As we all know, the pension freedoms turned the industry on its head.
Suddenly annuities were cast as a prison cell from which clients had been freed and, for those who resisted the urge to blow their life savings on a Lambo, drawdown has become the mainstay of funding retirement.
However, as drawdown becomes the norm, the real challenge for advisers is we move from the world of accumulation where we’re largely focusing on risk in terms of investment volatility, to a world where we’ve got two dimensions of risk.
On the one hand we have investment volatility, and on the other there is the impact the withdrawal rate has on the pension pot. Prior to having the conversation about their client’s retirement journey, advisers need to understand how those two components operate together. What underlies both is the uncertainty of how long the client will live and so how long the money needs to last for.
The traditional way of managing this added dimension of risk is to identify a so-called sustainable withdrawal rate. That is, a rate of income that can be taken each year, and increased with inflation, while giving a high degree of certainty that the client won’t run out of money before they die. But this approach, while 'safe', can have a significant cost for clients.
Sustainable withdrawal rates are invariably built on very high levels of certainty, sometimes up to 90 per cent. This means most won’t run out of money, but consequently a huge number of people will leave a lot of money on the table; in a reasonable number of cases more than they started with.
The 'cost' for clients is not having the retirement they could have done because they were too frightened of running out of money.
In fact, the notion that someone is going to sit there for 20 to 30 years continuously taking out the same amount of money each month, when markets have either gone for or against them, is quite simply ludicrous.
For a start, retirement spending patterns are unlikely to require a steadily increasing retirement income. Many will want more money in the early years of retirement and less as they get older and less able to spend it.
Secondly, pretending that people won’t need to adjust their income requirements as time goes on, ensuring they either don’t run out of money or leave lots on the table is denying the nature of drawdown. It’s like me buying a Lamborghini but driving it at 30 miles an hour in case I crash.
Actively managing income
The challenge and opportunity for advisers is helping clients understand how fast they can drive, or how much income they can take, while staying safe. Advisers also need to think about how clients will manage if they do crash.
The first of these challenges will involve actively managing income levels as market conditions develop. While this can be done by starting at a low income and increasing it if markets do well, this may not meet a client’s spending pattern.
It's likely to be necessary to start off at a reasonable speed and recognise this may mean having to brake a bit harder down the road if markets don’t perform. For those that aren’t able to accept varying income one has to ask whether drawdown is the right product in the first place.
The second challenge is much more difficult, and advisers may not yet have access to all the tools they need to manage this.
Providing a financial backstop if retirement savings do run out may mean turning to housing equity or buying a later life guarantee. Equity release is becoming more accessible but deferred annuities seem to be unattractively expensive.
The key is getting this backstop in place before the client needs it. Much more work needs to be done around how backstop arrangements can be integrated into retirement planning at the outset.
One area of advice that seems underdeveloped is getting a better idea of how long clients are likely to live for. Understanding this seems a fundamental part of retirement planning, yet research I conducted with NextWealth over the summer suggests few advisers attempt to do this.
This inevitably means planning to a longer time horizon than may be necessary, with a consequent reduction in retirement income. Of course, any such assessment will still have a margin of error. But it should allow a much more informed decision about how much income can be taken and the likelihood that any backstop arrangement will be needed.
With non-advised drawdown providers being pressed by the FCA to provide better solutions for their customers, advisers will increasingly need to demonstrate how they can add value in retirement.
Providing a tailored, actively managed income solution is the obvious way to do this and will ensure clients really do get to enjoy the retirement they saved for.