than a drawdown plan. Annuities are primarily designed to provide an income for life, and this safety and predictability is invaluable for many clients. The price of this predictability is that annuities are less able to evolve and adjust to changes during the client’s retirement.  

Conventional annuities

Often perceived to be poor value, some clients prefer to avoid conventional annuities completely. It should be remembered annuities provide the security of an income for life, however long the client lives. It cannot run out.

It has been suggested that annuities should be thought of more as insurance policies rather than investments. Once the decision to purchase the annuity has been made, the focus is no longer on how much money the client can make, it is about knowing how much they have to live on and not worrying about outliving their assets.

The level of income and the shape of the annuity are set at outset and may not be changed, which is why it is often a choice that is easier to make in later life when the client will also benefit from better age-related annuity rates. Alternatively, a degree of flexibility may be built in using different annuity products.

Asset-backed annuities

These allow clients to set a minimum floor of income and build in the opportunity to benefit from positive investment returns. These are suitable for those who would like to improve the level of income they receive over time, but do not want the risk of their income falling in value. 

Temporary annuities

These allow clients to fix their income over a shorter period of time, while leaving the remainder of the fund invested for growth. They allow the client to choose different annuity shapes as their circumstances change, which is ideal for clients who are unsure whether to purchase dependant’s benefits. 

Enhanced annuities

Enhanced (underwritten) annuities often provide significantly higher levels of income to individuals who are expected to have a shorter life span. This gives much better value than a conventional annuity where it is available. Some advisers suggest clients should avoid committing to an annuity until an enhanced rate is available to them.

The availability of more flexible forms of annuity could well increase as providers look for ways in which to manage their liabilities to meet new legislative requirements under Solvency II and the Gender Directive.

Portfolio approach

It is possible to use a number of different retirement options over time to meet a client’s changing income needs and tolerance for investment risk.

An alternative to the linear de-risking route is to use a blend of products to provide different income needs. A client’s basic income needs can be secured using a lifetime annuity, with more flexible solutions providing top-up income for less fixed requirements and longer term requirements.

This approach reduces the amount of income exposed to investment risk. It also ensures that a combination of flexible income and a guaranteed underpin may be available to those who do not qualify for flexible drawdown.

The vast majority of individuals will still be planning to buy an annuity, but for many it will be at a later stage, or possibly over a number of stages, in their lives.

Key points

• Income levels are difficult to predict over long periods of time in retirement.
• Clients can manage their income and de-risk their retirement assets by switching from income drawdown to annuities over time.
• Flexible drawdown may be used by those who can meet the MIR to take increased income in the years of greatest expenditure.
• Capped drawdown should provide long-term income, but with the flexibility to adjust to varying income needs.
• Asset-backed and temporary annuities provide a guaranteed floor of income with the prospect of benefiting from positive investment returns.
• Enhanced annuities can provide considerably higher income to people with impaired lives.
• A retirement solution involving two or more different product types may be the most efficient for many people.